The International Consequences of the 1979 U.S. Monetary Policy Switch: The Case of Switzerland

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INTRODUCTION

When the news of a fundamental change in U.S. monetary policy hit the Swiss National Bank (SNB) in October 1979, its key officials welcomed the Fed's decision with noticeable sighs of relief. The SNB was pleased about the U.S. policy switch for two reasons. First, the Fed's unwillingness to take decisive action against inflation had complicated considerably the conduct of Swiss monetary policy. In particular, accelerating U.S. inflation had prompted worried international investors to sell dollar-denominated assets in exchange for other currencies such as Swiss francs. The ensuing sharp drop in the exchange rate of the U.S. dollar had upset the SNB's calculations and had undermined its efforts to achieve price stability without jeopardizing real growth of the domestic economy. second, the SNB hoped that the Fed's conversion to monetary discipline would help to convince other monetary authorities of the need to achieve low inflation. As a matter of fact, the 1979 policy switch, combined with similar developments in Europe and other parts of the world, thoroughly transformed the global monetary landscape. Most central banks now regard low inflation as the primordial objective of monetary policy. The beneficial effect of this change in attitude has been a dramatic fall in inflation in most parts of the world. In what follows, I will examine the international consequences of the Fed's policy switch in light of Swiss experience.

ACHIEVING PRICE STABILITY IN THE FACE OF A WEAK U.S. DOLLAR

In the second half of the 1960s, Swiss inflation began to accelerate in line with the worldwide surge in prices. Despite a strong desire to stabilize prices, the SNB was powerless in curbing inflation as long as Switzerland insisted on maintaining a fixed exchange rate. Furthermore, as the postwar system of fixed exchange rates began to collapse, Switzerland faced massive inflows of speculative capital triggered by expectations about a substantial revaluation of the Swiss franc and other European currencies against the U.S. dollar. Since the SNB could sterilize at best a small portion of the attendant increase in its foreign exchange reserve, the capital inflows led to an excessive expansion in the money supply, adding fuel to the already serious inflation problem. Notably in 1971, the Swiss monetary base expanded enormously.1 Not surprisingly, the year-on-year inflation rate, measured in terms of consumer prices, shot up to a peak of 11.9 percent in December 1973. The Swiss public regarded this development as a major calamity. In the past, persistently high inflation had never arisen during peace-time.

A realignment of exchange rates in 1971 provided only temporary relief to Swiss authorities. Another incipient speculative assault at the beginning of 1973 forced the authorities to float the exchange rate of the Swiss franc. As a result, the SNB acquired the ability to combat inflation through a tight monetary policy. Under the influence of Karl Brunner and other leading monetarists, it opted for a policy strategy of strictly controlling the money supply. The SNB was convinced that inflation was due largely to excessive money growth. For this reason, it decided to stabilize the monetary base at the level attained at the beginning of 1973. Toward the end of 1974, it adopted monetary targeting and allowed the money supply to increase again. At first, it announced annual growth targets for the money stock Ml and subsequently for the monetary base.

Since inflation remained at relatively high levels until 1975, keeping the monetary base more or less constant for over a year amounted to a very restrictive policy indeed. As monetarists would have predicted, inflation began to abate in due course and fell to a low of about 1 percent in 1977 and 1978. However, price stability could be restored only at the cost of a sharp temporary contraction in real activity, which was magnified by the negative effects of the first oil price shock on aggregate demand. …