Mr. Heikensten discusses recent economic and monetary policy developments in Sweden  (Central Bank Articles and Speeches, 19 Aug 98)
Central bank: riksbank | Type: speech | Date: 1998-08-19

Mr.

Heikensten discusses recent economic and monetary policy developments in Sweden Speech by the Deputy Governor of the Bank of Sweden, Mr. Lars Heikensten, at the Authorities Economics Seminar in Malmö on 19/8/98.Thank you for the invitation to attend this Seminar and talk about the Swedish ec and monetary policy.

I shall begin with a brief account of how the Riksbank operates with it target.

In that context I shall also be saying something about economic policy's results in Then I shall consider the Riksbank's appraisal of the Swedish economy, as presented in ou inflation report last June, together with subsequent economic tendencies.

Finally I shall be the somewhat longer perspective of my opening section.

This will tie in with the theme of th and highlight some factors that are of crucial importance for our success in creating a potent economic expansion.

## 1.

Inflation target policy-how does it work?The objective of monetary policy is to keep the value of money stable.

This ha defined more specifically as keeping the annual rate of inflation (measured as the chang Consumer Price Index) at 2 per cent.

Around this target there is a tolerance interval of ±1 point which serves to accommodate normal deviations that arise, for instance, from transitory But the possibility of larger deviations than this cannot be ruled out.

If they occur, it is i explain their causes and state how inflation is to be brought back into line with the target.To influence consumer prices, the Riksbank uses its instrumental rate-the repo Simplifying somewhat, one can say that, by altering the marginal interest rate for banks, th influences other domestic interest rates and thereby the level of economic activity in S consequently the development of prices.

It should be noted, however, that in the short and med pricing is also affected by other factors, such as the construction of fiscal policy and the d wages.

That is why the Riksbank is concerned that, when making decisions, politicians and market organisations should also promote low inflation.

It is the reason, moreover, for my r these matters at the end of this talk.

But in the long run the course of inflation is crucial monetary policy.Interest rate adjustments have their main effect on prices after an interval of years.

Monetary policy decisions therefore have to be based, not on the latest figures for inf the Riksbank's current assessment of future price movements .

Our quarterly inflation reports accordingly present ongoing inflation forecasts based on analyses of a large array of economic indicators by economic models and knowledge of relationships between different parts of the economy. inflation assessment is used by the Riksbank in drawing conclusions about the direction of policy.

A forecast rate of inflation above the target normally leads to interest rate increa expected rate below the target prompts the Riksbank to lower the repo rate.Inflation is assessed on a continuous basis.

New information-fresh economic stati for instance, or signs of a change in some economic relationships-leads the Riksbank to re current forecast and make the necessary changes.

If a new forecast indicates that future in deviate from the target, then the Riksbank has to adjust the repo rate in accordance wit assessment.However, assessments of future inflation-like any other forecast-are bound to inc an element of uncertainty.

Moreover, observers are liable to differ on which future path is mo So it is hardly surprising-rather a healthy sign-that our inflation assessments and monetary p sometimes a subject of lively debate.

But while inflation assessments may vary, in Swedish soci there is broad support for focusing monetary policy on price stability.

## 2.

Recent yearsThe Swedish economy, as we all know, went through a profound crisis in the e 1990s.

This is not an occasion for discussing the causes of the crisis in depth.

It will suff the origins lay in structural weaknesses in Sweden's economy.

But the crisis also had to shortcomings in stabilisation policy in the late 1980s and early 1990s.Since production stopped falling and growth restarted in the course of 1993, ec developments in Sweden have exceeded expectations in several respects.

The average annual grow of above 2.5 per cent is higher than the average in the boom period in the 1980s.In a way, perhaps this is hardly surprising.

The weak exchange rate gave exports a impetus and there was plenty of unutilised capacity.

But I do not think many people expected high growth could be combined with low inflation.

In these years Sweden has rejected the pol the decades of high inflation and reinstated the time-honoured tradition of annual price incre 2 per cent.

Inflation has also been low in an international comparison.

Judging from the expe economic agents, a low-inflation regime has now been established.The composition of growth has also been favourable.

After decades of growth that generated to a high degree by rising consumption-with an accumulation of external debt-it is a sign that expansion been associated with strong export demand and industrial investment.

One this, the large current-account surpluses since 1994, has made it possible to repay external deA dramatic turnaround has also been achieved in government finances.

Massive bud deficits have been succeeded by a surplus.

This trend is primarily a consequence of the recovery, just as declining activity was the main cause of the earlier fiscal collapse.

But extensive measures for budget consolidation, neither the economic upturn nor the improvem government finances would have been feasible.Tax increases and spending cuts on the scale we have experienced in recent obviously leave their mark.

Household income has been sharply restricted, particularly in 199 have public activities.In one respect, moreover, the outlook is still troublesome, namely as r employment.

Despite the economic recovery, a rapid expansion of employment has proved diffic achieve.

It is worth noting, however, that the number of private sector jobs, in services in p in fact been rising continuously since 1995.

But this has not made up sufficiently for the co employment during the 1990s in, for example, the public sector and construction.After this review of developments in recent years, I shall now discuss the Rik appraisal of the coming twenty-four months, which is the period we need to consider when con monetary policy.

## 3.

The message in JuneIn the latest inflation report last June the Riksbank presented an economic for Sweden and its implications for the path of inflation up to the middle of the year 2000.

Our was that the trends in recent years, with high growth and low inflation, would continue in ahead.The economic upswing was assumed to continue in the forecast period, with ann growth rates around 2.5 per cent this year and 3 per cent in the next two years.

The forecast increasing contribution from rising domestic demand, accompanied by a successive fall-off i growth.

Private consumption was expected to pick up, partly in view of rising household income.Notwithstanding the prospect of further good economic growth in the coming years, Riksbank judged that the rate of inflation would remain low and even be less than we had e earlier.

The strong demand was certainly assumed to give some increase in inflationary pressu forecast period but not so much as to be a cause for concern.

One reason lay in the good pr growth that was also foreseen, indicating that full capacity utilisation in the economy wo reached in the coming twenty-four months.

Although capacity utilisation was high in certain se Riksbank envisaged that in the economy as a whole there would be a capacity surplus.External inflationary pressure was expected to be low in view of subdued interna inflation, low raw materials prices and a somewhat stronger exchange rate.Expectations of future inflation among households, financial agents and manufact indicated a belief that future inflation would be low.

Thus, confidence in economic policy' price stability seemed to have been firmly established.The Riksbank noted that the uncertainty in the assessment of future inflation was whether it would be even lower than we foresaw in the main scenario.

One of the main factors the crisis in Asia and its conceivable effects on international economic developments and pri were risks of the crisis' effects being greater than assumed in the main scenario in June, demand and low inflation in the rest of the world would lead to an even lower price rise in t economy.All in all, these considerations meant that in the June report the Riksbank's assessment of inflation in the coming years was adjusted downwards.

As the rate of inflation twenty-four months ahead was judged to be below the target, the Riksbank considered that, at l time, there was room for a somewhat more expansionary monetary stance.

The repo rate was the lowered 25 basis points.

## 4.

What has happened since the June report?Let us now look at what has actually happened since the beginning of the summer.

## Low pressure from international pricesDuring the summer the Asian crisis has got worse and the uncertainty about its course seems to have grown.

More countries in the region are now expected to show a fall i during the year.

One of the main factors behind the deterioration is the weak Japanese econ knock-on effects of the Japanese crisis in other parts of the world are highly uncertain, as in such countries as Russia and China.An impact from the Asian crisis is now discernible in economic growth in the U States and the United Kingdom.

These economies show signs of a slowdown that can be trace decreased exports to Asia but there are also indications that their domestic demand is slackeniIn the euro area, however, growth prospects seem to be more favourable.

The reco appears to be firm-to a growing extent as a result of stronger domestic demand-and it looks as inflation will remain low.The overall picture of international activity is somewhat weaker than the Ri forecast in June.

International inflationary pressure is low.

The extensive economic problem and the unrest in global stock exchanges are contributing to this.

## Swedish economy strongEconomic growth in Sweden seems to be good, however.

As expected, the statistics s an accelerating growth of domestic demand, accompanied by a slowdown in foreign trade.Private consumption is rising strongly and a continuation of this trend is indic number of factors: households' personal economic expectations are still rising, employment is and disposable income is growing as a result of low inflation and a less restrictive fi Uncertainty about share prices could have a contrary effect but the downward movements that ha observed constitute no more than a correction after a relatively strong increase.

Since the 1998 the Stockholm Exchange has risen 20 per cent.

The statistics also show strong growth fo consumption as well as gross capital formation.But foreign trade is weakening; export growth is slowing and imports are rising. are several signs that exports will go on slackening; the inflow of export orders has deter confidence has fallen among purchasing managers in manufacturing.

However, the weaker exchange may have a contrary effect on exports.The inflation statistics show that inflationary pressure in the Swedish economy low.

In June and July the price level fell 0.2 per cent.

This means that for both months the t rate of inflation was 0.6 per cent.All in all, it looks as though the growth of domestic demand in 1998 may excee assessment in the June report.

On the other hand, foreign trade may be somewhat weaker th counted on at that time.

Thus, the figures on real economic developments that have been publis the latest inflation report do not seem to call for any substantial revision of the forecast the summer figures for inflation or the regular surveys of inflation expectations altered the the early summer.

## Weaker exchange rateIn the June report we counted on some appreciation of the krona in the forecast During the summer the krona has weakened and I want to take this opportunity of commenting o tendency since June.

Most of the weakening has occurred in August.

In effective terms (TCW) th has depreciated somewhat more than 3 per cent since the beginning of June, from 119 to 123.

Aga US dollar and the German mark the fall in this period amounts to somewhat more than 5 per cen per cent, respectively.Several explanations are given for the weakening of the krona.

A downward tende was already evident in May-June in connection with the repo rate cut.

After that the krona see been pulled down by the unrest in Asia, which has hit relatively small industrialised countr dependent on foreign trade.

Some observers consider that countries with a high export share materials have experienced a currency depreciation in connection with the price fall for raw That explanation is not really all that applicable to Sweden because it is difficult to show t particularly dependent on raw materials exports.The stock exchange turbulence is also considered to have had a major effect on the recently in that nonresidents have disposed of Swedish shares, which involves selling kronor currencies.

Since the June inflation report there has been no new information that warrants concern about economic development in Sweden.

So the weaker krona does not appear to refl change in confidence in the economic fundamentals.

The traditional indicators of credibility, from price trends in financial markets, convey the same picture.

Both the long bond differe Germany and the expected future short interest rates point to persistently strong confide low-inflation policy.In this context I should like briefly to rehearse the role of the exchange rate i policy.

The Riksbank does not target the exchange rate; monetary policy focuses instead on a inflation.

The exchange rate can be seen as one of a number of indicators-albeit one of important-that we use to predict inflationary pressure in the Swedish economy.

If the krona we strengthens permanently , then thisall else equal -will affect inflation.The difficulty accordingly lies in assessing the permanence of exchange rate move and incorporating the assessment in the overall picture of inflation.

The economic fundamenta an appreciation of the krona in the coming years.

For this reason we believe that the current w temporary and will be followed in time by a renewed appreciation.

It should be underscored, that if the krona's weakening to date can be regarded as permanent, then there are also r expecting that the weaker exchange rate will lead to inflation at a higher rate than we foresa report.

That would have consequences for monetary policy, always assuming, of course, tha factors have not simultaneously contributed to a better outlook for inflation.The recent weakening of the krona, together with increased concern about conti turbulence in Asia and global stock exchanges, has shown up in money market pricing.

The ma earlier assessment was that room existed for further interest rate cuts.

Today the picture is This I find entirely natural in that the exchange rate is an important factor in our assessm inflation.

## The overall pictureTo

sum up, the new statistics since June largely support the opinion about in prospects that we presented in the latest report.

The figures for real economic activity a suggest, if anything, that the path of inflation will be lower than in our main scenario in t If so, however, it is presumably a question of marginal revisions.

The exchange rate, however, moving as we predicted, has weakened.

The assessment of this tendency and how it should be we up with other factors in an overall assessment of inflation prospects is a matter to which t will be returning in the next inflation report on September 28th.

## Concluding remarksHaving presented the Riksbank's picture of current economic developments, I should to return to the somewhat longer time perspective from the beginning of this talk and take u that is the theme for today's speakers.

Is there room for expansion in the Swedish economy?

In shall concentrate on two fields that are closely connected with monetary policy: the functio labour market and fiscal policy.The economic policy that has been implemented in recent years, with its emphasi price stability and sound government finances, has had favourable results in a number of resp growth has been combined with persistently low inflation.

Moreover, the composition of growth h structurally desirable, focusing on exports and industrial expansion.

This helps to establ foundation for a sustained increase in future consumption.

A reduction of external debt has begProspects for the coming years also look favourable.

It seems that output can relatively rapidly by Swedish standards, accompanied by relatively low inflation.There is reason to emphasise, however, that what we see is hardly the final sol our problems but rather important initial steps towards a more balanced development.For one thing, the positive trend in the Swedish economy does not yet apply substantially to the labour market .

A downward adjustment in the rate of wage increases towards more reasonable long-term figures has begun but we do not know how permanent it will be.

What will in the next round of wage negotiations if capacity utilisation at that time is high?

Is the funlabour market in other respects sufficiently smooth for the adequate creation and filling vacancies?

This is a key question.

If we do not succeed in finding good solutions in Sweden comes to wage formation and the workings of the labour market, in the longer run it will not b to permit such strong economic expansion as we have experienced in recent years.Another aspect of economic policy that, like the functioning of the labour mar closely connected with the Riksbank's domain is fiscal policy .

In recent years monetary policy has been assisted in the first place in that the consolidation of government finances has restor foundation for economic policy; in addition, there has been the more direct restraint-in perspective-on demand and price impulses.

In recent decades that was by no means invariably th On the contrary, there were periods when fiscal policy accentuated the cyclical movements.I find it important to issue a warning about repeating mistakes of this type.

In of an economic upswing we are now hearing calls for expansionary fiscal policies in the increased public spending as well as unfinanced tax cuts.

There are strong long-term grounds the upswing in activity to build up government surpluses as a buffer for harder times.

That w our future freedom of action in economic policy.

It will be easier to cope both with futur downturns and with structural challenges such as an ageing population.

A tighter fiscal policy the burden on monetary policy and increases the probability in the years ahead of being able t to have low interest rates and a stable economic development, with good growth of producti employment.