Mr Heikensten discusses the new currency and the Swedish economy  (Central Bank Articles and Speeches, 23 Jan 99)
Central bank: riksbank | Type: speech | Date: 1999-01-23

## Mr Heikensten discusses the new currency and the Swedish economySpeech by the First Deputy Governor of the Bank of Sweden, Mr Lars Heikensten, before Swedish Shareholders'Association in Sölvesborg, Bromölla, on 23/1/99.On New Year's Day, ten currencies in Europe were replaced by a single, common currency. changeover went well, no doubt exceeding some expectations.

The elaborate systems that used in earnest for the first time to transmit cross-border payments functioned proper serious technical hitches.

This made it possible to establish a uniform instrumenta monetary policy throughout the euro area.

The new currency also had a favourable recep financial markets, accompanied by falling interest rates.EMU has thus got off to a successful start.

But the challenges posed by monetary union risks connected with the project are mainly of a different nature.

They are economic and affecting the participants as well as non-euro countries.

With eleven countries subsc single monetary policy, the conditions for economic policy in Europe have changed.

So h terms for Sweden and economic policy here.

These matters have not yet been discussed fully in Sweden.Under these circumstances, I shall be opening our debate today by touching briefly issues: the new challenges posed by the euro to economic policy in Europe; the conseque Sweden; the path of the krona's exchange rate; and current monetary policy.

## Challenges to EU economic policiesThe euro's successful launch was underpinned by intensive preparations.

Now that the e been introduced, there is still work to be done to ensure that the monetary union als properly in the longer run.One of the major challenges is to achieve a good working relationship in the euro area the single monetary policy and other components of economic policy.

Achieving this inte can be difficult even at the national level.

Sweden's problems in the 1980s are a good fiscal policy was not sufficiently tight to counter the rapid expansion of credit and the supply side functioning all that well, which also contributed to the overheati monetary union, the single monetary policy has to mesh with the national fiscal, w structural policies of eleven countries.While decisions about the other components of economic policy are still mainly nation are highly important for the monetary union's success.

It is envisaged that good inter be achieved in that the euro countries monitor each other and jointly discuss thei policies.

Starting from mutually agreed policy guidelines, each EU country is to prese accounts of how it intends to fulfil the common objectives.

If a country's policy div the agreed guidelines, the idea is that other countries will protest at an early stage must shoulder its share of the responsibility for this.The work of constructing uniform rules has made most progress in the field of fiscal po the Stability and Growth Pact lays down clear constraints on budget policy: the countr strive for budgetary positions close to balance or in surplus in the medium term a normal circumstances they are to prevent the budget deficit from exceeding 3 per cent o process has been set up for supporting the forces in each country that back a responsi The process gets its muscle from the ultimate possibility of applying sanctions to cou do not follow the guidelines.The background to the EU countries' agreement on strict guidelines in this field is t about the size of government debt and the central role of fiscal policy in relation policy.

Fiscal policy affects price stability both via the level of economic activ expectations of future inflation.

Without the support of generally consolidated fiscal the euro area, the task of achieving price stability would be a heavy one.

Prob shortcomings in fiscal policy hit growth and employment in that they necessitate a interest rates that is higher than otherwise.Today, far too few countries fulfil the medium-term fiscal policy objectives and the m countries have very small margins to the Pact's definition of an excessive deficit.

Th to problems in the Union, particularly if a weaker economic development were to result i budgetary deterioration.Considering the size of government debt in a number of EU countries, continued adheren tight budget policy is to be desired.

Such a policy can make further interest rate cut economic activity slackens and inflation prospects improve.

There is a consensus on thi the European Union but reaching an agreement on how the countries should share the bur adjustment can be difficult.

It will no doubt require many lengthy discussions, wh already begun, between the finance ministers of the euro countries.

## Consequences for SwedenThe Riksdag (Sweden's parliament) has decided to stay outside the monetary union at p We are accordingly continuing to conduct our own monetary policy with a flexible exchan and an inflation target.The political consequences of being outside the euro area were considered by the Riksbank i submission on the report from the EMU Enquiry.

The conclusion that the consequences woul considerable has been reinforced now that the monetary union has started with eleven c This would be even clearer if Denmark and the United Kingdom were to decide to join.It is also clear, from discussions in which I have taken part, that the advent of the accompanied by closer collaboration on the construction of economic policies in Europe, as on Europe's actions on the global stage.

In these respects Sweden now carries less weA distinct message that we intend to remain outside the euro area for the foreseeab would probably weaken our influence in the European Union still more.

Our partners in would then be less interested in allowing for our positions on other matters as monetary union is, after all, one of the Community's most central integration projects.On the other hand, the economic consequences of Sweden still having a flexible exchange rat should not be exaggerated, at least in the short run.

Basically, the development of th rate and interest rates depends on how we manage Sweden's economy relative to the euro we succeed in making our economic policy credible, the costs of remaining outside fo years should not be unduly high.

But our decision not to participate does mean that we extra clear in demonstrating our determination to implement a sound economic policy, on sustained growth with low inflation and high employment.

There are no easy short cut in the short run.That Sweden, as a euro outsider with a flexible exchange rate, will have to live with rate fluctuations is evident from events last autumn.

We know from international experifloating exchange rates do in fact float.

Not even good economic fundamentals suffice stability in financial markets.

Here we have a price for being outside the monetary unio

## The exchange rateThe exchange rate is an important but elusive item in assessments of inflation.

Last a main assessment was that the krona would become successively stronger as the fin turbulence subsided and relatively more importance was attached to the favourable ec fundamentals, which include low inflation and a growing surplus on public finances.

R moreover, it seems that such a process has begun.

Signals of a move by Sweden towar monetary union may perhaps have acted as a catalyst here.The new political signals about the handling of the EMU issue have brought the questio krona's equilibrium level to the fore.

Participation in the euro area means that at so krona's exchange rate with the euro will have to be locked.

In the discussion that w held with colleagues in Europe, the actual decision will be a matter for the Governm Riksbank, however, is responsible for choosing the conversion rate we find reasona Sweden's behalf.

Meanwhile, we must bear in mind that we are dealing with negotia between Sweden and the other EU member states, so it may be inadvisable to get tied d matters of detail at an early stage.The Riksbank has made it clear on numerous occasions that it considers the krona undervalued.

Much of the debate on this issue has stemmed from an article on the equilibrium exchange rate that was published early in 1996 in our Quarterly Review .

The article was intended to serve as a basis for public debate; in our opinion it provided the bes that was then available for discussing the krona's long-term value.The krona's equilibrium value is naturally something that the Riksbank considers cont and the analysis is constantly being developed.

Accounts of various aspects of the exch have been presented in the Inflation Report .

The material that will be produced in the event Sweden deciding to participate in ERM2/EMU will have to incorporate the additi information since 1996.

It should also be noted that the levels and intervals that wer in the article refer to the krona's trade-weighted exchange rate and are therefore applicable to the question of a reasonable central rate for the krona against the euro. the euro is a new currency.

Arriving at just the right future exchange rate for the k the euro is therefore not exactly easy.Although the financial markets are naturally eager to know, at this stage it is too e the discussion of the krona's path to focus on specific intervals or levels.

But t clear-in the event of a euro peg, the rate for the krona will be stronger than the curre

## Current monetary policyIn conclusion I should like to say something about the monetary policy situation in International economic prospects gradually deteriorated during 1998.

Knock-on effects f crisis that originated in Asia were included from an early stage in the Riksbank's s risks.

Early in 1998, it was judged that they would be countered by other factors, not development of domestic demand.

In June, however, when price tendencies proved to be subdued than expected earlier, the repo rate was lowered by 0.25 percentage points.During the autumn, increasingly clear signs of an international slowdown were accentu growing turbulence in financial markets.

The Riksbank considered that the effectsSwedish economy and the path of inflation would be of a magnitude that warranted an ea the monetary stance.

In November the repo rate was accordingly lowered in two steps fro to 3.60 per cent.

In the December Inflation Report the assessment was still that in one to tw years time, both CPI and underlying inflation would be below the Riksbank's price s target of 2 per cent.

On December 16th the repo rate was therefore lowered by anoth percentage points to 3.40 per cent.

With this cut, the monetary stance was considered balanced; responsibility for monetary policy's future formulation was left to the Riksb Executive Board, which would be taking over in the new year.Since the publication of the December Report , international economic activity can hardly be sa to have changed appreciably for the better.

Prospects for both the euro area and the economy seem to have worsened, if anything, at least for the coming year.

In the euro manufacturing which has weakened in particular, while consumption still seems to be fo a relatively favourable path.

Developments in the United States are still fairly stro slowdown is still foreseen.

The situation in Brazil in recent days has created some unrest in international financial markets, with a limited flight to safe assets.

This, future international activity, though the turbulence in the wake of the falling re anything, to have been less than expected.The economic statistics for Sweden suggest that industrial activity may go on weakeni picture of total resource utilisation is still difficult to assess but there is much t proportion of unutilised resources is still comparatively large.

Forward indicator incoming orders, also point to a further deterioration.At the same time, households' expectations of their own economic situation indicate development of private consumption will remain relatively good.

Household optimis supported by increased employment and a favourable development of disposable inco However, the sustainability of this development is uncertain, as it was last autu because households and firms differ in their assessments of the future.

Negative news business community may make households more pessimistic, and so may renewed unrest financial markets.

Recently, moreover, there have been tendencies for households to uneasy about their own economic situation.A more positive development is favoured by the fact that the international financial subsided.

During the autumn there were strong fears that financial problems would international activity for several years.

With the normalisation to date, the probabili decreased.The December outcome for consumer prices was somewhat lower than expected.

The CPI fe 0.6 per cent, which can be compared with our forecast of a fall of 0.3 per cent. explanations are a weaker development of commodity prices and falling interest rates.The assessment of future inflationary pressure has to take these and other factors into the same time, the downward path of market interest rates in recent months represents stimulus further ahead.

This, too, must be considered in the assessment of inflation.If nothing untoward happens, the Riksbank's next monetary policy meeting will be he February 11th.

It will then be up to the new Executive Board to evaluate the informatio been received and decide the level of the repo rate.