rfr · H30WRFR7 · 2016-01-19 00:00:00 — a significant future rise in the repo rate and so a much tighter monetary stance than was actually being implemented, and yet inflation was falling below target. That led to a more open statement of the view that monetary policy had to be tighter than would be implied solely by reference to the outlook for inflation in order to respond to risks to financial stability – an issue we return to below. For the minority, there was a tension between the two different arguments that they deployed. On the one hand, their rather aggressive criticism of the majority position was based on forecast simulations using the assumption that monetary policy was actually described by the published desired repo rate path. On the other hand, the lack of market credibility in the Riksbank’s published repo rate path made it increasingly difficult to attribute bad outcomes to an overly tight monetary policy when market expectations were of a continuing lower repo rate. The one conclusion that can safely be drawn is that forecasts, and policy, should not be based solely on forecasts from a model that assumes full credibility in the stated policy path. There must be room for judgement about the credibility of the inflation target and the repo rate path – a point emphasised by . The key point is that markets, and households and businesses more generally, will form their own expectations of future interest rates and inflation which may differ from those of the Riksbank, and policy must take that into account. The models used by the Riksbank, and most other central banks, are silent on this point. Recommendation: as a matter of course the Riksbank should publish in its Monetary Policy Reports an analysis of why in its view there is a divergence between its published repo rate path and market expectations of the repo rate path, and what implications it believes any such divergence has for the setting of monetary policy. Third, it is striking that all members of devoted so much time to thinking about the future path of the repo rate and to providing guidance as to their views on how it should evolve over the following three years. There is something surreal about the precision of the guidance provided by individual board members as to the future path of the repo rate when contrasted with the sheer uncertainty about the future and the fact that markets took rather notice of the published path in determining their own expectations. As an example, consider the Monetary Policy Meetings in and . At the meeting, the majority voted to raise the repo rate from to , and to publish a path for the repo rate that over the following three years rose to . Two members dissented – who voted to defer the increase until but then to follow the path for the repo rate agreed by the majority, and who voted to leave the repo rate at and then approach more gradually the rate of . Market rates implied a repo rate of only three years ahead. In , the majority voted to raise the repo rate to , with the repo rate continuing to rise to . also voted to raise the repo rate to , but wanted to see the rate climb to only . voted to hold the rate at and for a 7 EVALUATION OF MONETARY POLICY IN 2010-2015 flatter profile of the repo rate which rose to . Three years later the actual repo rate set by the Riksbank was only and was about to start falling towards and then beyond zero. The point of this example is to illustrate that central banks cannot predict their own actions, not because they behave erratically, but because they cannot predict developments in the economy to which they must respond. Market expectations of such developments may well differ from those of the central bank. Since 2007, the Riksbank has published forecasts of its own policy rate. It was encouraged to do so by the Review carried out by Giavazzi and Mishkin who recommended that the Riksbank “should base its forecasts on its own assessment of the policy path”. The experience has not been an entirely happy one. If the idea was to tighten policy by projecting future increases in the policy rate, then it could not be judged a success. Policy was looser throughout the period than was intended by almost everyone on the Board. The precision of the forecasts for the future rate belies the uncertainty surrounding the economy, and can lead to a temptation to resist modifying earlier judgements and to follow the previous forecast path. The wish to avoid changing one’s mind means that it is possible that policy reacts too slowly to changes in the economy. Moreover, the danger of publishing a future path for the repo rate is that the Board can be seduced into thinking that changes in monetary policy can be made solely by changing the slope and end-point of the future path, making it possible to defer changes in the current policy rate. There is some evidence from the minutes that differences in view were diverted into disagreements about the future path rather than confronting the need to change the current repo rate. And time was spent discussing and debating the merits of differences in the repo rate path two or even three years ahead that had relevance to market expectations and so on actual monetary conditions. It became too easy to paper over major differences of view on the current stance of policy by expressing them in terms of differences of view about the likely future path of the policy rate. Nevertheless, we were impressed by how many of our interlocutors, even when they disagreed with the policy set by the Riksbank, said that they felt the publication of the Riksbank’s own judgement about where the policy rate might go was useful. We feel this should be a matter left to the Board itself. Recommendation: the Riksbank should conduct and publish (i) a review of its experience with the announcement of a future path for the repo rate, and (ii) a post-mortem on the substantial deviation of market expectations from its published forecasts during the period covered by this Review. Fourth, there was heavy reliance, among both the majority of the Board and the dissenters alike, on forecasts produced by models developed by Riksbank staff. Although such models are useful in putting together consistent quantitative forecasts, inevitably they are based on strong assumptions and can act as no more than a starting point for a discussion of the challenges facing monetary policy at any particular juncture. They cannot be used mechanically. 7 EVALUATION OF MONETARY POLICY IN 2010-2015 no time was this note of caution about the use of models more relevant than in the immediate aftermath of the global financial crisis. Models that not only didn’t, but couldn’t by their nature, predict the crisis were unlikely to tell the whole story of the difficulties facing economies during the recovery phase. A greater degree of humility about those models would have been appropriate. It is therefore surprising that it was thought sensible to rely so heavily on forecasts generated by models which were clearly capturing only part of the true picture. The minutes reveal remarkably challenge to the results from model simulations from either the majority or minority members of the Board. The majority was clearly concerned about the risks to financial stability – factors that were missing from the models – but seemed unable to articulate their concerns in a way that challenged the relevance of the model simulations. The minority seemed wedded at times to a fixation on precise simulations that indicated how a different position and shape for the repo rate path could fine tune outturns for inflation and unemployment, despite the many important factors missing from the models.11 The two sides in the debate on monetary policy on were unable to engage in a conversation about what was happening in the economy, and retreated to fixed positions. Monetary policy cannot be reduced to the automatic application of one specific model. Choosing the so-called optimal policy in a misspecified model can lead to serious mistakes. Alternative “models” of the economy must be considered and judgement used. One important failing of the models used was the assumption of complete credibility in the willingness and ability of the Riksbank to hit the inflation target. The forecast of inflation always returned to over the medium term. The presumed credibility of the inflation target gave a false sense of confidence in its own strategy which encouraged a belief that persistent departures of inflation below could not undermine credibility in the target. By 2015 that confidence was being sorely tested. The models that were being used by the Riksbank assumed that the inflation target had such credibility that small changes in current or expected future interest rates would enable the Riksbank to guide inflation back to the target in two years, irrespective of the underlying state of the world economy. An important role for members of is to challenge the assumptions of models used to generate quantitative forecasts so that there can be a full discussion of all relevant aspects of the outlook before members reach their policy judgements. As described in Chapter 5, works closely with the Monetary Policy Department some weeks prior to the Monetary Policy Meeting to forecast international activity, inflation, and policy rates abroad upon which to condition monetary policy, and to decide the Riksbank's repo rate path that delivers forecasts of output, inflation, and unemployment in – the core of the – that the majority of deems to be “well-balanced ”. As things stand, the Monetary Policy Meeting of essentially ratifies after the fact 7 EVALUATION OF MONETARY POLICY IN 2010-2015 the , effectively decided at earlier meetings. An alternative procedure would be that at those earlier meetings three, say, different scenarios with different Riksbank repo rate paths be agreed and included in the , with choosing among them at the Monetary Policy Meetings a couple of weeks later. Such a change would impose a considerably greater burden on the monetary policy department, and for that reason we are reluctant to recommend it. But some change in procedure is needed because the currently released Minutes of the Monetary Policy Meetings do not serve well their purpose of providing individual accountability for each Board member's contribution to the policy deliberations. Recommendation: the Riksbank should augment the current minutes with minutes of the meetings where the is decided – at the First or Meetings and also the Ex- ecutive Board Forecast Meeting. Those minutes could then be released to the public together with the current minutes two weeks after the Monetary Policy Meeting. Fifth, tensions among members of , while not leading to significant differences in policy judgements in 2010 and 2011, grew in 2012 and spilled over in 2013 into disagreements not only about the setting of interest rates but also, and significantly, about the objectives of policy. The meeting of was critical in this respect. The frustrations of the dissenters were clear. Despite evidence of the need for a loosening of monetary policy, the majority seemed unwilling to accept the logic of an inflation target. The problems were compounded by the fact that both sides, with the honourable exception of , appeared content to place weight on model simulations and forecasts. This led one side of the argument to believe that the need to cut interest rates was completely obvious, and the other to obfuscate about the reasons for being reluctant to cut rates. Underneath the surface was a major issue that was not discussed in a fully articulated way. It is clear that by 2012 the majority on were sufficiently concerned about developments in house prices and the growth of household credit to set the repo rate at a level higher than was justified by a strict application of targeting inflation two years ahead. There were three problems with such a strategy. First, the concerns over financial stability held by the majority were never explained within a clear conceptual framework. Second, it was not easy to reconcile the objective of “leaning against the wind” with the official mandate of the Riksbank to pursue price stability. Third, no empirical evidence was produced on the magnitude of the costs and benefits of pursuing such a strategy. On the first of these – the role of financial stability in monetary policy – one must have sympathy with the Riksbank. All central banks have struggled to reconcile the inflation targeting framework used before the crisis with the existence of economic and financial “imbalances” in the economy which both 7 EVALUATION OF MONETARY POLICY IN 2010-2015 contributed to the crisis and also affected the recovery from it. From our conversations it is clear that the majority on were concerned about the impact of rising asset prices and indebtedness on the economy and felt that if no-one else was going to do something about it then they should. They felt that they would be damned if they did and damned if they didn’t. The Riksbank, therefore, took it upon itself to allow concerns about financial stability to affect decisions on monetary policy. The dissenters on the Board took a much narrower view of the commitment to price stability which reflected a particular view of how the economy worked. They believed that policy should aim to set interest rates in order to meet the inflation target looking 18 months to 2 years ahead based on forecasts of inflation generated by a particular set of models. The problem for this group was that those models were based on past correlations which were assumed to represent causal relationships when in fact they had to say about how and why the crisis came about. The focus on models by both sides in the debate played into the hands of the minority because the issues that worried the majority were absent from the models. As a result the two sides talked past each other. There was nothing particularly Swedish about this debate. At the international level, the two views represented in by the majority and minority on are reflected in the positions of () and the Federal Reserve, respectively. Neither side has a monopoly of wisdom. Those on who believed in long run risks to output growth and price stability from the build-up of financial imbalances within the Swedish economy faced the problem that the Riksbank Act did not give the central bank a formal role in the area of financial stability. Moreover, the wind against which the majority wished to lean had dropped by 2012 to something closer to a breeze (even though it was to blow more strongly later). One of the difficulties that beset policy at the time was the failure of the Government to decide which body should have the responsibility for financial stability. Final decisions on the allocation of responsibility in this area were announced only in 2013. For that, the Government must take responsibility. It was a mistake to allow conflicting objectives to persist within the Board. The Riksbank stepped in to fill a vacuum in policy, and made clear that in its view had taken insufficient action to deal with concerns from the housing market. And when by 2014 and 2015 those financial stability responsibilities had been clarified and given to , the Riksbank decided that inflation had fallen to a level at which the credibility of the target was at risk, and adopted an extraordinarily expansionary monetary policy with negative repo rates and asset purchases in order to raise inflation to the target. It seems as if those concerned with household indebtedness and asset prices had abandoned their earlier attempt to use monetary policy to influence such behaviour and had instead accepted that other authorities, presumably and the Government, should implement policies that would gradually reduce household indebtedness. 7 EVALUATION OF MONETARY POLICY IN 2010-2015 became focused solely on re-anchoring inflation expectations on . So began an extraordinary phase in monetary policy actions with official interest rates moving into negative territory, and asset purchases on a large scale. The concerns of the Riksbank were reinforced when in the spring of 2015 withdrew proposals to make households amortise their mortgages because, although accepting that such proposals were necessary, they felt they should respect the statement of the Administrative Court of Ap- peal of , among others, which found deficiencies in the legal basis for to implement such a requirement. The Riksbank’s task has been made much more difficult by the dithering of the Government in introducing a clear regime for macro-prudential policy. Recommendation: the Government should ensure without further delay that has the legal powers and range of macro-pruden- tial instruments appropriate to its role in promoting financial stability. The main lesson from this episode is that the question of which objective should be pursued by the Riksbank is not one that is sensibly left to itself without providing further accountability for decisions. The debate about monetary policy from 2011 onwards became very personal, in part because it reflected differences about the framework within which monetary policy was being conducted and not just the current state of the economy. It is, therefore, important to the governance of the Riksbank that the framework which disciplines the factors determining monetary policy is laid out clearly in the Riksbank Act. We return to the question of the mandate of the Riksbank in Chapter 8. Sixth, the success of the decision-making process in the Riksbank is heavily dependent on the willingness of Board members to respect each other’s viewpoint and to use the Monetary Policy Meetings to further a collective understanding of developments in the economy and the appropriate response of monetary policy. Differences of view and judgement are an important part of this process, but they must be expressed in a conducive to the collective venture on which the Riksbank is embarked. A key part of the structure of is that each individual has one vote and is entitled, indeed required, to express clearly their own view on the stance of monetary policy. This is a strength of the process. A healthy debate benefits from such differences of view. Explanations of those differences are essential to the promotion of greater understanding among the wider public of the challenges facing monetary policy. It is evident from the minutes and public comments made by members of the Board that respect for others’ viewpoints was not always present during the period covered by our Review. The extent of divisions, and in particular the way they were expressed, was damaging to the reputation of the Riksbank. Members of the Board must remember that their role is to present coherent arguments in a reasonable and persuasive fashion. If they use language which is designed to attack other members of the Committee the public standing of the Board is damaged. It was not helpful that 7 EVALUATION OF MONETARY POLICY IN 2010-2015 minutes and interviews by Board members displayed a degree of brusqueness uncharacteristic of normal public debate in . Yet the essential problem was that the Riksbank had too much freedom to interpret its remit in ways that made it possible for different members of the Board to pursue different objectives. Disagreements on policy decisions should be expressed openly in minutes but in a form that does not denigrate other members of the Board who may take a different view. We took sufficient evidence to be confident that the question of how members of the board behaved towards each other was an important consideration in affecting the ability of the Board to confront extraordinarily difficult challenges. Nevertheless, those intellectual challenges have proved difficult for all central banks, and differences of view about the appropriate objectives of monetary policy are not confined to . Compared with the early years of Monetary Policy Meetings, the minutes during much of the Review period became extremely long and contained mainly the views of dissenters, the majority view being expressed in the regular Report. The minutes no longer represented a to-and-fro between different viewpoints on the Board, and did not reflect the balance of discussion. It is not helpful for the majority and minority to express their views in differing formats. There needs to be a degree of collective discipline in how the minutes are produced. The minutes should cease to be a detailed and uneven record of submissions by individual members and should contain a more balanced explanation of the decision reached by the majority and the arguments against that put forward at the meeting by the dissenting minority. Recommendation: the minutes should attempt to record the differing points made at the meeting and not a sequence of individual formal presentations. Longer analyses by particular members should be made available publicly in speeches. 8 The Mandate and Governance of the The Riksbank operates under a mandate determined by the Riksdag and set out in the Riksbank Act. The Act is a comprehensive description of the powers and responsibilities of the Riksbank. In many ways, it is a model. Chapter 1 Article 2 sets out the two main policy responsibilities of the Riksbank: “The objective of the Riksbank’s activities shall be to maintain price stability”. “The Riksbank shall also promote a safe and efficient payments system”. At one level these objectives are unobjectionable. But the interpretation of the phrase “price stability” is left to the Riksbank itself. In essence the Act mandates an inflation target but without specifying anything else. This begs a number of questions. What should the numerical target be? Should it be a range or a point? Who should set the target? What inflation rate should define the target? Should the objective of policy be modified to include real variables? The Riksbank defines price stability as an inflation rate of a year as measured by the Consumer Price Index (CPI). As explained in Chapter 5, in practice consistently employs a different definition of inflation, CPIF, rather than CPI in its policy deliberations because the latter includes the direct effect of its own interest rate changes on the measure of inflation. In itself, that is a sensible approach. But it would be better if the inflation target itself were to be specified in terms of CPIF inflation. To overcome concerns that the Riksbank was able to set its own target, and to change it at will, it would be preferable, in our view, for the mandate for the inflation objective to be given to the Riksbank by the Riksdag. Recommendation: the Riksdag, on a recommendation by the Finance Minister, should specify the inflation target, in terms both of its definition and its numerical value, and should delegate that objective to to achieve. At present, we recommend a target of a year as measured by CPIF. The target should be reviewed every ten years unless the Riksdag legislates to change the target earlier than the next due review date. We do not think it sensible to extend the objective of the central bank to include numerical targets for employment and output. The experience of forward guidance in both and suggest that attempts to use numerical values for these variables can crumble in the hands of policymakers within a short period of time. do we recommend setting the objective for monetary policy in terms of nominal spending or GDP. Flexible inflation targeting offers a perfectly acceptable way of making the trade-off 8 THE MANDATE AND GOVERNANCE OF THE RIKSBANK between volatility in inflation and volatility in output, and avoids the problem of revisions in data for nominal GDP.