Since the breakdown of the Bretton Woods system of fixed exchange rates in the early 1970s, monetary aggregates have played a key role in guiding Swiss monetary policy. The intermediate objective of Swiss monetary policy for 24 of the past 25 years has been to stabilize the money supply. However, the Swiss National Bank has recognized the limitations of following a strict monetary targeting framework and has, on occasion, set aside its monetary goals either to accommodate a shift in the demand for money or to counteract deflationary pressures caused by a sharp appreciation of the exchange rate. The resulting framework can be described as a “monetary policy rule with an escape clause.” In IMF Staff Country Report No. 99/30, Ketil Hviding of the IMF’s European I Department describes Switzerland’s monetary policy framework, considers its performance, and outlines a number of challenges the country will face in conducting its monetary policy in the future.
Switzerland, which became a member of the IMF in 1992, is a small economy relatively open to international trade. Perceived as a safe haven for capital, it is subject to large capital flows and is thus vulnerable to exchange rate pressures. A sharp appreciation of the currency, Hviding notes, could have adverse, and potentially long-lasting, effects on the economy. These considerations have at times given rise to pressures to abandon the monetary targeting framework and, instead, to use monetary policy to limit large exchange rate movements.
Monetary targeting framework
When the Bretton Woods system collapsed in the early 1970s, the Swiss authorities decided to float the Swiss franc. To achieve their medium-term goal for inflation of 1 percent a year, they intended to pare down the excess supply of money that had accumulated during the period of fixed exchange rates by slowing monetary growth from 6 percent a year in 1976 to 2 percent a year. In 1974, they announced a goal for the growth rate of narrow monetary aggregates (M1). Within three years of floating the exchange rate, the authorities had succeeded in bringing inflation down. As a result, according to Hviding, the early years of the monetary targeting framework were considered a great success.
In the late 1970s, the Swiss franc appreciated dramatically (in trade-weighted terms, the nominal effective appreciation amounted to about 80 percent), making the exchange rate a primary policy concern. In response, the Swiss National Bank suspended the monetary target strategy in the fall of 1978 and introduced a temporary floor on the value of the Swiss franc against the deutsche mark while imposing temporary capital controls. These measures, Hviding says, led to rapid monetary growth and caused the money supply to exceed the authorities’ target for 1978.
The sharp monetary expansion, in turn, created expectations of high inflation, which the Swiss National Bank countered in late 1979 by reintroducing monetary targets in place of the exchange rate floor. It also changed the targeted monetary aggregate to the monetary base (M0), which bank authorities thought would be less influenced by relative interest rate developments than M1 and thus easier to control. The goal—as it had been in the early 1970s, Hviding observes—was to reduce monetary growth gradually, from 4 percent a year in 1980 to 2 percent a year beginning in 1986. In fact, monetary growth fell far short of the target in 1980 and 1981, whereas for the next six years, actual growth came close to the goal in an environment of declining inflation and economic expansion. Because the real exchange rate and the Swiss franc-deutsche mark exchange rate were both stable, exchange rate pressures did not arise. Thus, the monetary targeting framework was not challenged and enjoyed a second “honeymoon.”
Difficulties emerge in late 1980s
In general, Swiss monetary policy has been successful in maintaining a low level of inflation and relatively stable growth over the past 25 years. However, its relative performance appeared to deteriorate in the second half of the 1980s, Hviding notes, as structural changes in the financial system made the demand for money increasingly volatile. He lists the introduction of the Swiss Interbank Clearing System—a new electronic interbank system based on real-time gross settlement—and changes in the reserve requirements for bank cash as two developments that sharply reduced banks’ demand for base money. A period of rapid inflation ensued, whose origins, Hviding observes, are open to debate. Between 1988 and 1996, the supply of base money fell short of the authorities’ medium-term target path and then significantly exceeded it when the authorities shifted to a policy of monetary relaxation.
Although Hviding suggests that the large shifts in demand for base money can be attributed to specific events, he notes that it is difficult to determine the size of the shifts and whether they are short term or whether they are more persistent. Moreover, their frequency has made other indicators of monetary conditions more important in the implementation of Swiss monetary policy since the early 1990s. In December 1997, for example, the Swiss National Bank indicated that it would use a broader definition of money (M3) as a monetary indicator for its 1998 policies. Although research shows that the demand for M3 is more stable than that for base money, broader monetary aggregates are highly sensitive to relative interest rate developments and to financial innovation. Thus, using a broader monetary aggregate is unlikely to prevent a shift toward using a still broader set of indicators, including short- and long-term interest rates, in the operational implementation of monetary policy.
Swiss monetary policy is likely to face many challenges in the future, Hviding observes, including the effects of the move to monetary union by Switzerland’s neighbors, the undiminished pace of financial innovation, and the large number and complexity of demand shocks.
The introduction of the euro had little effect on the Swiss franc, but, until euro notes and coins completely replace national currencies in 2002, the demand for the Swiss currency could fluctuate widely. Institutional investors seeking to diversify their portfolios could increase the demand for Swiss francs as several European currencies are replaced by euros. In contrast, as confidence in the euro increases, leading to currency substitution by Swiss firms and households, unexpected outflows of capital and downward pressures on the exchange rate could result. Currency substitution, he cautions, would add to the instability of money demand and further undermine the monetary targeting framework.
Hviding cites one approach for dealing with the effects of portfolio preference shifts, which was the subject of an earlier study conducted by IMF staff. It consists of timely monetary policy action, which would reduce the short-term negative effects on export industries of a currency appreciation, created by either a temporary or a persistent shift in portfolio preference. This active application of monetary policy could not, however, prevent an initial drop in output and could also increase consumer price inflation temporarily. Imposition of a temporary exchange rate ceiling would stabilize output as well as the exchange rate after some initial appreciation.
An alternative and—according to Hviding—radically different approach entails fixing the Swiss franc in terms of the euro, which would eliminate the currency risk involved in trade between Switzerland and the euro area. It would also result, however, in the removal of Swiss monetary policy independence. Monetary policy would effectively be determined in the European Central Bank, without regard to Swiss economic conditions.
A final alternative to the problem of portfolio preference shifts is an inflation targeting framework. It does not differ much from the monetary targeting framework that the Swiss National Bank has followed since 1980, but offers several advantages. It opens the way for a broader set of indicators to be used as the basis for monetary policy and is more forward looking. In such a framework, the authorities would have to produce an explicit medium-term inflation projection on the basis of developments in a range of factors, such as actual inflation, industrial production, business and consumer confidence, measures of capacity utilization, real exchange rate developments, and developments in monetary aggregates. This projection could then serve as an anchor for inflation expectations in the private sector.
Hviding notes that, despite its recent popularity elsewhere, such a framework has several problems. First, if actual inflation were to fall short of, or exceed, the authorities’ projection too often, policy credibility would be undermined, even if the central bank were to focus on “underlying inflation,” which excludes direct import price effects and other short-term effects, such as mortgage interest rates or consumption taxes. A dramatic change in the fiscal policy stance or other unanticipated events could affect the inflation outcome. Thus, setting a precise inflation goal could be counterproductive. A final complication of this strategy is the exchange rate. Large exchange rate movements could disrupt domestic prices, which could then cause actual inflation to miss the targeted level.
In his study, Hviding discusses monetary policy feedback rules—first proposed in connection with the U.S. Federal Reserve—as a starting point for monetary policy decisions. He considers these rules in the context of Swiss monetary policy, concluding that none of them fully captures the Swiss National Bank’s decision-making process. The estimations suggest, however, that the monetary policy formulation of the Swiss National Bank is not too different from that of countries that formally target inflation. The difference lies in how monetary policy is communicated to the markets and the public.
Copies of IMF Staff Country Report No. 99/30, Switzerland: Selected Issues and Statistical Appendix, are available for $15 a copy from IMF Publication Services. See page 180 for ordering information.