Irma Rosenberg: Assessment of monetary policy
Speech by Ms Irma Rosenberg, Deputy Governor of the Sveriges Riksbank, at Norges Bank's
conference on monetary policy 2006, Oslo, 30 March 2006.
* * *
Let me begin by thanking you for the invitation to come here and speak to you! This type of
conference, with participants from various inflation-targeting central banks, and where we can discuss
common issues is very important in helping us to improve our knowledge.
Introduction
Many countries, including the UK, Norway and Sweden, today conduct monetary policy with an explicit
inflation target. Moreover, in many countries the central bank has been given an independent position
and responsibility for maintaining price stability. Experiences indicate clearly that it is difficult to
maintain low, stable inflation unless the central bank can act with a large measure of independence.
Maintaining confidence in monetary policy and in the inflation target requires that the central bank can
be free from any suspicion that it might give way to pressure from the political system or from various
pressure groups to conduct monetary policy aimed at other targets that are not compatible with price
stability.
Maintaining confidence also requires an understanding in society as a whole and broad political
support for monetary policy. The central bank's independent position therefore entails a requirement
for openness and clarity with regard to the bank's method of working with monetary policy.
Independence also means that it is important to be able to assess monetary policy. I therefore really
appreciate the opportunity to participate in today's discussion on assessing monetary policy.
I have today chosen to highlight a very fundamental question with regard to assessing monetary
policy; is it really necessary to interpret inflation that deviates from target as a failure for monetary
policy? It is clear that short-term deviations do not necessarily imply failure. But how should we regard
a deviation from target that persists for a longer period of time, perhaps several years? Here I take as
a point of departure the changes in the supply side of the economy that have occurred in recent years
in a number of countries, including Sweden and Norway, where inflation has for a period of time been
below target. I will, however, begin with a more general description of my views on the assessment of
monetary policy and how we in Sweden work to create the conditions for a good and fair assessment
of monetary policy.
Assessing monetary policy
When discussing and assessing central banks' target fulfilment, it is important to base the assessment
on a realistic picture of what monetary policy actually can and should achieve. To make the most
correct assessment possible, it is therefore necessary for central banks to have a clear analytical
framework to produce the material on which decisions are made. Similarly, it must be quite clear which
principles have been used as a basis for monetary policy decisions and on what information the
conclusions were based.
An assessment of monetary policy must be based on how the inflation target is formulated, and one
important issue is of course whether the central bank has interpreted the target in a way that is
compatible with the original intention. Most central banks take into account not only inflation, but also
in one way or another the stability of the real economy. For an assessment of this policy to be correct,
there must be a description of how it is done.
An assessment must also be based on what monetary policy can achieve. Inflation is constantly
subjected to shocks and as monetary policy affects the economy with a time lag, it is not possible to
keep inflation exactly on target all of the time. Monetary policy decisions must therefore be based on
forecasts. The success of monetary policy will be partly dependent on the accuracy of the forecasts.
An analysis of the forecasts and the reasons behind various forecasting errors must therefore form
part of an assessment of monetary policy.
However, there is considerable uncertainty linked to forecasts for the economy a couple of years
ahead and there are many reasons why forecasts prove inaccurate. As forecasts are based on the
information available at that point in time, it is natural that unexpected events can occur which cause
the economy to develop differently than the central bank had expected. There is insufficient
knowledge of how the economy functions and of how monetary policy affects the different parts of the
economy. Errors and omissions in statistics can also be one reason why forecasts are based on
incorrect assumptions. It is therefore also interesting to assess the central bank's forecasts against
those of other analysts. Would it have been possible to make better forecasts than those the central
bank produced? In order to answer this question, it is necessary to keep a record of both the central
bank's forecasts and other analysts' forecasts.
Another important factor in an assessment is whether the monetary policy decisions are
wellbalanced, given the forecasts and judgements that have been made. The way the strategy has been
formulated is important in this context. However, an assessment does not need to stop here. It may of
course be more comprehensive and cover not only target fulfilment, but also the monetary policy
framework as a whole.
Against this background, let me just say a few words about the monetary policy strategy we have
chosen in Sweden and the changes we have recently made to our analysis framework. The strategy
has of course developed gradually during the period we have applied inflation targeting and is
primarily the result of practical experiences of inflation targeting in Sweden and in other countries. New
findings in academic research in this field have also had significance.
The Riksbank's monetary policy strategy
In Sweden, the Riksdag (the Swedish parliament) has delegated the responsibility for monetary policy
to the Riksbank, through the Sveriges Riksbank Act, which came into force in 1999. According to this
Act, the objective of monetary policy is to maintain price stability. The Riksbank has specified this as
an inflation target, which states that the annual rate of change in CPI should be 2 per cent, with a
permitted deviation of ± 1 percentage point. The Riksbank shall also promote a safe and efficient
payment system. The preliminary work to the Sveriges Riksbank Act also makes clear that the
Riksbank as a public authority under the Riksdag, without neglecting the price stability target, should
support the general economic policy objectives of sustainable growth and high employment.
The Sveriges Riksbank Act also established increased independence for the Riksbank. Since 1999,
decisions on the repo rate have been made by the Executive Board of the Riksbank and the members
of the Board are expressly forbidden from seeking or receiving instructions when carrying out their
monetary policy tasks.
Price stability is thus the objective of Swedish monetary policy, but like Norges Bank and most other
inflation-targeting central banks we conduct monetary policy that also to some extent takes into
account activity in the real economy. The fact that the interest rate is often adjusted in relatively small
and predictable steps can partly be regarded as an expression of this. If the aim had instead been to
bring back inflation to the target as quickly as possible, without any other considerations, it is probable
that larger and more frequent adjustments would have been warranted. A more gradual change in the
interest rate can also be justified by the uncertainty of the forecasts and statistics.
Monetary policy is normally aimed at attaining the inflation target within two years. This horizon is
justified by the fact that monetary policy's impact comes after a time lag, but also by the desire to
contribute to subduing fluctuations in activity in the real economy. By aiming to allow some time before
the inflation target is attained, the Riksbank can contribute to stabilising the development of the real
economy, but at the same time we must safeguard confidence in the inflation target. Taking into
consideration developments in the real economy must not mean that the price stability target is set
aside. The two-year horizon provides scope for flexibility but at the same time sets a limit for how large
the deviations from target can normally be.
The fact that we have chosen to specify an exact target for inflation is an expression of our desire to
be clear and open. This is also why we have explicitly stated that inflation will normally be returned to
target within two years. Similarly, the deviation interval around the inflation target aims to explain that
monetary policy cannot, and does not, attempt to exactly attain the target all of the time. The deviation
interval thus also emphasises that there must be scope for temporary deviations from the target, which
may be justified with regard to avoid unnecessary fluctuations in growth and employment.
We thus endeavour to attain the inflation target within a two-year time perspective, under normal
circumstances. In certain cases, however, we may need to have even greater flexibility than the
twoyear perspective allows. If the economy were to suffer very large supply shocks, for instance, in the
form of structural changes that have a major effect on inflation, or if extreme situations such as war or
natural disasters occur, the process of bringing inflation back to the target may need to take even
longer to avoid excessive strain on the real economy. In this type of situation it would be even more
important that there was confidence in the inflation target. However, flexibility must not be allowed to
undermine the nominal anchor. If confidence were to fail, we would be forced to act more strongly and
would not have the same possibility to consider the real economy.
Thus, the objective of monetary policy is to maintain price stability. However, it is possible to give
consideration to the development of the real economy. This does not mean having a target for growth
or employment. Instead, this type of consideration is made possible by the way in which we have
chosen to formulate the principles for attaining the inflation target. However, it assumes that there is
sufficient confidence in the inflation-targeting policy.
Changes in our analytical framework
As monetary policy has an effect after a time lag, the Riksbank must look ahead and base its interest
rate decisions on forecasts of future developments, for instance, regarding economic activity and
inflation.
Like other central banks, we work constantly on improving our analysis work in order to produce the
best possible forecasts and analyses, and these improvements in methods also contribute over time to
making monetary policy easier to understand and assess. In recent years, for instance, we have
focussed on improving the models we use in our forecast work.
Last autumn we changed the interest rate assumption that forms the basis for our forecasts and at the
same time we chose to lengthen the time horizon for the forecasts. Previously, up to and including the
second Inflation Report published in 2005, the Riksbank's forecasts were based on the assumption
that the repo rate would remain constant over two years. As the repo rate is usually adjusted during
the forecast period, and thereby affects the outcome of inflation and other economic quantities, it is
difficult to obtain a good perception of the accuracy of the forecast with this assumption. It therefore
makes it more difficult to assess monetary policy.
As of the third Inflation Report published in 2005, the forecasts are instead based on the assumption
that the repo rate will follow market expectations as reflected in implied forward rates. This makes is
easier to compare the Riksbank's forecasts with those made by other forecasters. They do not usually
base their forecasts on an unchanged interest rate. The new assumption makes it easier to assess the
forecasts, as the conditions are normally more realistic. The fact that we have chosen to make this
change can be partly regarded as a result of academic research, and also partly because this
assumption appears to have worked well for other central banks that have chosen to base their
forecasts on assumptions other than a constant key rate, such as Norges Bank and the Bank of
England.
Basis for assessment
So much for our monetary policy strategy, which is what I believe we should be assessed against. Let
me now say a few words about the basis we supply for assessment.
The analysis work on which the monetary policy decisions are based is published in the form of
Inflation Reports. These contain analyses of the determinants of inflation and forecasts for inflation
developments over the coming years. They also contain analyses of why deviations from target have
arisen or are expected to arise, given a particular monetary policy stance. The Inflation Reports thus
contribute to spreading knowledge about the Riksbank's assessments and thereby make it easier for
external parties to follow and understand monetary policy. Moreover, we want them to encourage
discussion of monetary policy issues.
So far we have published four Inflation Reports a year, but we have now decided to reduce the
number to three. This is because the two Inflation Reports in the autumn have come too close together
to have sufficient new material to justify publishing two separate reports. The reason for this is that the
first autumn report is published in connection with the Riksbank Governor's hearing in the Riksdag
Committee on Finance, which is usually held in October, after the Riksdag has opened for the autumn
session.
Let me emphasise that this does not reduce our openness. Openness and transparency involve
ensuring that the information provided is clear and relevant, so that those monitoring us can
understand what we do and why we do it. Publishing Inflation Reports that contain little new
information does not seem very important in this context. Now we can instead obtain a more even
spread of the reports across the year and thereby use our forecasting resources more efficiently.
In addition to the Inflation Report, a press release is published after each monetary policy meeting,
with an account of the motives behind the decision made. Press conferences are organised when an
Inflation Report is published or when an adjustment has been made to the repo rate. The Executive
Board's monetary policy discussions are reported in separate minutes that are published
approximately two weeks after the meeting where the decision on the interest rate was made. The
minutes also show whether a member has expressed a reservation against the forecasts or the
decision, and if so, on what grounds they base this reservation. In this way, all those who wish to
closely follow our reasoning can do so and it creates a basis for assessing our evaluations and
decisions.
I can also mention that the Riksbank Governor appears before the Riksdag Committee on Finance
twice a year to answer questions on monetary policy. On the first occasion every year we publish an
Inflation Report that contains a special appendix with material for assessing monetary policy over the
past 2-3 years. This contains, for instance, comparisons of our forecasts with other forecasts and with
outcomes. In addition, we Executive Board members hold around forty published speeches every
year, where we can describe our joint or our individual view of economic developments. We also
publish information in our quarterly journal and other publications issued by the Riksbank.
The Riksbank thus publishes a substantial amount of information that enables the general public to
examine our analyses and to understand how monetary policy decisions are made. At the same time,
it creates the conditions for a serious debate on monetary policy. This is a major change compared
with central bank history.
Monetary policy is assessed regularly in Sweden. In 1999, the Riksdag Committee on Finance made
the assessment that the Riksbank's increased independence meant that there was a greater need to
examine and assess monetary policy. Since then, the Committee has annually examined the monetary
policy conducted over the past three years in connection with a more in-depth review of our activities.
The main basis for these examinations is the appendix to the Inflation Report that I mentioned earlier.
One might think that it would be even better if more, and independent, agents took an active part in
serious assessment.
From time to time, assessments or assessment reports are commissioned. For instance, the National
Institute of Economic Research1 was given the task of producing background and facts prior to the
Committee on Finance's assessment in 2002. Last year the Committee on Finance decided to
commission an independent, in-depth assessment of Swedish monetary policy during the period
19952005, that is, the ten-year period during which the inflation target has acted as official anchor for
Swedish monetary policy. This assessment is being made by two international experts in this field, and
it will, for instance, illustrate whether the inflation target is correctly designed to ensure price stability,
to what degree the monetary policy conducted has led to attaining the inflation target during this period
and the background and forms for the monetary policy decisions. This is something that I and my
colleagues in the Executive Board welcome and I look forward to the analyses and debates this
assessment will lead to.
Of course, one can regard the general debate as an examination of our activities and as an indicator
of how well we explain our monetary policy. However, it is rare that particularly thorough comparisons
of, for instance, the forecasts published by the Riksbank and others are made in the debate. The
debate thus cannot replace systematic assessments.
The development towards increasingly open central banks appears to be the same in other countries
that work in similar ways, particularly in Norway where the Centre for Monetary Economics has
organised an annual, independent evaluation of monetary policy for the past few years. As I said at
the beginning, this openness and the possibilities for evaluation are necessary conditions for an
independent central bank to enjoy confidence and legitimacy.
To summarise, I consider it extremely important that independent central banks should be assessed.
To ensure that this is carried out in a purposeful manner, the central banks' forecasts and other
information on which decisions are based should be well-documented and reported openly. It also
requires a reasonably coherent explanation as to why the forecasts look the way they do. This means
that we need to constantly develop our methods for making and assessing forecasts. However, it also
requires that an institution actively commits itself to making thorough analyses of the information
compiled so that the assessments and debate can be serious and constructive.
What happens if low inflation persists?
Not only the Riksbank, but also several other central banks have in recent years faced a situation
where the economy has grown strongly, while inflation has been below target, despite very
expansionary monetary policy. Let me therefore go on to discuss an important issue that has arisen
due to developments in recent years, namely how to deal with a situation where structural changes
contribute to inflation remaining low over a long period of time.
In Sweden, the upswing in world trade has contributed to strong growth in Swedish exports. Over the
past year, domestic demand has also developed strongly, partly due to stimulation from expansionary
monetary policy. At the same time, inflation has been kept down by high productivity growth and weak
growth in import prices. This is partly related to developments in economic activity. However, there
also appear to be factors of a more structural nature behind the low inflationary pressure. This is
probably to some extent connected to the fairly comprehensive investment in new technology.
However, it is clearly also largely concerned with the effects of increased global competition. Our
analyses thus indicate that the low inflation rate has in many cases been the result of a number of
changes in the supply side of the economy.
Our forecast is that growth in the Swedish economy will remain high over the coming years. We also
envisage inflation rising as capacity utilisation increases. Our most recent inflation forecast indicates
that inflation will approach the target a couple of years ahead, on condition that the repo rate is
gradually increased.
However, forecasts are of course uncertain. In addition to the usual uncertainty regarding
developments in economic activity, it is very difficult to determine the durability of this type of structural
change. Is, for instance, the upswing in productivity we have seen in recent years only temporary or is
it a more permanent improvement? There is a discussion that inflation could remain low over a long
period of time, as a result of structural changes in a globalised economy2.
The question is what the consequences would be if we were to respond to such a development by
conducting a very expansionary monetary policy over a long period of time to bring inflation back on
target. What would happen to economic activity, the exchange rate, domestic inflation, asset prices
and household and company balance sheets? Probably, such a situation would lead to risks in both
the real economy and the financial economy, resulting perhaps in overheating in the economy, high
domestic inflation and rapidly rising asset prices. However, if we on the other hand were to allow the
inflation adjustment to take a long time, how would this affect confidence in the inflation target? How
long can inflation deviate from the target without this affecting confidence and without the inflation
target being perceived as meaningless?
These are difficult considerations that I assume many of you have also reflected on. In Sweden our
forecast, which we reported in the February Inflation Report, is that increasing capacity utilisation over
the coming years will lead to inflation gradually rising. However, continued low inflation despite high
growth is a development that requires consideration. As I see it, it is possible to take such a scenario
into account, with low inflation over a long period of time, within the framework of flexible application of
the inflation target. However, confidence in the inflation target is of central importance here, which
makes considerable demands on us, to be clear that the policy we conduct is in line with our strategy
to attain the inflation target in the best possible way. In a situation where, for example, there is reason
to expect that inflation will be below target for a long period of time and we do not intend to bring it
back on target until a couple of years from now, we should explain our intentions clearly. And this
should then be taken into account when we are assessed. Once again, it is largely a question of
openness and clarity.
Conclusion
Let me say in conclusion that the assessment of monetary policy is an important part of an
independent central bank's endeavour to be open and clear and of the endeavour to attain and
maintain confidence in the inflation target. In Sweden, we publish a substantial amount of information
that enables the general public to examine our analyses and to understand how monetary policy
decisions are made.
The developments in the economy in recent years have given rise to many important issues, not only
for us decision-makers, but also for those who assess us. We are several central banks who have
faced structural, unforeseen factors contributing to keeping down inflation, while monetary policy is
expansionary, the economy is showing robust growth, and household borrowing and asset prices are
rising rapidly.
An inflation rate lower than the target level need not be interpreted in this situation as due to
excessively tight monetary policy and as a failure for monetary policy. It is interesting to note that this
has not been the conclusion in the most recent assessment of Norges Bank.
Developments in recent years have raised issues which are extremely important in the discussion and
which require improved analysis. If we were to aim at keeping inflation on target at any cost, without
taking into account developments in the real economy, what would the consequences be of trying to
stimulate demand further so that inflation comes closer to the target? On the other hand, what effect
would it have on confidence in the inflation target if we allowed a long time for the adjustment? How
long can inflation deviate from the target without this affecting confidence and without the inflation
target being perceived as meaningless?
These are difficult questions that I know we at the Riksbank are not the only ones to be reflecting on. I
would very much like to hear your thoughts and reasoning on this. Safeguarding confidence in the
inflation target is of central importance for monetary policy. I therefore believe that the best means of
managing these concerns is to be open and clear with regard to the analyses produced and the
decisions made on the basis of these analyses. I believe that this will in the long run create the best
conditions for the policy to be accepted and to win confidence.
Thank you!