Mr. Bäckström speaks on Swedish monetary policy outside EMU  (Central Bank Articles and Speeches, 22 Apr 98)
Central bank: riksbank | Type: speech | Date: 1998-04-22

Mr. Bäckström speaks on Swedish monetary policy outside EMU Address by the Governor of the Bank of Sweden, Mr. Urban Bäckström, to the Monetary Policy For organised by the Centre for Business Policy Studies and the Riksbank in Stockholm on 22/4/9I am pleased to note that the Centre for Business Policy Studies (SN maintaining the tradition, together with the Riksbank, of arranging the Monetary Polic This is our sixth annual opportunity of discussing monetary policy issues in the Forum could be more natural on this occasion than to consider the monetary policy future in connection with the launching of what is perhaps history's most momentous project in th Besides the question of how monetary policy will be conducted in the euro area, an important issue for us in Sweden is how our monetary policy will be affected when Stag of EMU starts and Sweden does not participate initially.The discussion of 'Monetary Policy in EMU' is to be opened by my Finnis colleague, Dr. Sirkka Hämäläinen, and I want to take this opportunity of wishing her welcome to Sweden.

In this context I should also like to express my appreciation of cooperation between Suomen Pankki and Sveriges Riksbank, which we reckon to continue e though Finland participates in the monetary union.The topic assigned to me is 'Swedish Monetary Policy Outside EMU'.

Firs shall paint my picture of what an outsider position will entail for Sweden's economi Then I will look at how monetary policy in Sweden is constructed in principle and concl some remarks on the current situation.In that Sweden will be outside the euro area initially, our economic policy constructed to fulfil the goals that are set up in Sweden.

These goals are based in domestic priorities together with the commitments we have as a member of the European U To a large extent, Sweden's priorities are the same as the EU's: implement an economic constructed for stability and low inflation, thereby creating conditions for a good dev prosperity.

Participation or otherwise in the monetary union does not affect the balanced economic policy.

## Monetary policy aimed at price stabilityA political majority has stated that membership of the European exchange mechanism,

ERM, is to be seen as a preliminary step towards participation in the m union.

Thus there are reasons for supposing that the question of ERM membership will topical until the issue of future EMU participation has been resolved.

Meanwhile, the will continue to operate with a flexible exchange rate regime and an explicit price sta for monetary policy.

Here it should be underscored that experience to date indicate regime is working well.From the beginning of 1999 the Riksbank's present independent position wil formally embedded in law.

The price stability objective will have statutory force function of the Riksbank will be to ensure that this objective is fulfilled.

The amend legislation on the Riksbank have already been approved once by the Riksdag (Swed Parliament) and a second vote on this constitutional change is scheduled for after t election in September.

The reform is supported by five of the political parties and th parliamentary majority.These changes meet EU requirements concerning monetary policy and the role the central bank.

Whether or not we adopt the single currency, Sweden has undertaken an independent central bank and this entails a far-reaching delegation of monetar decisions on the basis of an operational objective.

## Budget policy aimed at surplusSimilarly, Swedish fiscal policy will continue to be based both on our n objectives and on the requirements that have been adopted for the European Union.An objective for Sweden's public finances has been set up by the Government approved by the Riksdag.

In the medium term the government budget is to show a su measured as the cyclical average, of 2 per cent of GDP.

In that a surplus is government debt can be reduced so that future challenges which Sweden's economy may f can be tackled without creating problems for government finances.Considering the government debt that has accumulated in the 1990s and the that Sweden's public finances are relatively sensitive to cyclical activity, this reasonable.

Current assessments, based on existing decisions and official economic suggest that the budget policy target will be met in the coming years.Besides the greater awareness of the importance of stable finances, the con for fulfilling the budget objective have been improved by institutional changes to t process.

Sweden's new budget process is inherently more disciplined than before and contribute to the maintenance of sound finances.The Swedish objective of government financial consolidation is in line wi EU budgetary aim of positions close to balance or in surplus over the medium term Sweden's fiscal policy is also subject to EU agreements even though we have def participation in the monetary union.

Sweden has undertaken to aim for the objectiv Stability and Growth Pact.More generally, as a member state, Sweden has undertaken to regard its econ policy as a matter of common concern to all EU member states.

We will accordingl participating in the economic policy discussions and be subjected to assessmen evaluations.

We are also taking part in the drafting of the broad guidelines of econom these guidelines, which can be likened to fiscal plans for the Community, are to be in in the construction of EU countries' economic policies.

## Sweden moving towards stabilityA broad consensus has been established - in the world in general as well Sweden - about the objectives and institutional arrangements that are appropriate for policy, as well as the importance of international economic cooperation.

The inflatio that prevailed earlier caused major problems.

An expansionary economic policy subsequent devaluations does not generate any lasting positive effects in the real eco liable to result in high inflation that erodes the short-run gains in terms of costs. period of inflation, moreover, the more painful will be the readjustment to a more s economic development based on low inflation.˝Developments in Sweden have been moving in the right direction for a number years.

Inflation is low and growth favourable.

Earlier imbalances, in the government well as in foreign transactions, have been turned into surpluses.

Whether the adjustm labour market are sufficient to permit a sustained and more extensive increase in empl the coming years remains to be seen.

## FLEXIBLE EXCHANGE RATE WITH PRICE STABILITY TARGETSweden is in its sixth year with a flexible exchange rate regime and the year with a specific price stability target.

Insights into the new regime have been ga step, both in the Riksbank and in the Swedish community in general.

The constructio regime and its underlying ideas have been discussed over these years, not least in thes Policy Forums.The present monetary policy regime provides good conditions for long-term p stability and thereby for an economy that functions better.

It also contributes to a short-run balance between acting as a clear anchor for price stability and promo economic stabilisation.

Basically, it is a matter of minimising both the fluctuation price stability target and those around the Swedish economy's growth trend.

C fluctuations cannot be eliminated but we can hope that sequences of intense boom-and-bu thing of the past.

## Low inflation and good growth go hand in handWhen inflation converges internationally and long-term inflation expectatio permanently lowered to the level of the target for price stability, the core of the in lies

in the relationship between prevailing demand and the sustainable level of o resource utilisation is so high that it becomes strained, inflation will tend to rise when resource utilisation is low, inflation tends to fall.

To a large extent it is t demand and supply that determines whether inflation is rising, falling or constant in the 2 per cent target.Monetary policy is capable of exerting a direct effect - through the repo only one of these two sides of the economy, namely demand.

The supply side is esse influenced by structural factors that the Riksbank cannot control directly.

But perman inflation can indirectly impair the workings of the economy, leading to weaker growth. same token, today's low inflation should help the supply side to function more efficienSeen from this angle, it is easy to appreciate that a policy for safeguar stability should be able to go hand in hand with a development of demand that matc supply side's sustainable capacity.

In the event of a demand shock, even in the sho Riksbank's objective therefore coincides with that of general economic policy - a favou economic trend.

In view of the discussion that arises from time to time about objecti Riksbank, this should be borne in mind.

Consider these two examples:- Suppose, first, that a shock causes demand to fall; resource utilisat then decline, with a risk of inflation dropping below the 2 per cent tar monetary stance must then be adjusted so that the rate of inflation re the target.

This involves lowering the repo rate so that demand recovers˝- Suppose, instead, that a shock causes demand to rise faster than the side can cope with.

Inflation will then be liable to rise above the tar The monetary stance must therefore be tightened so that inflation falls the target, which involves subduing demand to output's sustainable levelIn the various situations, the impact of monetary policy can be contr expansive or neutral, depending on the degree of resource utilisation and the risk o deviating from the target in either direction.

The relevant rate of inflation here an is affected by total demand, is the underlying trend.

In that this trend is in line conditions are created for sustainable growth.

In the event of a demand shock there conflict between combating inflation and promoting growth.

## Transient price effects of secondary importanceBesides

effects from demand shocks, price movements are influenced b disturbances in supply.

Supply-side shocks vary both in kind and in the duration of t on the economy.

The monetary policy response accordingly depends on how suddenly suc shock occurs and how soon it fades.

A supply shock with a direct effect on prices, for VAT increase, should be distinguished from an increase in productivity, which affects via resource utilisation.

Let me start with the former case.A VAT increase will tend to subdue demand at the same time as it adds to 12-month rate of CPI inflation over a period of one year.

In this case, in the first tax increase, demand and inflation move in opposite directions.

If the monetary stanc be tightened in order to achieve a prompt return to inflation's targeted rate, it demand to fall further.

Temporary price stabilisation would be accompanied by a desta of real economic activity.

A similar dilemma is posed by VAT reduction, which stimula economy and lowers registered inflation.

A monetary policy response in the form of a cut - to return inflation to the target - would act as a further economic stimulus. temporary price stabilisation would be accompanied by a destablisation of real ec activity.I have used VAT adjustments here as an example of shocks from the supply s Effects of the same type are associated with changes in other indirect taxes, for i current proposal to lower the tax on tobacco.

The same applies to international movements, as well as to the Riksbank's own interest rate adjustments, which have a impact on house mortgage interest costs.How, then, should monetary policy deal with a situation in which price exposed to supply shocks of this kind?

Part of the answer lies in the circumstance that people's medium or long-term inflation expectations remain unaffected - most shocks type are transitory.

The Riksbank has concluded that in the normal course of events, price effects of this type ought to be a secondary consideration in the construction policy in so far as they do not affect inflation expectations and thereby have a more impact on inflation.Effects of supply-side shocks may, however, be more permanent.

A improvement in trend productivity, for example, implies lower resource utilisation an lower underlying inflation, and vice versa.

Such supply shocks should therefore infl construction of monetary policy.˝

## Advantages and drawbacks of the CPIA

drawback with the CPI is that it combines information about both the underlying trend and temporary price movements.

So why has the Riksbank chosen the CP its target variable instead of some indicator of underlying inflation?

The reason lies advantages as a familiar index that is used in many contexts, whereas the opposite app concept of underlying inflation.Sweden could, in fact, supplement the CPI figures with a series on under inflation statistics that would ultimately become more familiar.

This is a matter t Enquiry will be considering.

But it is still not clear just how an index of underly should be constructed.What is clear, however, is that this function cannot be performed by the Ne Index because that excludes only one type of transitory effect, namely indirect taxes. includes other transitory effects - for example mortgage interest costs and internatio movements - the Net Price Index gives a picture of inflation's underlying trend incomplete and distorted.Another alternative would be to use the EU's harmonised index of consum prices (HICP), which is constructed to exclude house mortgage interest costs.

One disa of this index, however, is that some of its components have not yet been finalised.As an aid in the analysis of price trends, the Riksbank's inflation report various indicators of underlying inflation.The tolerance interval of ±1 percentage point serves, among other thing accommodate the various transitory price movements that normally occur.

Experience shown, however, that in periods when the transitory price effects are extensive, inf move outside the interval without this by itself having consequences that should be con monetary policy.

Thus, the tolerance interval represents the range that is normally expected for fluctuations in CPI inflation.

It serves to indicate that the target variable, the controlled exactly.Still, I am convinced that people's awareness and understanding of these f will gradually grow as time passes.

This will happen not least as a result of the e those knowledgeable analysts and business journalists who follow monetary policy close mostly do their utmost to explain these complex details to a broader public.

## Exchange rate of indirect importance for monetary policyNow

I should like to say something about the role of the exchange rate. monetary policy strategy is premised on a flexible exchange rate.

In other words, the does not explicitly target the exchange rate and, given Sweden's position on ERM, i today that the rate will continue to be flexible at least until a new political decis the issue of EMU.

This complies with EU agreements.

ERM membership is voluntary. even in a flexible regime, exchange rate movements constitute an important policy in albeit more indirectly .- If the exchange rate weakens and remains at the weaker level, demand in Swedish economy is stimulated via increased exports and decreased impor˝In this way, a permanent depreciation can lead to higher inflationary pr The Riksbank then has to keep its instrumental rate at a higher leve otherwise in order to fulfil the price stability target.- A permanent appreciation of the krona tends to dampen demand, leading lower inflationary pressure.

All else equal, the Riksbank can then ke instrumental rate at a lower level.With reference to the exchange rate, the Riksbank is wont to talk of 'permanent' or 'lasting' developments and that is applicable here.

We do not react to occasional movements because they are unlikely to influence inflation prospects.The Maastricht Treaty requires all member states to treat exchange rate pol matter of common interest; this applies even if the exchange rate is flexible.

An EU expected to focus economic policy - both monetary and budget policy - on stability to degree as the other EU countries.

This, basically, is the absolutely crucial co sustained exchange rate stability.

An exchange rate that deviates permanently f long-term real equilibrium level may be an indication that economic policy lacks credi such a situation the EU member states have a 'common interest' in discussing how conf in economic policy can be enhanced.During the spring there has been a discussion in Sweden about the exchange tendency in connection with the move to Stage Three of EMU.

What will happen if instance, companies adopt the euro as their unit of account?

The Riksbank has undersc it does not see any strong reasons for large currency outflows on account of the moneta And if such outflows were to occur and the krona suddenly weakened, we consider countervailing forces would act in financial markets.The value of a currency is determined by numerous factors, of which the important is confidence in the country's economic policy.

The general trend t internationalisation in recent years has entailed relatively large currency outfl portfolio diversification among resident investors.

But at the same time the krona ha an appreciating trend as growing confidence in economic policy generated a compens currency inflow.All in all, conditions for a stable exchange rate between the krona and th currency should be good.

There are many indications that the European Central Bank wil a price stability target that resembles Sweden's.

Similar inflation trends, to confidence in economic policy as a whole, should result not only in stable nominal exchange rates between the euro and the krona but also in conditions for a reasonable of the krona.

## MONETARY POLICY'S CURRENT CONSTRUCTION

## A long target horizon permits a gradual monetary adjustmentWhen assessing monetary policy's construction, we look ahead to assess the of inflation in the coming twelve to twenty-four months.

A relatively long target ho have the drawback that earlier assessments may have to be revised.

One reason for ch long horizon - with the attendant difficulties in making reliable forecasts - is the t effects of monetary policy materialise.

By acting in good time, it is possible to a˝policy more gradually and smoothly.

In this way, any consequences that altered i prospects may have for the monetary stance will usually be gradual and small.With a shorter target horizon, the inflation assessments might be more ac but the monetary policy responses would have to be more pronounced in order to ful target.

There would also be wider fluctuations in output and employment.

Real fac production and employment are accordingly taken into account when making this choice.In view of the difficulties in assessing and forecasting economic tendenc monetary policy effects exactly, the Riksbank has opted for one to two years as its nor horizon.

## Lower CPI figuresThe forecasting problem can be illustrated with assessments from the Nat Institute of Economic Research; I use them here simply as an example, not to single National Institute from other forecasters.

But the National Institute is one of the fo the largest resources and it usually 'sets the trend' for other forecasters.

Last N Institute counted on annual rates of CPI inflation of 2.0 per cent for 1998 and 2.5 1999.

In other words, inflation would move gradually upwards from the price stability keeping with this, the Institute also counted on an monetary policy realignment, with a increase in the repo rate from 4.10 to 5.5 per cent, that is, by 140 basis points.This March - only four months later - the National Institute's predict inflation had changed considerably, to annual rates of 1.1 and 1.5 per cent for 1998 respectively.

The Institute's most recent assessment is that during 1998 and 1999 t need for any change from the present level of the repo rate.

What has happened to fo perception of inflation?

## Increased element of transitory price effectsBasically, nothing has happened in the appraisal of the upward cyclical The National Institute, like most other observers, counts on good growth in the comi The strength of the upswing may vary but the overall picture is that demand growth somewhat above the long-term trend, which implies rising resource utilisation.But besides expectations of lower wage increases, there have been a numbe favourable price shocks on the supply side.

Falling international crude oil prices h led to price reductions for energy-related goods.

Moreover, falling interest rates h house mortgage interest costs.

Then there is the Government's proposed reduction of tax.

However, the price shocks from the supply side are mainly transitory and tend to CPI temporarily but not necessarily inflation's underlying trend.

It follows that t probably should not have much influence on monetary policy.

This holds even though th change figures are likely to move outside the lower tolerance limit for a time dur mainly on account of the lower tobacco tax.

## How strong is the upward trend?As

I mentioned earlier, the primary concern for monetary policy is infl underlying rate and trend.

In that the monetary conditions have been expansionary f time and both economic activity and resource utilisation are rising, Sweden should be˝towards a situation with some increase in underlying inflation.

This phase may not be or involve anything dramatic but rising resource utilisation will ultimately lead to i are some factors which may defer it.

They have to do with the momentum in the Sw economy and the impact that may come from the crisis in Asia.

Another central facto exchange rate's underlying trend.

In addition there is the increasingly discussed about the sustainability of international share prices.To sum up, most of the evidence suggests that economic growth in Sweden w become stronger in the coming two years.

To date, however, the upswing has been accomp by subdued price movements.

This mainly reflects a number of favourable transitory eff there may also be signs of a somewhat lower inflation propensity.

The strength disp productivity may perhaps enable the Swedish economy to expand somewhat faster with immediately generating inflationary pressure.

But it is still too early to form a m opinion on whether the productivity trend has changed.

It is now important that statistics are still followed closely and assessed.

As I just said, there is no reas alter the repo rate.˝