Mr Bäckström reports on the current situation for monetary policy in Sweden  (Central Bank Articles and Speeches, 13 Nov 98)
Central bank: riksbank | Type: speech | Date: 1998-11-13

## Mr Bäckström reports on the current situation for monetary policy in SwedenSpeech

by the Governor of the Bank of Sweden, Mr Urban Bäckström, to the Standi Committee on Finance in Stockholm on 13/11/98.First a word of thanks to the Committee for the invitation to discuss the current s monetary policy.

A good deal has happened in the global economy since our previous disc with the Committee last March.

The crisis in the emerging markets in Asia, regarded ini regional concern, has continued to spread, first to emerging markets in other parts o and then, mainly via financial markets, to the industrialised countries.

This has economic climate.

## The Swedish economy in perspectiveFive years with good growth and low inflationLet us begin, however, by shifting our attention from recent events and noting that crisis in the early 1990s, economic development in Sweden has been rather good.

Relativ growth has been combined with a rate of inflation that has remained low.

Since the su 1993, total output (GDP) has been rising at an average annual rate of almost 3%.

That less matches the growth rate during the upswing in the 1980s (Fig. 1).Fig. 1It is markedly higher, however, than the average annual rate of 2% which was achieved two decades from 1970 and 1990; it also exceeds what can be regarded as the sustainabl term rate.

One important reason why inflation could still be kept at a low level in re that in this period the economy has had a reserve of unutilised capacity.

That, in consequence of the deep recession that preceded the upswing, plus the fact that the capacity has been high.

Moreover, inflation expectations have gradually stabilised arou inflation target (Fig.

2).

Recently, however, and in certain earlier periods, tramovements have brought the average annual change in the consumer price index (CPI) outside the inflation target's lower tolerance interval.Fig. 2

## Large transitory price effectsThe nature of transitory price effects and the appropriate monetary policy response we that I discussed in detail with the Committee last March.

So now I shall simply rei Riksbank's view that as long as more long-term inflation expectations are unaffected, price movements should be a subordinate consideration in monetary policy.

A contrary o would necessitate drastic monetary policy measures that might have destabilising ef output and employment, which is clearly undesirable.

In theory, a CPI change figure higher than the current 0.4% could of course be engineered simply by raising the interest rate.

That would fuel CPI inflation via higher house mortgage rates.

It need hardly be said not the way to conduct monetary policy.

It should be borne in mind that a monetary poli formulated in terms of the change in the CPI has major advantages.

The CPI is a broad a known measure of inflation.

But the construction of the CPI does pose problems, not this Committee, when it comes to assessing monetary policy's past performance.

This still more important if the Riksbank is accorded the independent status which the (Sweden's parliament) will shortly be voting on.

The use of a target variable, such a which necessitates frequent reference to factors that cause temporary deviations, is n solution.

There are grounds for supposing, however, that sizeable transient price move the type we have experienced recently are not commonplace.

They derive predominantly the marked improvement in recent years in economic policy's credibility.

There have be periods in the past when, for example, house mortgage rates have dropped from about 14% present level around 5%.

So the problems with targeting CPI inflation should not be exa In order to facilitate the assessment of monetary policy, the Riksbank has arranged fo Sweden to supplement its CPI statistics with figures for various indicators of u inflation.

Another matter to bear in mind is the lag before monetary policy measures economy.

If the rate of inflation happens to move outside the tolerance interval in onecentral bank is not capable of bringing inflation directly back on target in the foll That is why the central bank needs to present an inflation forecast, which has t advantages.

One is that the central bank can be explicit about the time horizon at whic is to be returned to the target.

The other is that people in general can judge for whether monetary policy can be considered to be properly balanced.

If the forecast devi the inflation target at the time horizon at which monetary policy exerts its main effec months - then the instrumental rate has to be adjusted.

## Jobless growthAlthough

Sweden has experienced five years of good economic growth, there has been corresponding reduction of unemployment.

The picture since 1993 speaks for itself: upturn in the output curve, while the low level of employment is still virtually (Fig. 3).

This suggests that neither low demand nor a poor growth potential are responsible for the weak development of employment.Fig. 3Part of the problem with employment may be that much of the growth in the past five seems to have occurred in sectors that are capital-intensive.

More balanced growth in would presumably result in stronger demand for labour.

But the weak employment t probably also stems from more fundamental factors.

For several decades now, the g structure of business activities in Sweden has tended to move towards a growing input o at the expense of labour.

The fact that certain countries have achieved a sustained im in employment is often explained not so much by high growth as by a production process t been generally more labour-intensive.

If an economy is characterised by the combination stable growth and weak employment, this points to the existence of structural problems. be added that Sweden shares the problem of jobless growth with other countries in though not with all.

## Monetary policy to date

## Warning lights a year agoA year ago there were many indications that economic growth in Sweden would continue high rate.

It also looked as though capacity utilisation would rise in the coming years some increase in inflation.

The crisis in Asia was expected to ease inflationary press extent but not sufficiently.

As most of the warning lights were thus blinking red, th adjusted its policy stance; in December 1997 the repo rate was raised from 4.10 to 4.35 statement to this Committee in October 1997, I described the planned policy realignme movement from an expansionary to a more neutral monetary stance.

It amounted to keepin economy moving at the rate which is structurally feasible, not to arresting its mov gradual monetary policy adjustment would bring the path of growth into line with the su long-term trend, thereby protecting the economy from capacity shortages and inflation. interest rate increase at an early stage was intended to prevent problems from arising requiring larger interest hikes to bring inflation back to the targeted rate.

In this price level and growth would be more stable.

In the December 1997 Inflation Report, ho we included a risk scenario that pointed to lower inflation compared with the main sce noted: 'As regards inflation, however, a substantial impact from the economic crisis in presuppose that the situation deteriorates so much that international activity i weakened.' As things turned out, the effects of the Asian crisis did exceed our assum the main scenario.

During the first half of this year the main assessment was revised s downwards.

As a result, the monetary policy adjustment did not continue as envisaged ea view of the risks of a weaker trend, the repo rate was left unchanged during the connection with the June Inflation Report, the Riksbank concluded that inflation pros changed; our inflation forecast, based on an unchanged repo rate, pointed to a rat increases 12 to 24 months ahead that was below the 2% target.

In accordance wit Riksbank's procedure, at the beginning of the summer the repo rate was therefore lower 4.35% to 4.10%.

## Increased financial market unrest and lower international growthIn the September Inflation Report the Riksbank noted that the real economic situation relatively

bright.

In our main scenario, growth was expected to remain stable while slowly moved up towards the target in the coming one to two years.

However, this pa inflation did start from a lower level.

The risk of slower international growth on ac Asian crisis had grown but the picture was also complicated by the marked weakening krona, which could have a contrary effect on inflation.

In the current exchange rate Riksbank does not target the level of the exchange rate but this is still one of the f to be weighed into the assessment of future inflation.

In the context of monetary polic pertinent aspect in recent years has proved to be the extent to which the exchange r inflation via its impact on production, primarily in the export sector.

The effects t exchange rate may have on import prices should be a secondary consideration, along wit transitory price movements, as long as more long-term inflation expectations are un During September and part of October - before and immediately after the publication Inflation Report - the monetary policy environment was turbulent and difficult to asses was the uncertainty confined to the international scene.

It also came from the general Sweden and the future direction of fiscal policy.

All in all, this prompted the Riksb the repo rate unchanged.

The possibility of a lower rate would be considered when i prospects were clearer.

During the autumn the financial unrest continued to grow.

The Government's suspension of payments in mid August and the problems that emerged inSeptember with the U.S. hedge fund Long Term Capital Management contributed to the mu more nervous atmosphere.

Share prices dropped around the world and the financial cris on spreading to other emerging markets that had previously been spared.

There was a r the falling stock markets and the wider extent of the crisis would elicit effects v export demand and more cautious behaviour among consumers and firms.

At the same time, problems with Long Term Capital Management aroused fears of a considerably more serious that had not attracted so much attention earlier - the risk of banks becoming so cau credit that this, by itself, would paralyse the global economy.

When the banks are reducing exposures and slimming balance sheets in order to avoid loan losses, borrowe less access to capital.

If risk aversion becomes unduly pronounced, even sound borro liable to be hit, with serious effects on the total level of activity in the global ec of an imminent credit squeeze was the growing spread in market interest rates betw soundest borrowers and others.

In this way it was envisaged that the financial crisis negative effects on the real economy.

Forecasters altered their assessments and th prospects for growth and inflation were revised downwards.

The Riksbank likewise adjus assessment of developments in the rest of the world.

## The current monetary stance

## Repo rate cut on 3 NovemberThe assessment that growth in the rest of the world will be weaker than we counted on e the Riksbank to conclude that with an unchanged repo rate, in the coming 12 to 24 mon rate of inflation would be below the target.

Resource utilisation would be lower and i pressure would decrease.

Signs of this were discernible in recent statistics:

net weakened, stocks were accumulating and corporate borrowing was rising somewhat mo slowly.

The financial unrest had also had some negative impact on household confidence, could mean that consumption rises more slowly than expected earlier.

The effects on i from the slowing tendencies were judged to be greater than the stimulus from the exchange rate.

Moreover, the financial market unrest had tended to subside.

Under circumstances, on 3rd November the Riksbank lowered the repo rate 25 basis points to 3. should be noted that the Riksbank's downward revision of demand and inflation prospects Swedish economy is not dramatic.

In the September Inflation Report the path for infla already below 2% for much of the forecast period.

But the revision is of an order th conditions for the Riksbank's operations.

In order to provide more room for manoeuvre formation of monetary policy, yesterday the Governing Board decided to lower the co surrounding the repo rate: the deposit rate was reduced by 0.5 percentage points to 3.2 lending rate likewise 0.5 percentage points to 4.75%.

The concern about an invo contraction of credit - and the serious consequences it might have - has also prom central banks to heighten surveillance of the financial system.

For the Riksbank thi contacts with the major banks as well as increased oversight of bank financing in co with the Financial Supervisory Authority.

On the whole, the Swedish banking system app be stable.

This conclusion is elaborated in the year's second Financial Market Report, published yesterday.

Lending to the most problem-burdened countries is relativel Moreover, the banks have built up liquidity reserves as a precaution against a worseni situation in the international markets.

The supply of credit in the Swedish market does to have suffered to date.

Neither has the Riksbank seen any indications that the Swed intend to curtail their lending to domestic sectors.

Recently the global financial unr have become somewhat less pronounced.

It is difficult to tell whether this could be a calm associated with being in a hurricane's eye - whether the international financial will return or whether the cyclone is receding.

The Riksbank is therefore continuingthe banking system with heightened readiness until the situation has become more stab course of events in the international arena has warranted measures of a short-term natu to safeguard the functioning of the global financial system.

Interest rates have be recently in a number of countries, for example.

In the longer term, work must focu construction of international rules and systems that limit the risk of - and preferably prevent crises of this type from happening at all.

What has happened reveals clear shortcoming the global financial system functions.

But it should also be underscored that 'free t financial domain can very probably confer large welfare gains, just as free trade does of goods and services.

The conditions for forecasting in general and for inflation monetary policy in particular have been illustrated by what has happened in recent year indicators has to be relied on in an endeavour to form a definite opinion abou developments.

Central banks are unfortunately not in a position to wait for a complet before acting.

It takes time for our actions to elicit their full effect; when all t puzzle are finally available, the time for action has passed.

The continuous fulfil monetary policy target would then probably require more drastic measures; such a nearpolicy would lead to greater economic instability.

The course of the Asian crisi contagious effects in the industrialised countries is having a larger impact than we earlier.

I cannot rule out the possibility that in order to fulfil the inflation adjustments of the monetary stance will be called for in the same direction as recently development in the rest of the world also affects conditions in Sweden.