The Swiss National Bank May Need to Cut Its Target Rate Further Now That It Could Get In Trouble with the US If It Keeps Buying So Many Foreign Assets

The Swiss National Bank has been using two tools to keep the Swiss franc from rising more than they want: negative interest rates to discourage foreigners from purchasing Swiss assets and direct purchases of foreign assets by the Swiss National Bank itself. Within Switzerland, the purchase of foreign assets has been politically controversial because it exposes the Swiss National Bank to foreign exchange risk. (This controversy led to a referendum on whether the Swiss National Bank should be forced to hold more gold, that leaders of the Swiss National Bank went out on the hustings to defeat.) But negative interest rates are also quite controversial in Switzerland. 

Now the balance between negative interest rates and foreign assets may shift because the direct purchase of foreign assets by a government is (appropriately) part of the US's formal definition of a "currency manipulator." The Wall Street Journal article linked above explains: 

Mr. Trump vowed on the campaign trail to revive American manufacturing, in part by taking a hard line on Chinese trade practices and labeling the country a currency manipulator. ...

All three countries, which rank among the U.S.’s top five trading partners, have brushed off the Trump administration’s claims. ...

Still, some smaller economies appear to be taking notice, notably Taiwan and Switzerland. The U.S. Treasury in October found both had engaged in persistent, one-way currency intervention, essentially by buying foreign currencies such as the U.S. dollar and selling their own to maintain weak exchange rates.

Analysts say the central banks of Switzerland and Taiwan are now stepping back from those activities, perhaps to avoid closer scrutiny from the Trump administration. The upshot: The Swiss franc has advanced 1.6% against the U.S. dollar this year, while the new Taiwan dollar has surged 5%. 

In my view, the direct purchase of foreign assets by an arm of a government should be considered the defining characteristic of currency manipulation. There can be sound reasons for governments to purchase foreign assets, but such purchases are a fit subject for international negotiation. For example, it makes a lot of sense for countries that have sovereign wealth funds to have their sovereign wealth funds internationally diversified. But then it is reasonable for the governments of all nations (or strictly speaking, currency blocs) thus invested in to be allowed to directly invest amounts of equal value in the country with that sovereign wealth. Such countervailing two-way investments would neutralize the effects on the exchange rate between those countries.

One reason the direct purchase of foreign assets by an arm of a government should be considered potential currency manipulation is that as an aggregate demand management method, the purchase of foreign assets can be a zero-sum game. If I sell my T-bills to buy your T-bills and you sell your T-bills to buy my T-bills, then we can both wind up back where we started. 

By contrast, if you cut your interest rate, and I cut mine, we are not back where we started. Our two countries combined now have a more expansionary monetary policy. So a rule that allows interest rate cuts, despite their effect on exchange rates, but is suspicious of direct purchases of foreign assets by an arm of the government threads the needle of giving nations the tools they need for aggregate demand management without allowing zero-sum-game currency manipulation. 

(Note that well-done aggregate demand management through interest rate policy, by stabilizing output at the natural level, gracefully keeps capital flows induced by market forces to a manageable level. For example, unless the production capacity of the economy has increased, a capital inflow that reduces aggregate demand will then be matched by an amount of extra investment, consumption or government purchases that uses that raises aggregate demand and uses the local resources released by that extra capital inflow. As long as the extra investment, consumption or government purchases is of high-priority items, as a well-regulated free market would tend to insure, that shouldn't be a big problem.)