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Downwards and Upwards Drivers of Swiss Inflation

UPDATE with June 2013 data.

For many economists, monetary expansion and rising asset prices have an effect on price inflation. One of these economists is SNB’s former chairman Hildebrand. He showed in 2004 that a period of inflation had regularly followed the SNB’s monetary expansion in response to the rise of the franc.

Swiss consumer price inflation has not yet followed the path Dr. Hildebrand indicated. Even Dr. Jordan, his follower as chairman of the SNB, is not afraid of the risk when the central banks pegs the Swiss franc to a currency bloc currently in stagflation, the euro zone (see more on current stagflation).  With this move he has contradicted some statements he published previously:

The fixation of a nominal exchange rate would imply that Swiss inflation rate would not be equal to the European one, but even higher. The reasons are capital inflows into Switzerland, rising monetary expansion and increasing inflationary pressure. Dr. Jordan in 1999

During the 1970s, monetary targets helped the Swiss avoid the worst effects of the stagflation in the United States. Currently, however, the SNB seems not to care about monetary targets any more.

SNB Inflation Forecasts and current Swiss inflation

 

In the following we would like to know if and why Jordan and Hildebrand are right with their assumption that Swiss inflation remains subdued for the foreseeable future.

SNB Conditional Inflation Forecast June 2013

The most recent study of the Swiss Bureau of Statistics has reduced inflation forecasts for 2014 to 0.2%; this will affect the SNB forecast in its monetary accessment meeting on December 13th.

The following graph gives a quick view of where Swiss inflation is currently situated. The consumer price inflation (CPI) is still in negative territory on a yearly basis.

 (click to view more details)

Switzerland Inflation June 2013

The Consumer Price Index

The following are the details of the Swiss CPI of November 2012. Imported goods like clothes and footware, furniture and household articles, cars (inside “transportation”) and holiday packages (inside “culture and recreation”) have seen price reductions (see green color below) thanks to the stronger franc. Prices of services, energy, housing and locally produced goods have slightly increased in recent years. The deflationary effects on imported products is slowing. In June they were still at minus 3.9%, now at minus 1.6%.

 

Swiss Consumer Price Inflation November 2012 Konsumentenpreise Details

Swiss consumer price inflation November 2012 (source)

 

Downwards drivers of consumer prices

Still in November 2012, over one year after the lows in the EUR/CHF rate, there are many factors that continue to drive Swiss consumer prices downwards.

1) Slow price adaptation for imported goods

 

Imports make up 26.5% of the Swiss consumer price index. Apart of energy, especially clothes, foot ware, package holidays, cars, furniture and household articles are the main items. According to the Swiss price monitoring agency (page 4), import prices need up to one year to reflect 40% of the foreign exchange rate. The main reasons are the following:

  • Transfer prices for imported goods only adjust gradually and multi-national firms try to keep higher profits in Switzerland in order to pay lower taxes. Swiss retailers like Migros and Coop are often bound to Swiss franc contracts with these multi-nationals and cannot give FX rate changes directly to the consumers.
  • Retailers have long-term contracts, longer lasting production processes or purchased early. This and their bargaining power prevented a quick weakening of prices.
  • Many companies expected the EUR/CHF to rise again and waited before they gave FX rate changes to the consumer.
  • Some importers hedged the weaker euro, for example to EUR/CHF 1.29 via forward contracts. Due to this higher EUR/CHF rate they could not give cheaper prices in full.
  • Parts of the supply chain are still in Switzerland, e.g. the retailers who must pay rent, labour costs and high marketing costs are in the Swiss franc. We will clarify, if and how far the 26.5% import share is affected by this Swiss part of the supply chain.

Imported clothes, shoes, household articles and cars (under “transportation”) were still relatively expensive in 2010 and 2011 despite the stronger franc. The following table from the November 2010 consumer price index (still against the 2005 index) shows that prices for clothes and shoes (“Bekleidung and Schuhe”), transportation (cars and fuels, “Verkehr”) and household articles (“Hausrat”) were still relatively high.

Swiss CPI November 2010

Swiss CPI November 2010 (indexed to 2005 levels)

Finally, clothes prices fell by nearly 6% this year; apart from cars it was the main component that prevented higher CPI inflation

2) Car oversupply and weakening prices for existing inventory

 

During 2010 and 2011 car dealers thought about making big profits with the perceived “temporary” euro weakness. Large quantities of new and used cars were imported to Switzerland, which created an oversupply even in used cars of Swiss origin.  According to the price monitoring agency, car prices in August 2011 were up to 20% higher in Switzerland than in the euro zone, but until 2008 only 5 to 10%.

Subsequently prices for used cars that were still in stock, needed to be reduced. The price index for cars and motorcycles (4.1% of the CPI basket, part of the “transportation” category) stood at 99.4 in November 2010, the same value as in November 2009 despite the weaker euro and price reductions, that car dealers called the “euro bonus”. In November 2012, however, this index subcomponent of “transportation” has fallen down to 95.9.

 

3) Existing rental contracts: reference interest rate

Due to falling Swiss government bond yields and monetary easing, mortgage rates have fallen to record lows. By Swiss law, weaker mortgage rates must be reflected in the so-called “reference interest rate” for existing rental contracts. Based on the reference interest rate, Swiss tenants have the right to demand and receive a rent reduction for existing contracts. Even if many are reluctant to really do this, it helped to contain rising rents caused by higher real estate prices.

Changes in Swiss “reference interest rate” since 2008:

2.25% 02.12.2012
2.25% 02.09.2012
2.25% 02.06.2012
2.5% 02.03.2012
2.5% 02.12.2011
2.75% 02.09.2011
2.75% 02.06.2011
2.75% 02.03.2011
2.75% 02.12.2010
3.00% 02.09.2010
3.00% 02.06.2010
3.00% 02.03.2010
3.00% 02.12.2009
3.00% 02.09.2009
3.25% 02.06.2009
3.5% 03.03.2009
3.5% 02.12.2008
3.5% 10.09.2008

source: Swiss landlord association 

(click to expand)

Credit Suisse Hypothekarzinsprognosen

Development of Swiss mortgage rates and Credit Suisse forecast

Nearly every year, Swiss banks announce the “bottoming out” of mortgage rates. In 2009 Credit Suisse called for a bottom of 3.75% for fixed ten-years mortgages. In 2010 they saw rising rates coming: 10 years mortgages were at 3%.

In December 2012 they were at 2.04% and once again, CS calls it the bottom. With the European debt crisis whose full-fledged start was in 2011, we doubt that this is really the bottom.  For 2013, the ECB and other economists see lower inflation in Europe.

Lower rates, however, does not mean that one needs to delay the decision to buy a home: For us, the Swiss real estate bubble has just started and has another ten to fifteen years to go. With the counter-cyclical capital buffer, however, the SNB might require more capital from banks. A reason that rates might really bottom out in two or three years time.

 

4) Long-term rental contracts for businesses

Especially for Swiss businesses, rental contracts are on a long-term basis, e.g. over five or ten years. The landlord cannot increase rents for existing business contracts. On the contrary, a lower reference interest rate could theoretically reduce the rent (details here).

5) Owner-occupied rent missing in CPI 

Similar to the European HICP, the Swiss consumer price index contains only some smaller components of owner-occupied rent. Rising house prices are therefore not reflected in the inflation figures, but only via homes for rent.

6) European debt crisis and lower European inflation

The continuing European debt crisis, the weak ECB monetary transmission and weak growth in monetary aggregates in the euro zone put limits on European inflation and therefore on Swiss import prices.

Furthermore, a slower increase of peripheral wages, might slow down prices for imported goods: 10% of Swiss imports come from Italy, 3% from Spain.

Upwards drivers of consumer prices

 

1) Monetary expansion and capital inflows

In the introduction of this article, we discussed that monetary expansion leads to consumer price inflation. But it seems that this higher inflation has not come 2 or 3 years after monetary expansion, but has been delayed. Swiss M1 has risen by 100% between 2008 and 2012, the same as between 1994 and 2004; credit growth has also expanded by nearly 20% in both of these periods.

EMU vs. Swiss M3 Credit
 

2) Immigration into Switzerland

In the 1970s the Swiss decided to accept a far bigger revaluation of the Swiss franc. The USD/CHF rate fell from 4.35 to 1.55 in only eight years. Swiss GDP fell strongly because many foreigners left Switzerland. Today things are different: With the Swiss-European bilateral agreements, the smallest part of foreigners will leave Switzerland. Most of them are very well qualified,

Swiss Change Residence longterm
On the contrary, UBS even speaks of the “ten million Switzerland”, as compared to the eight million today.

3) Rising wealth

According to SNB data, in 2011 the net worth of households rose by CHF 128 billion, or 4.7%, to CHF 2,822 billion. Financial assets held by households climbed by CHF 24 billion to CHF 1,982 billion (1.2%), with the increase dampened by the decline in share prices in Switzerland and abroad. Overall, assets were up by CHF 153 billion to CHF 3,528 billion (4.5%). Liabilities – mainly mortgage loans – grew by CHF 26 billion to CHF 706 billion (3.8%). As a result, net worth per capita increased by around CHF 12,000 to CHF 354,000 (3.6%). Higher wealth, however, has the consequence that cheaper consumption prices are less important for consumers and increase the ability of sellers to ask higher prices.

4) Rising real estate prices and resulting higher rents 

The same SNB data shows that the rise in wealth was mainly due to increased real estate prices, with the market value of real estate owned by households growing by CHF 130 billion to CHF 1,547 billion (9.2%). When the tenant changes the landlord is then able to ask for a higher rent, which pushes inflation upwards.

5) Higher real wages and disposable income

Real wages are up 2.2% against last year, rents and other prices are rising far more slowly. Hence, disposable income is getting bigger. With the higher disposable income consumers are less sensitive to higher consumption prices.

6) Rising German salaries and imported goods from Germany

The majority, namely 38.5% of Swiss imports come from Germany.  German labour costs were rising by 3.4% per year in 2012. Swiss salaries have increased by 1%.
Update November 2013: Food prices in Germany are up 4% YoY, in Switzerland 1.7% and in France only 0.2%.

7) Collective bargaining

Another aspect of inflation is (collective) bargaining: Workers want to obtain higher salaries, either they negotiate a higher salary e.g. together with unions or more often they go for a different employment opportunity. Traditionally bargaining is much stronger in Anglosaxon countries, Southern America and Southern Europe than in Germany or Switzerland.

In many of Asians collective societies, in particular in Japan,  people stay longer at one job with the consequence that wage increases are smaller.

 

Summary

The following table compares the upwards and downwards drivers of Swiss inflation.

FactorDirectionHorizon
Slow price adaptation for imported goods after strong francslowing inflationshort-term (1-2 years)
Car oversupply, weakening prices slowingmid-term (2-5 years)
Existing rental contracts with smaller reference interest rateslowingshort-term
Missing owner-occupied rentslowingsystematic failure, in SNB secondary targets
European peripheral debt crisisslowingmid- (to long-term)
Monetary expansionhigher inflationmid-term to long-term
Immigrationhigherlong-term (> 10 years)
Rising wealthhighermid-term to long-term
Rising real estate prices, higher rentshighermid-term to long-term
Higher disposable incomehighermid-term
Higher German salaries, higher import priceshighermid-term
Low unemployment, (collective) bargainingHighershort-term to mid-term

 

It becomes clear that the short-term and some mid-term deflationary factors will be washed out in the next two to five years: Car prices, the weak reference interest rates and price adaptation of imported goods will continue to put downwards pressure on the CPI. How quickly this happens depends on the state of the global economy.

Over the mid- and long-term, in about three to five years, the factors that provoke Swiss inflation will be dominant. The SNB has set its inflation forecast for 2015 to values of close to 1%. The 1% threshold is for us the level when the floor should be removed. This inflation forecast also implies that the floor will not be raised.

Given that the strong inflows in the franc have stopped, the bank does not have a reason to impose negative interest rates, a measure with supposed low effects and big efforts. Capital will always finds its way.

According to UBS real estate index, prices are in the risk zone. Therefore the SNB might make steps to avoid an asset price bubble, which is part of the central bank’s official mission. They might finally establish the countercyclical capital-buffer. This measure would force banks to set capital aside for each loan, but would further reduce the capital basis of major Swiss banks.

We think that in three to five years time, Switzerland will reflect the German inflation rates: wages and labour costs will rise a bit more slowly than in Germany, but real estate and rents more quickly.

Should the floor still exist in ten years time, we agree with Thomas Jordan’s view of 1999 when he said “Swiss inflation rate would not be equal to the European one, but even higher.”

 

George Dorgan, snbchf.com

Disclaimer: The opinions expressed above are not intended to be taken as investment advice. It is to be taken as opinion only and we encourage you to complete your own due diligence when making an investment decision. Even if we often write about Forex trading, our advices aren't written for day traders who follow technical channels, but rather for mid- and long-term investors. Our aim is to show discrepancies between fundamental data and current asset valuations, which can lead in mid-term to an inversion to technical channels.
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