Mr. Heikensten examines economic policy and the fight against inflation in Sweden  (Central Bank Articles and Speeches, 27 May 98)
Central bank: riksbank | Type: speech | Date: 1998-05-27

Mr. Heikensten examines economic policy and the fight against inflation in Sweden Speech by the Deputy Governor of the Bank of Sweden, Mr.

Lars Heikensten, at the MeetingAlmega -Affiliated Employers' Associations on 27/5/98.Thank you for the invitation to attend your meeting and talk about economic poli inflation.

Today I shall begin with a brief review of the historical background to the f inflation in the Swedish economy.

It is worth recalling that more than eight years have pass was decided in Sweden that combating inflation would have top priority.

This policy has been consistently ever since.

After a couple of initial years that were troublesome in many ways, have been encouraging and Swedish stabilisation policy now looks good even in a European compar This will be followed by a discussion of three policy fields-fiscal policy, labour market formation-that are closely linked to monetary policy, as well as some remarks about compe conditions in Sweden's economy.

Successful results in these policy fields enlarge the room to m in monetary policy.

In conclusion I shall consider some topical monetary policy issues, inc current appraisal of inflation and monetary policy's construction.

## 1.

The fight against inflation and its resultsHigh inflation characterised Sweden's economy for a number of years in the 1970s 1980s, a period that clearly illustrates an inflation economy's negative consequences.

Repeate were made to rectify the economic imbalances by means of devaluations and fiscal stimu development remained unstable.

The problems with inflation were then accentuated when the fin markets were deregulated.

Prices and wages rose steeply and Sweden was caught in wage-price s The occurrence of price bubbles made investment decisions more hazardous and led to productivity.

A high level of inflation became a permanent feature of our economy.

As monetar at that time was focused on maintaining a fixed exchange rate, fiscal policy ought to have beenBit by bit, there was a growing awareness across party political lines that in t run this economic policy strategy was not viable, a perception that had already dawned on most in our part of the world in the early 1980s.

It was now that low inflation in Sweden came to b necessary condition for achieving stable and sustained growth and thereby high employment.

Th clearly expressed officially for the first time in the Budget Statement in January 1991. inflation was given pride of place on the economic policy agenda.

The final policy objectives same as before but the perception of the conditions that were needed to attain them had changedThis realignment of stabilisation policy occurred, however, at a time when the policy's negative consequences had begun to leave their mark.

Due to the high level of manufacturing, for example, economic growth in Sweden was weak.

In addition, a rising real inte coincided with a period when the tax reform made savers and investors more sensitive to inter All this had a marked downward effect on domestic demand.The drop in output-almost 6 per cent in the course of three years-meant in turn government finances worsened dramatically.

From a surplus at 4.2 per cent of GDP in 1990, the balance swung to a deficit of 12.3 per cent in 1993.

In this period, moreover, registered un shot up from 1.7 to 8.2 per cent.In a way, the economic crisis in the early 1990s can be said to have been gener political decisions.

The combination of a stabilisation policy realignment with some structur did play a part in the course of the crisis.

But it should also be underscored that such m broadly essential.

The problem was not so much the measures that were implemented when inflationary bubble had already developed as the fact that policy had not been realigned earlieIn recent years, economic developments in Sweden have been favourable.

Growth h been stronger than in the high phase in the late 1980s and it has proved possible to combine g with low inflation.

A couple of years after the realignment of economic policy, inflationsharply to around 3 per cent.

Moreover, the reduction of current inflation has been accompa downward revision of inflation expectations.

Today, neither households, firms nor financia agents perceive any serious threat from inflation in the coming five years.Government finances have also improved markedly since the effects of the acute cri the early 1990s were overcome.

After rapid budget consolidation, a surplus of 1.6 per cent is 1998.

Government debt has been reduced since 1995.

Still, the restoration of confidence did t time.

There were strong and persistent doubts about both the determination and the abili Government and the Riksdag (Sweden's parliament) to carry out the proposed measures.Finally it is worth noting that the steps for reorienting economic policy on stab taken with a consensus that was considerably broader than is sometimes suggested by the p debate.

A good foundation for the years ahead has now been laid, although high unemployment is serious problem for Sweden's economy.

The positive picture is underpinned by institutional re the budget process and the status of the Riksbank.

## 2.

Three fields of importance for monetary policyNow I should like to turn to some issues or policy fields that are of major importance for monetary policy.

They are:

fiscal policy, the labour market, wage format competitive conditions in the Swedish economy.

It is generally the case that the more price supported by other policy fields, the greater the contribution monetary policy can make economic policy goals.

## Good fiscal foundation but storing up for lean years is advisableFiscal policy is relevant for monetary policy in a number of ways.

Fiscal decisio the room to manoeuvre in monetary policy not only via their direct impact on demand-and henc inflation-but also by how they influence economic policy's credibility.

A fiscal policy that i as being untenable in the longer run can raise doubts about the overall policy commitment inflation and stability.

To this should be added fiscal policy's influence on the macro economy in which taxes are levied and public revenue is spent influence the behaviour of households which may thereby-generally in the longer run-alter the economy's inflation propensity.

T however, I shall not be developing this aspect.In the first respect-fiscal policy's impact on economic activity-the picture is cl in recent years the fiscal stance has been very tight.

Of course, this has contributed to t inflation and in this sense it has assisted monetary policy.

With the current fiscal proposals ahead, however, the stance will not be as tight as before.

But to some extent the growth of income is still being restrained by the overall change in taxation and public spending.As regards credibility, there has been a marked improvement.

Last year the Govern laid down a long-term objective for government finances which goes further than the average corresponding commitments in Europe.

Over the business cycle the budget balance is to ave surplus of 2 per cent of GDP.

The Riksdag has approved this objective.The Riksbank finds this objective reasonable.

A budget surplus over the business can contribute to a speedier reduction of government debt, which is currently high.

This w greater freedom of action for future economic policy, which is particularly important in tha public finances are no doubt still relatively sensitive to the cyclical economic situation.

But further challenges in store for fiscal policy.

An ageing population implies new and growing req for example.

Another matter that may alter the conditions for fiscal policy is the increased mo bases, which in some respects may make it difficult to maintain present levels of taxation.Better wage settlements but what about the next round?As things now stand, fiscal policy will continue to provide good room to manoeuv monetary policy in the coming years.

So what about the contributions from the labour market a formation?Of the aggregate value-added in the Swedish economy, wages make up almost 70 pe cent.

Wage trends are therefore crucial for the path of inflation.

For many years, the wage ri has been above the rate in most other countries in Europe.

But as we all know, instead of Swedish employees a better real wage, the outcome has been the reverse.

In the 1990s the rate increases in Sweden has been curbed but the negotiated increases in the 1995 round were ab European average.As I mentioned earlier, economic policy in Sweden has been focused on low infla since 1991.

A consistent implementation of this policy, with an inflation target, clarifies th game for wage formation.

High wage increases are liable to boost inflation, which necessitat interest rates.The inflationary consequences of the wage increases can be modified if product growth is good, as has been the case in recent years.

But at least a part of this productiv achieved at the expense of jobs; this is one aspect of the process whereby higher labour cos stronger rationalisation and maybe also an increased capital input.

In this way, too, and not the higher interest rates directly affect demand and employment, a rapid wage rise is liable jobs.Against this background, the outcome of the latest wage negotiations is better earlier years.

Agreements for the next three years have been concluded at levels around 3 per It has been said that this takes wage drift into account but that is probably not entirely th one should no doubt count on wage drift averaging around 1 per cent.

The average annual wage o in the period 1998-2000 would then be 3.5 to 4 per cent.

This does still represent some downw in the rate of wage increases, which in turn assists the Riksbank's task of ensuring low infla equal, we can allow ourselves a somewhat lower level of interest rates and a somewhat stronge of demand.Speaking to you, it seems natural to take up two more aspects of this issue:- The outcome of the 1998 wage round does not appear to be sufficiently low to m major contribution to employment in Sweden.

But our wage level is still rising faster, if any the European average.

This may prove to be manageable as regards inflation and Sweden's compe position, thanks to good productivity growth, but what will it then entail for employment?- Neither is it easy to feel really confident about the next wage round.

What w responsible for the better outcome this year compared with 1995?

The greater credibility of th target can be cited as one explanation but is it the whole story?

And if not, what were arguments on this occasion and will they still hold good in two to three years time?

These ar questions that need to be analysed and answered, in the first place by the parties in the labou

## Better competition and price formation but there is more to doA third issue, which presumably has had practical consequences for monetary polic the

fight against inflation in recent years, although it is seldom discussed in these con competitive situation in the Swedish economy.In work at the Riksbank on monitoring prices in the Swedish economy, we could not to notice some positive changes in competitive conditions and pricing in recent years, as we more negative patterns that seem to be persisting.Let me take the positive aspects first.

One is the favourable price trend for goods in recent years.

This is particularly notable in that for much of this period the exch been comparatively weak, which by itself should push import prices up.

A favourable price trend been observed for food products, for example; this seems to be a consequence, at least i Sweden's membership of the European Union.

Today, moreover, there are many indications that combination of European monetary union and increased IT-based trade, for instance, will competition even stronger.There is a general difference between the development of administered prices and m prices for goods and services.

The administered prices have risen faster.

This may be a increased fee setting in the public sector in recent years, both in connection with structura from tax financing and to fill existing 'holes' in public finances.

Then there is the classi that it is not so easy to raise productivity growth in some parts of the services sector. applies in particular to a number of the services that are mainly provided under public auspi medical care and care of the aged.I have raised the questions of competitive conditions and price formation today ma as to help initiate a debate on these matters.

For monetary policy it is self-evidently increased competition, by keeping costs and prices down, can lead to better inflation prospec turn can improve the conditions for monetary policy.In recent years there have been indications of tendencies in this direction, in well as globally.

At the same time, it is difficult to tell just how much of the reduction of attributed specifically to changes in competition and price formation.

Neither is it clear such a process can continue and whether the same potential exists for keeping prices down ove of years.

These are matters to which we intend to return.

## 3.

Some monetary policy issuesSweden has had good experience, as I demonstrated earlier, of efforts to es credibility by means of a direct inflation target.

Inflation is currently low and the level remain low in the coming years.

The conditions for continuing with monetary policy's focus on are being further improved by the far-reaching delegation of monetary policy that is invol Riksbank's enhanced status from the turn of this year.

Against this background, I should like on some of monetary policy's topical issues.

## The exchange rateThe part played by the krona's exchange rate is a matter for debate that surfac time to time.

A recent instance is, for example, the run up to European monetary union and the this drew to Sweden's commitments as a member of the European Union.

Some observers believe the Riksbank may have an (unacknowledged) exchange rate target.

That is a misconception.

Riksbank does not target the krona's exchange rate.In a flexible exchange rate regime with a price stability target, the exchang admittedly a major factor, but only one of many factors that impinge on inflation.

A p appreciation or depreciation of the krona affects inflationary pressure via import prices, fo given exchange rate trend may well support monetary policy's drive for price stability; when the case, however, the Riksbank has to intervene and adjust the repo rate.At the same time, the exchange rate is the price of an asset that is current thro economy; the value of the krona is highly important in many economic decisions, not least f companies.

This makes a stable exchange rate fundamentally desirable.

It is then easier for al agents to make decisions.

All else equal, this should lead to higher growth.To this basic endeavour to keep the price of the krona stable should be adde European undertakings.

As a member of the European Union we are committed to treating our exch rate policy as a matter of common interest.

Opinions in the Union presumably differ from time about the practical application of this commitment but the basic requirement is that poli consistently on stability.The Riksdag has left the door open for Sweden's participation in the monetary uni later date and stated that in connection with such a move it can be relevant to join the Europe rate mechanism (ERM).

In this perspective, too, it is an advantage if the krona is more or lessMonetary policy in the euro area is to have the primary objective of price stabi do not yet know just how the European Central Bank (ECB) will formulate its target but it is u differ from the norm that has applied in Germany since the mid 1980s.

This means that inflatio exceed a medium-term level of 2 per cent.

In practice, therefore, the differences in this between the ECB and Sweden will probably not be so great as to have any real consequences f exchange rate.With policy focused on price stability both in Sweden and in the monetary union, should be good possibilities of a stable exchange rate between the krona and the euro.

This i by the path of the krona relative to the German mark in recent years.

As measured, for exampl long-term interest rate differential with Germany, confidence in Swedish economic policy has b since 1996.

In this period there have been only two occasions when the krona has fluctuated mo per cent against the German mark.

## Managing transitory effectsThe subject of the Riksbank's attitude to the inflation target is also raised fr time in the media.

It has been claimed that the Riksbank shows less concern about inflatio outside the tolerance interval's lower limit than it does about the upper limit being exceeded.That is not the case.

A couple of years is too short a period on which to base a that deviations from the targeted rate are a sign that policy has not been symmetric.

Monet work involves a lot of uncertainty, which is no doubt inevitable when the interest rate has to basis of forecasts that extend several years into the future.

At present, moreover, asse particularly difficult so soon after the changeover to a low-inflation regime, with all that th in the form of altered behaviour by households and firms.

Another complication is that in rec inflation throughout the world has been lower than expected.Another aspect of this issue is the Riksbank's choice of a target variable conceivable indicator of inflation has its shortcomings and these have to be weighed ag advantages when choosing monetary policy's target variable.

The consumer price index (CPI) h advantages of being well-known and established among economic agents and people in general measure of inflation.

It also covers a large proportion of household consumption.

These wer arguments when the CPI was chosen as the target variable in the beginning of 1993.A disadvantage with the CPI, however, is that it combines information about infl underlying trend with transitory price movements.

In the period in which the inflation target force, transitory factors have had a marked effect on the CPI on a number of occasions.

Example factors are tax changes (most recently the increases to and subsequent cuts in property and tob and fluctuations in interest rates (which affect the CPI in the form of house mortgage ex During 1996 and 1997 in particular the CPI has been relatively markedly below not just the tar but even the tolerance interval.

This has faced the Riksbank with educational problems.Transitory effects on inflation ought to be a secondary consideration in monetary and be absorbed inside the tolerance interval of 1-3 per cent.

That is one of the interval's fprovided it is a question of temporary price movements around a stable rate of inflation, reason to counter such movements with repo rate adjustments.

On the contrary, that might destabilising effect in the real economy.

Instead, monetary policy's central concern is the inflation's long-term trend.

It is this trend which can be affected more directly by total dema by monetary policy.Against this background, the Riksbank has contacted the CPI Enquiry, set up by Government, to obtain assistance in specifying an indicator of underlying inflation that is widely accepted and can be published regularly by Statistics Sweden.

In the future, such an might be able to have a more direct function in monetary policy, either by replacing the CPI a variable or by serving as an operational target or aid in the continuous work of constructing Riksbank has also asked Statistics Sweden to publish, for the time being, one or more indi underlying inflation together with the CPI.

Perhaps I should emphasise that in no way do these alter monetary policy's fundamental commitment to price stability.

## The current situation for monetary policyThe question of transitory effects leads me on to current monetary

policy.

Tra effects are playing a major part in the CPI's present development.

As a result of tax chan interest rates and a lower oil price, since December the Riksbank has had to revise the prediction downwards by about 1.2 percentage points.

In 1999, too, transitory effects mean inflation will be lower than we envisaged earlier.Thus far, however, the altered picture of inflation need not have any si consequences for monetary policy.

It is now too late to influence this year's path for inflati marginally.

Moreover, some of the transitory effects entail a risk of higher inflation, if an 1999; tax cuts and lower interest rates leave households with more money to spend and the same to cheaper oil.But underlying inflation also shows signs of being weaker than expected even th economic activity seems to be relatively strong and in line with the paths we have counted on time, with a further increase driven by domestic demand and supported by strong activity in EurThe better picture of prices comes from a variety of factors.

The rate of wage inc likely to be somewhat more advantageous than we counted on earlier, even though we have consis been cautiously optimistic in this respect.

Of greater importance is productivity, where good recent years has helped to brighten prospects.

Somewhat lower import prices together with a stronger exchange rate also contribute.Work on our next Inflation Report is nearing completion.

There are several indication that in the two years horizon that is relevant for monetary policy, CPI inflation may be somew our target.

The picture of underlying inflation is much the same.

Neither are these positi prospects modified by the various risks that lie ahead.

In a perspective that extends to the m the element of uncertainty is obviously high; if anything, however, the main risk seems t international activity will be marginally weaker and inflation accordingly somewhat lower.This is a pleasant situation to be in.

The Swedish economy appears to be growin rate that is reasonable and broadly expected.

At the same time, inflation is lower than exp prospect that the Riksbank faced last autumn, of inflation two years hence being half a perce above the target, no longer seems probable.For monetary policy, the outlook has accordingly changed.

The present infla prospects clearly imply that the need to raise interest rates has disappeared for now interpretation of the Riksbank's rule that monetary policy is to focus primarily on the se coming two years could even indicate some downward adjustment of the instrumental rate.

WhaRiksbank now has reason to consider is whether a minor downward interest rate adjustment woul to good conditions for a stable economic development in the future.

## 4.

ConclusionStabilisation policy in Sweden was realigned in the early 1990s and focused o inflation.

The background was our own and other countries' experience in the 1970s and Repeated attempts to stimulate demand, with a view to boosting employment, and accept the ass increase in inflation had failed to produce the intended results.

On the contrary, economic become more unstable and growth in the longer term had, if anything, weakened.In recent years the results of the policy realignment have been good in many re Economic growth in Sweden has been higher than in the latter part of the 1980s and it has possible to combine this with low inflation.

Government finances have also undergone a improvement.

Moreover, revised rules for both fiscal and monetary policy have provided conditions for future stability.

This means that a good foundation has also been established economic development.The 1998 round of settlements agreements represents a step in the right directio sense that, compared with the previous round, the agreed rate of wage increases in coming ye like being easier to combine with low inflation.

Unfortunately, however, there are still reaso concern about the future.

Do the wage settlements create really good conditions for i employment and has a foundation been laid for further responsible wage settlements in t negotiating round in two to three years time?Some positive things in the Swedish economy have also happened in recent years regards competitive conditions and price formation.

With the ongoing process of internation European monetary union and advances in the IT field, there is likely to be a further intens competition and downward pressure on prices, to the benefit of Swedish consumers.

But there is consider whether more can be done, which if there is would also assist monetary policy.Finally I considered aspects of monetary policy and the current situation in thi In the past six months inflation prospects have improved.

Like many central banks in central E Riksbank has accordingly moved from a situation that pointed to the likelihood of a relativ succession of continued interest rate increases to one where the need of higher interest rate future seems to have disappeared.With the bright inflation prospects and a strict interpretation of the Riksbank' monetary policy decisions, today there may even be grounds for considering a minor downward rep adjustment.

What the Riksbank now has reason to consider is whether such an adjustment would l good conditions for stable economic development in the future.* * *