Mr. Heikensten discusses monetary policy  (Central Bank Articles and Speeches, 14 Oct 98)
Central bank: riksbank | Type: speech | Date: 1998-10-14

Mr. Heikensten discusses monetary policy Address by the Deputy Governor of the Bank of Sweden, Mr. Lars Heikensten, at the Autumn Conference arranged by the Centre for Bus and Policy Studies on 14/10/98.First a word of thanks for the opportunity to attend this meeting.

The autumn conf are a fine tradition to which it is a pleasure to contribute.On previous occasions I have used the opportunity to look back over the past ye discuss what the Riksbank has been doing, including how monetary policy is conducted.

Then tried to look ahead and pick out some issues of importance for monetary policy in the longer ruMy approach this year will be broadly the same.

First a review of what has hap since last autumn, with comments on how the Riksbank's assessment of inflation has evolved o year.

Then, as previously, a look at the question of how we communicate policy and how it h perceived in financial markets.On this occasion we are in the throes of an international financial crisis, w uncertainty as to what its real economic effects may be.

Contagious effects of the crisis ha become larger and larger.

Looking back, one can clearly see how the economic forecasts o observers have swung during the year, from a phase of concern about a future increase in in pressure to a phase of strong anxiety that the global economy will be hit by a recession.Against this background I shall be discussing the current monetary policy appraisa Swedish economy, together with some factors of importance for the final assessment.

First, ho shall briefly outline monetary policy's line of thought.

## Forecasts and probabilitiesMonetary policy's overriding objective is to safeguard the value of money.

The a rate of inflation, measured as the change in the consumer price index, is to be kept at 2 pe takes time for the Riksbank's monetary measures to work in full, our actions have to be based on an assessment of inflation's future path.

The policy horizon - the period in which most of of monetary policy materialises - is around twelve to twenty-four months.The Riksbank's assessment of future inflation is presented continuously in our I Reports.

Since the first Report was presented in October 1993, the content has been develope Riksbank has, for example, become increasingly explicit in its assessments.

In the first tw Report contained a more general account of how the inflation indicators and inflationary pres economy were developing.

From November 1995 onwards the Riksbank has been attaching numbers t its inflation assessments.In the June 1996 Report the inflation assessment was underpinned for the first ti an overall picture of the cyclical position.

A further step was taken in September 1997, inflation assessment was supplemented with a path for inflation in the forecast period.

In the our main path for inflation was flanked by uncertainty intervals.

The probabilities of inflati various alternative paths are weighed into the overall picture on which monetary policy dec based.How, then, are the uncertainty intervals calculated?

In practice, our forecasters assessments of a range of variables, taking into account both their current uncertainty an compares with their normal uncertainty.

This information is then incorporated in a fairly sim model that is used to estimate future inflation.

The probability distributions we obtain in th course, highly subjective but they do give a consistent picture of how the Riksbank evaluate risks.While we are on the subject of the inflation assessments, it is particularly im bear in mind that they are predicated on the repo rate being unchanged throughout the forecast forecast path for inflation that deviates from the target - or the large deviations that intervals represent as conceivable paths - constitutes a diagnosis that may indicate treat called for, repo rate adjustments are used to bring inflation into line with the target.

In r the uncertainty about future inflation is not as great as the uncertainty intervals might su consequence is that our inflation forecasts become out of date as soon as the Riksbank alte rate.

## Assessments in the past yearMuch

has happened in the past year as regards economic developments and th conditions for monetary policy.

The Riksbank, along with other official observers and market fo has revised its assessments in the light of the increasingly widespread effects of the internat- Last autumn most observers counted on a strong economic trend, both in Sweden an in the rest of the world.

The crisis that had erupted in Southeast Asia was ex lead at most to a welcome easing of international price pressure.

In the S economy, some indicators last autumn pointed to rising inflationary pressur particular, a gradual increase in capacity utilisation was judged to lead i inflation above the Riksbank's target.

Inflation expectations, moreover, were to move up, having previously stabilised after a falling trend for a number o In the December Report it was judged that inflation would exceed the target in The Riksbank raised the repo rate 0.25 percentage points.- At the same time, the Riksbank underscored that, due to uncertainties i assessment, the outcome might differ from the main scenario.

On the one hand exacerbation of the crisis in Asia could result in weaker inflationary pressur other, there were risks that high wage increases and weak productivity growth fuel the rate of inflation.

These two alternative scenarios were judged to be probable.- During the spring the picture of inflation changed by degrees.

In the March Repo inflation prospects had altered somewhat in connection with the mounting cris Asia and low import prices.

Subdued inflation expectations and restrained demands pointed in the same direction.

In view of a weak development international activity, it was foreseen that full capacity utilisation in t economy would not be reached until the end of the forecast period, when infl was assumed to be marginally above the target.

This called for a readine undertake some cautious tightening of the monetary stance later in the year.- At the same time, the spectrum of risks had shifted, with less risk of i exceeding its expected path but a continued risk of development being weaker in the main scenario.

In view of the uncertainty, the Riksbank chose to await developments.- At the beginning of the summer we observed that inflation was following a lower path than we had assumed in the main scenario in March.

Weaker import prices w contributing to this but so were other factors.

Transitory effects - lower int and changes in indirect taxes and subsidies - were particularly prominent.

Mor on account of lower wage increases and stronger productivity growth than expe earlier, it seemed that inflation in the longer run would be somewhat lower t Riksbank had predicted.

With the outlook for productivity, it was likely tha surplus capacity would continue to exist during the whole period.All in all, inflation prospects one to two years ahead were accordingly more s than before and predicted inflation was below the target throughout the fo period.

In addition, there was judged to be a large risk of inflation being path in the main scenario.

Under these circumstances the repo rate was lowered percentage points.Notwithstanding these revisions, the economic outlook for the near future ha changed much in the past year, with expectations of good growth during 1998, to an increasing account of rising domestic demand.

These predictions have been fulfilled.

During the year, how uncertainty about growth prospects further ahead has risen, above all in the late summer and au

## Transitory effects and lower import pricesAnother matter to note is that although the cyclical picture has proved fairly acc path of inflation during 1998 has been markedly lower, mainly on account of large changes in t effects and import prices.At the beginning of the year it was foreseen that the transitory

effects would largely cancel out, with no impact at all on the course of inflation during 1998.

With the spring dec tobacco taxes and property tax, however, it was assumed that the transitory effects would act curb on inflation.

In the June Report it was foreseen that the transitory effects would have impact on inflation during 1998 of as much as 1.2 percentage points; in the September Report t was adjusted upwards to 1.3 percentage points.

For 1999 and 2000 the transitory effects on infl assumed to be marginal.Import prices have also been more subdued than expected.

In the December assessment last year the Riksbank assumed that during the forecast period the annual contribution to inf import prices would amount to about half a percentage point.

Some downward revision was mad March, followed by a further adjustment in June, when it was envisaged that the impact of impo on the CPI would not be sizeable.

The lower outcome and the adjusted forecasts mainly reflec fall for raw materials, though the international price trend for manufactured products has weaker than expected, presumably in part as a consequence of the Asian crisis.Rents are another CPI item that has been more subdued than foreseen in the spring. the beginning of the year, the rate of rent increases has dropped to levels that are historica partly attributable to lower mortgage interest costs and lower expectations for wages and infl also reflects the cut in property tax and decreased heating costs.Wages seem to have developed more or less as the Riksbank foresaw.

Today we count an annual wage rise of 3.5-4 per cent in the period 1998-2000; that is only a little below o last December before the wage negotiations had been completed.

Opinions differ as to the effe the Riksbank's actions may have had on the latest wage round.

In the light of contacts with lab representatives, my view is that monetary policy's influence on the wage settlements was posi this was by no means the only factor.

Contributions to the low outcome seem to have been made wage round having been conducted both centrally, with efforts to hold wage formation togethe throughout the labour market then at least in large segments, and decentralised to indivi Whether this model can be repeated is another matter.Transitory effects, import prices and rents account for 2 percentage points substantial downward revision of inflation in 1998 by a total of 2.2 percentage points be Inflation Reports in December 1997 and this September.

The same factors are responsible for ab of the downward adjustments for 1999 and 2000 between the forecasts in March and June.Monetary policy increasingly understood, but problems last springFor some years now the Riksbank has been working hard to communicate the line thought behind its decisions both to the general public and to market players.

This is intended the general understanding of how monetary policy functions and what it can do and also preven as possible, market disturbances on account of uncertainty.

The more clearly the market unders way of thinking, the smoother should short interest rates adjust to new information about prospects.A comparison of market expectations (as expressed in implied forward interest with the actual repo rate can serve as a indicator of the market's error in foreseeing the r predictive error has, on the whole, decreased.

With a reservation for other effects on this i various interest rate premia that may fluctuate over time, this suggests a growing understan policy.With a longer time horizon, the predictive error naturally tends to be larger.

Wi year horizon the error presumably has less to do with imperfect communication or a l understanding of how our policy functions; it is no doubt more a matter of shifts in the whol economic activity and inflation.

Things are somewhat different in a three-month perspective; errors then presumably also arise from misinterpretations of the Riksbank's signals.During the past year the repo rate has been raised once and lowered once.

Thi required a great deal of the Riksbank in the way of communicating policy to the outside w explaining the reasons for its measures.A study of the market's prices, predictions and statements shows that the rep increase in December 1997 was broadly expected.

It was, in fact, just at last year's Conferenc an important piece of signalling took place.

As regards the repo rate cut in June, on the ot pattern of market expectations changed relatively late.

The implied forward interest rate c months earlier show that the June cut had not yet been foreseen by market players.

It was connection with an interview I gave some weeks before the decision that expectations shifted toThe Riksbank's management of information about the repo rate cut came in for mar criticism.

We were said to have been indistinct and to have changed our inflation assess abruptly.

Some players used big words, claiming that the lack of clarity had damaged confiden policy and would make it difficult to conduct an effective policy in future.

I think that was But the Riksbank should still have been able to make the market more prepared for what the fut have in store.It should also be underscored, however, that the tendencies during the sprin difficult to assess.

We certainly changed our opinion but not so abruptly and for a long time i uncertain what the next step would turn out to be.

In such a situation, with a high degree of communication is difficult.One reason for not reacting to the faulty pattern of market expectations was t forecasts of market players were in line with our own.

Thus it was not that we differed in the of inflation prospects but that, even though the path of inflation was below the target, mark not represent a view that the Riksbank would lower the repo rate.

To put it bluntly, mark seemed to share the Trade Union Confederation's view that the Riksbank acted with a 'bias'.A clear lesson from events last spring is, in any event, the value for market obs constructing independent forecasts of inflation as a foundation for their repo rate predict Riksbank, what happened has prompted us to work even more on continuously monitoring mark opinions so as to be able to react in good time if the assessments of market players seem to from our own.

## Main scenario and balanced risksNow for a look ahead in the context of our current assessment of inflation.In

the latest Inflation Report, published at the end of September, the Ri emphasised that inflation prospects contained a large element of uncertainty.

The cyclical p changed somewhat since June in that growth was judged to be strongest this year and then somewhat.

But we still counted on reasonably good activity, with annual growth in the comin averaging almost 3 per cent.

Inflation, measured as the 12-month change in the CPI, was assum below 2 per cent in 1998 and 1998 but to reach approximately 2 per cent at the end of the perioThe composition of demand had also undergone a shift.

The international crisis expected to render net exports weaker than assumed earlier, while domestic demand was likel somewhat stronger than foreseen in June.

The assessments were based on an assumed appreciation Swedish krona from the current TCW index level of 124 to 120 in the coming year and just over the year after that.Inflationary impulses from the rest of the world were expected to be low in the period.The rising domestic demand was not expected to result in an alarming increas inflationary pressure.

Investment growth and labour supply were judged to be sufficient to avo problems with capacity during the period.

The development of wages and productivity was expec be favourable for a moderate, though rising, rate of inflation.Inflation expectations among market agents, firms and households were still Inflation was expected to be below the target in the short run and then be in line with the ahead.With the fundamentally positive picture of the Swedish economy, including good gro in the forecast period and a successive return to the targeted rate of inflation, the Riksban rate unchanged.

As uncertainty had increased since the earlier assessments, however, the un interval surrounding the main path was considerably wider.

But the risk spectrum was symmetric is, the risks of inflation being higher than in the main scenario were judged to be as great lower inflation.

International economic activity may result in inflation being even lower than scenario, at the same time as a lastingly weak exchange rate that has no counterpart in poore fundamentals could lead to upward pressure on prices.

## Increased financial unrestFinancial unrest has grown since the September Report was published.

It is diffi foresee to what extent the crisis that began in Thailand almost a year and a half ago will a industrialised economies in the West.The direct real economic effects via foreign trade will probably be relatively small.For economic activity and inflation in Sweden, the effects that could aris decreased general confidence are more important.

Share prices in Sweden have gone on falling since September Report was published, wiping out not just the gains during 1998 but also a part of increase.

Since the high in July, the Stockholm Exchange 1 has dropped nearly 30 per cent, giving a fall o about 8 per cent from the level at the beginning of the year.

Since the Inflation Report was share prices have fallen nearly 6 per cent.1 Affärsvärlden's general index.Continued unrest and falling asset values would affect the behaviour of firm consumers.

If households and firms postpone investment and consumption decisions, economic ac will be lower.

Some signs of this can be discerned; the latest figures suggest a minor blow to expectations of Sweden's economy, though this has not yet affected their personal ec expectations.

There has been some fall in the growth of business credits.Another channel for effects on the real economy is the banking system .

A more cautious supply of bank credits could dampen economic activity.

In this respect the international turbu cause for concern.

The tendency in the late summer for investors to move to assets that were r generally secure - a flight to quality - has developed into a general aversion to holdin investors fleeing instead to assets that are more liquid.

The economic fundamentals in countries are currently playing little part in investment decisions.

This has hit some T countries very hard.The financial system in Sweden is monitored very closely by the Riksbank.

The avai statistics suggest that, compared with many international banks, Swedish banks are in a bette with lower exposures to countries hit by the crisis.

The picture also seems to be relativ regards exposures to hedge funds.

This low exposure is probably a consequence of the bank c Sweden in the early 1990s.

So the risk of a domestically generated credit crunch should be smal

## Weak currencyBesides increased uncertainty and greater risks of weaker economic acti developments since the September Report was written have involved downward pressure on the Swe krona.

Since September 28th the krona has weakened almost 2 per cent in terms of the TCW-index, since the depreciation began last May the exchange rate has fallen about 9 per cent.Just as on previous occasions, financial unrest has hit the Swedish krona as i play safe and move to larger and more stable currencies.

This time, however, the unrest seem less to do with uncertainty about the future for Sweden's economic fundamentals.

Instead it involve general risk aversion among investors.

Support for this interpretation is to be foun letters (Swedish as well as foreign), et cetera, as well as in price setting of # and ##.

That an appreciation in the next phase, when the general unrest has subsided and investors concent again on economic fundamentals.

Judging from Prospera's surveys for the Riksbank, for insta seems that market players are also allowing for this in their assessments.The recent market weakening of the Swedish krona is a reminder of both the advant and the drawbacks of a flexible exchange rate.

The weaker exchange rate can serve as a mechan adjustment when international activity is slowing down.

This could be valuable if the crisis At the same time, the recent events illustrate that our vulnerability with a flexible exch considerable.

The krona has fluctuated even though economic policy is basically focused on Other countries with a flexible exchange rate and an inflation target have had similar exper example Australia, Canada and New Zealand.

It not only complicates assessments of the future p also probably entails costs in the form of a poorer real economic trend.

## ConclusionMonetary policy in Sweden has been conducted with an inflation target and a fle exchange rate since January 1993.

The results have been good in many respects.

Since the uptu summer of 1993, growth has been good compared with, for example, the years of high activity in 1980s.

In contrast with that period, moreover, inflation has been low.

Another point worth no good real wage trend.

With the low price rise, the annual real wage increases have averaged 2. since 1994, which is more than in the 1980s, for example, when nominal wages rose rapidly bu households actually gained in real terms was very modest.Monetary policy also seems to be better understood.

Presumably this is mainly bec in spite of everything, economic development in recent years has been relatively good.

The c attitudes is evident in surveys of how people perceive the Riksbank and monetary policy.

A picture is obtained from the treatment of the Bank and monetary policy in the Swedish press. line of thought has been broadly accepted, though from time to time there has naturally (and perhaps even rightly) been criticism of what we do.

Another point worth noting is that a large the new Riksdag (Sweden's parliament) backs an agreement that includes safeguarding the va money as a statutory objective, as well as a more independent status for the Riksbank.

Th discussion suggests that an understanding of the Riksbank's actions has also grown among players, though that does not rule out further improvements.In recent weeks, instrumental rates have been cut in other countries.

This is, of reflection of the increased concern about a deeper crisis that leads to lower inflation.

The however, to be rather careful about citing interest rate cuts by other central banks as groun action by the Riksbank, though this is frequently done in the debate.

When making comparisons United States, for instance, it should be borne in mind that the initial level of interest ra percentage points higher.

Most observers consider, moreover, that the United States is in cyclical phase.

When making comparisons with Continental Europe, it is particularly impor consider exchange rates.

The present weaker exchange rate represents an appreciable economic s If the TCW index were to remain at the present level in the coming twenty-four months, i represent an expansionary effect on the economy that is equivalent to an interest rate cut o like one or two percentage points.The weeks that have passed since the Riksbank presented the Inflation Report have dramatic in financial markets.

Our main scenario for the years ahead is still relatively good a Swedish economy, with inflationary pressure that gradually rises from a low level.

But uncerta the future path has been further accentuated in connection with the financial turbulence.

T increased risk of a weak international development.

In addition, the continued stock-market made domestic demand more difficult to assess than before.

Meanwhile, the weakening of the kr the opposite of the tendency on which our main scenario in the Report was based.At the Riksbank we are keeping a close watch on developments.

That is a self-ev component of our work for promoting financial stability in the economy.

It is also a necessary work on monetary policy.

At present there are no grounds for altering the direction of interest