By Frances Coppola
Following part one of our history of modern monetary policy (which described the rise and fall of the Bretton Woods fixed exchange rate system), this is the story of how inflation was eventually brought under control when interest rates replaced exchange rates as the principal tool of monetary policy. Notably, the recent behavior of inflation, interest rates and currency exchange rates call into question the “happily ever after” nature of the story’s conclusion – or, indeed, whether the story has ended at all.
Between 1971 and the eventual end of the Bretton Woods system in 1973, FX traders made persistent speculative attacks on the U.S. dollar and other currencies including the British pound. In June 1972, unable to maintain the pound’s dollar exchange rate within the wider bands agreed in December 1971, the U.K. floated the pound. Other currencies followed suit, and in March 1973, the U.S. dollar itself was floated.
The shift to floating exchange rates coincided with the Yom Kippur war, in which Arab oil-producing nations imposed an embargo on the U.S. for supporting Israel1. The embargo pushed up oil prices to unprecedented heights, fueling domestic inflation not only in the U.S. but in other oil-dependent nations such as the U.K.2 The combination of the end of the Bretton Woods system and the oil price shock triggered a global recession. Unemployment in the U.S. rose to 8.5 percent in 1975.3 But unusually, so did inflation. In 1974-5, inflation in the U.S. hit 11 percent, the highest level since World War II.4 In other countries dependent on oil imports, inflation was even higher; in the U.K. it hit 26.7 percent in August 1975.5
Both inflation and unemployment in the U.S. reduced somewhat after their respective peaks in 1974 and 1975, as the dollar rose6 and oil prices stabilized. For the U.S., therefore, full employment, rather than inflation control, remained the main focus of monetary policy for some time. But elsewhere, the story was different.
In 1975, the GBP-USD exchange rate slumped as U.K. inflation soared above 25 percent. Speculative attacks continued to weaken the pound through 1976. But rather than allowing the pound’s exchange rate to fall freely, British authorities used FX reserves at the Bank of England to support its value and tightened price and income controls in a futile attempt to get inflation under control. Neither worked, and in September 1976 the U.K. government obtained an emergency loan of $3.9 billion from the International Monetary Fund (IMF) – at that time the largest amount ever borrowed from the IMF.7
Conditions for the IMF’s loan included drastic cuts to public expenditure. After a 20 percent cut in the government’s budget, inflation fell and the U.K.’s balance of trade improved. Despite continual industrial unrest, notably including labor strikes to protest enforced limits on pay rises during the “Winter of Discontent” in 1978 8 , the pound’s dollar exchange rate rose over the next 2-3 years. The IMF loan was never fully drawn.
The IMF’s intervention marked a turning point for U.K. monetary policy. No more would full employment dominate policymaking. Henceforth, controlling inflation would be the principal agenda.9 However, it would be some years before policymakers agreed that interest rate policy rather than exchange rate management was the best way of controlling inflation. Many policymakers remained concerned about the pound’s exchange rate, which resumed its fall after the U.K. lifted exchange controls in 1979 and in 1985 reached an unprecedented low. Further experiments with fixed exchange rate systems were to follow before the U.K. eventually committed to floating exchange rates in 1993.10 (See the related discussion: Understanding the Relationship Between Inflation and Foreign Exchange Rates.)
Consumer price inflation in the U.S. started to rise again from 1976 onwards, accelerating in 1978-9 when a coup in Iran caused another sharp oil price rise. In 1979 it averaged 11.3 percent and rose to 13.5 percent in 1980.11
This caused a dilemma for policymakers. The principal economic model used by monetary policymakers at that time, the Phillips Curve, showed that there was a trade-off between inflation and unemployment. If unemployment was high, inflation would be low.12 But now that global commodities such as oil were priced in dollars, and the dollar’s exchange rate was floating against other currencies, international price shocks such as oil price rises could transmit through to the U.S. economy, raising both inflation and unemployment. There was a widespread belief among central bankers that raising interest rates sharply to bring inflation under control would increase unemployment to socially and politically unacceptable heights.13
But all that changed when Paul Volcker became head of the Federal Reserve. Volcker was a strong proponent of using monetary policy to control inflation. Under his leadership, the focus of policymakers shifted from economic growth and full employment to inflation control, which was blamed for precipitating recessions in 1980 and 1981-82.14 The Federal Reserve sharply raised the principal policy interest rate, the Federal Funds Rate: in June 1981 it reached the historically unprecedented level of 19 percent.15 Very high interest rates forced a severe contraction in economic activity, which brought inflation down from its 1980 peak of 15 percent – but at the cost of deep recession and unemployment of over 10 percent.16
In the U.K., which also experienced rising inflation due to the 1978-9 oil price shock, the Bank of England raised interest rates earlier than the Federal Reserve: the main policy interest rate rose to 17 percent in 1979 and remained in double digits for much of the next decade. Unemployment peaked at nearly 12 percent in 1984 before slowly reducing over the next few years.17
The high inflation of the 1970s was eventually defeated in what has come to be known as the Volcker Shock, when central banks raised interest rates to unprecedented heights. But although very high interest rates successfully brought down inflation, monetary policymakers remained reluctant to rely entirely on interest rate policy. Our next piece discusses repeated reintroductions of fixed exchange rate systems throughout the 1980s – and how they failed every time.
With 17 years’ experience in the financial industry, Frances is a highly regarded writer and speaker on banking, finance and economics. She writes regularly for the Financial Times, Forbes and a range of financial industry publications. Her writing has featured in The Economist, the New York Times and the Wall Street Journal. She is a frequent commentator on TV, radio and online news media including the BBC and RT TV.
1.“Oil Embargo, 1973-74,” Office of the Historian, U.S. Department of State; https://history.state.gov/milestones/1969-1976/oil-embargo
3.“Labor Force Statistics from the Current Population Survey,” U.S. Bureau of Labor Statistics; https://data.bls.gov/timeseries/LNU04000000?years_option=all_years&periods_option=specific_periods&periods=Annual+Data
4.“Inflation, consumer prices, percent change,” St. Louis Federal Reserve statistical database (FRED); https://fred.stlouisfed.org/series/FPCPITOTLZGUSA
5.“Inflation Great Britain 1975,” inflation.eu; http://www.inflation.eu/inflation-rates/great-britain/historic-inflation/cpi-inflation-great-britain-1975.aspx
6.“Trade Weighted U.S. Dollar Index, Major Currencies,” St. Louis Federal Reserve statistical database (FRED);https://fred.stlouisfed.org/series/DTWEXM?utm_source=series_page&utm_medium=related_content&utm_term=related_resources&utm_campaign=categories
7.“Sterling devalued and IMF loan,” National Archives; http://www.nationalarchives.gov.uk/cabinetpapers/themes/sterling-devalued-imf-loan.htm
8.“1978-1979: Winter of discontent,” libcom.org; https://libcom.org/history/1978-1979-winter-of-discontent
9. “Sterling devalued and IMF loan,” National Archives;http://www.nationalarchives.gov.uk/cabinetpapers/themes/sterling-devalued-imf-loan.htm
10.“The Long Decline of the Great British Pound,” Credit Writedowns; https://www.creditwritedowns.com/2014/02/long-decline-great-british-pound.html
11.Historical Inflation Rates:1914-2017,” US Inflation Calculator; http://www.usinflationcalculator.com/inflation/historical-inflation-rates/
12.“Phillips Curve,” Concise Library of Economics;http://www.econlib.org/library/Enc/PhillipsCurve.html
13.How the world achieved consensus on monetary policy, National Bureau of Economic Research; http://www.nber.org/papers/w13580.pdf
15.“Effective Fed Funds Rate,” St. Louis Federal Reserve statistical database (FRED); https://fred.stlouisfed.org/series/FEDFUNDS
16.“Civilian Unemployment Rate,” St. Louis Federal Reserve statistical database (FRED); https://fred.stlouisfed.org/series/UNRATE
17.“U.K. unemployment rate (16 & over, seasonally adjusted),” Office for National Statistics; https://www.ons.gov.uk/employmentandlabourmarket/peoplenotinwork/unemployment/timeseries/mgsx/lms