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Monetary Policy Under Low Interest Rates: The Experience of Switzerland in the late 1970s

32nd meeting of the «Ausschuss für Geldtheorie und Geldpolitik - Verein für Socialpolitik», Frankfurt am Main, 16/17 February 2001 (revised version, 9 April 2001), 11.04.2001

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This paper addresses the problems arising from the conduct of monetary policy in a low-interest-rate environment. We examine a proposal advanced by Svensson in the context of the current debate on Japanese monetary policy. He recommends that the Japanese monetary authorities first devalue the Yen and than set a temporary exchange rate target, coupled with a permanent inflation target. In this manner, they could stimulate the domestic economy. Swiss monetary experience of the late 1970s and early 1980s sheds light on the question of whether Svensson's proposal is likely to work in practice. In 1978, after interest rates had already fallen to very low levels, Switzerland faced a threat of deflation, caused by an excessive real upvaluation of the Swiss franc. Considering the low level of interest rates, the SNB decided to react to this shock by pegging temporarily the exchange rate. While the SNB was successful in defusing the exchange rate problems, it could not prevent a resurgence of inflation. The existing literature mentions two possible reasons for the renewed increase in inflation: The SNB may have waited too long in returning to a floating exchange rate and/or its monetary targeting procedures may have been flawed. With the help of a structural VAR model, we explore the reasons for the SNB's failure to preserve low inflation. We determine the policy course the SNB would likely have followed had it attempted to maintain low inflation by relying on inflation forecasts, rather than monetary targets. We conclude that both reasons mentioned above probably account for the resurgence of inflation. However, the VAR-analysis involves an important caveat: Had the SNB returned to a floating exchange rate more quickly and more decisively, it might have reignited the exchange rate turbulences. Finally, the VAR-analysis provides evidence contradicting Svensson's contention as to the effects of a temporary peg on short-term domestic interest rates.