Lars E O Svensson: For a better monetary policy - focus on inflation and
unemployment
Speech by Mr Lars E O Svensson, Deputy Governor of the Sveriges Riksbank, at Luleå
University of Technology, Luleå, 8 March 2011.
* * *
The views expressed here are my own and are not necessarily shared by the other members of the Executive
Board of the Riksbank or the Riksbank's staff. I would like to thank Joanna Gerwin, Karolina Ekholm, Pernilla
Meyersson, Marianne Nessén, Lars Nyberg, Stefan Palmqvist, Cecilia Roos-Isaksson, Ulf Söderström and
Staffan Viotti for our discussions and their views. Hanna Armelius, Hans Dellmo, Lina Majtorp and Pernilla Wasén
have contributed to this speech.
Sweden's economy has grown dramatically following a severe downturn (Figure 1). GDP is
now more or less back to the level it was at three years ago (Figure 2). Since the summer of
2010, the majority on the Executive Board of the Riksbank has tightened monetary policy by
raising the repo rate. According to the Riksbank's forecasts for the years ahead, CPI inflation
will be higher than the target of 2 per cent over the next few years (Figure 3). However, the
fact that CPI inflation is higher than the target is due to the Riksbank's own repo-rate
increases. If we instead measure inflation using the CPIF index, which adjusts for the effects
of these repo-rate increases, the forecast is on average lower than 2 per cent. The rate of
unemployment will also continue to be high in the years ahead (Figure 4). Is increasing the
repo rate and tightening monetary policy therefore the right thing to do? It means that CPIF
inflation will be lower and further from the target and that unemployment will continue to be
unnecessarily high compared to what it would be with a lower repo rate and a more
expansionary monetary policy.
In this speech I would like to talk about three subjects. The first is that in my opinion the
existing framework for monetary policy could be improved if monetary policy consistently
focused on stabilising inflation measured in terms of the CPIF at around 2 per cent and on
stabilising unemployment around a sustainable rate. This would make monetary policy
simpler, clearer and more robust. In line with this I have entered a reservation in favour of a
lower repo-rate path and a more expansionary monetary policy as this would lead to CPIF
inflation increasing and coming closer to the target and to unemployment falling towards a
sustainable rate.
Second, I believe that it is important that the Riksbank's decisions and communication in the
future do not give the impression that monetary policy is focused on anything other than
inflation and resource utilisation. There has been an intensive discussion in the media and in
market newsletters about a new focus for monetary policy, for example on stabilizing house
prices and limiting household indebtedness. And when, in the choice between two repo-rate
paths, the majority of the members of the Executive Board choose a path that provides
poorer target attainment for both inflation and resource utilisation, this may undeniably give
the impression that monetary policy has more targets than inflation and resource utilisation.1
If, in addition, repo-rate increases are justified with reference to factors such as high growth,
house prices, household indebtedness, the low level of interest rates, possible financial
imbalances in the future and so on, there is a risk that this impression will be strengthened. If
so, monetary policy will become unclear.
Third, I would like to explain in more detail why I entered a reservation at the latest monetary
policy meeting and how I arrived at a significantly lower repo-rate path than the path in the
main scenario.
The Riksbank conducts flexible inflation targeting - but what does this mean in
practice?
In the Riksbank document Monetary policy in Sweden (2010) and in the introduction to every
Monetary Policy Report it says that the Riksbank "in addition to stabilising inflation around
the inflation target, also strives to stabilise production and employment around sustainable
paths. The Riksbank therefore conducts what is generally referred to as a policy of flexible
inflation targeting". We also usually express this by saying that monetary policy should
stabilise inflation around the inflation target and stabilise resource utilisation around a normal
level. The question then is which measures of the two target variables, inflation and resource
utilisation, we should use. Although the inflation target is expressed in terms of the CPI, I
believe that the most appropriate operational measure of inflation is the CPIF. I also believe
that the most appropriate measure of resource utilisation is the unemployment gap; that is
the gap between the actual rate of unemployment and the sustainable rate of unemployment.
Let me explain why I think that the existing framework for monetary policy could be improved
with these specifications.
The CPIF is the most appropriate operational measure of inflation
The Riksbank's inflation target is expressed in terms of the rate of change in the Consumer
Price Index, the CPI. This has advantages as it is measured often and is seldom revised. It
also means something to consumers as it corresponds to the price of an average basket of
consumer goods. The CPI is also the measure of inflation that is most well-known to the
general public. However, the CPI also has a well-known disadvantage, which in my opinion
makes it less appropriate as a direct, operational target for monetary policy. This
disadvantage is that the CPI is directly affected by interest rate changes through their impact
on housing costs. This short-term effect also has the reverse sign to the medium-term effect.
This means that the Riksbank's own repo rate increases contribute to an increase in CPI
inflation in the short term but reduce it in the slightly longer term. The major interest rate
changes during the crisis have led to considerable fluctuations in the CPI. I believe on the
whole that it is better to consistently use the CPIF as an operational target for monetary
policy and disregard the direct effects of interest rate changes on the CPI when assessing
whether monetary policy is well-balanced. By stabilising the CPIF around 2 per cent, the CPI
will be stabilised around the target in the slightly longer term. It would then be important to
consistently use the CPIF to rank various monetary policy alternatives and not change back
and forth between the CPIF and the CPI. If we sometimes refer to the CPIF and sometimes
to the CPI, monetary policy will become unclear.
The unemployment gap is the most appropriate measure of resource utilisation
There are many ways of measuring resource utilisation, for example the output gap, the
hours-worked gap, the employment gap, capacity utilisation or the Riksbank's RU indicator.
As there are so many ways of measuring resource utilisation one might think that it would be
appropriate to take a broad approach and make an "overall assessment" based on a large
number of indicators when making decisions about monetary policy. It is, however, generally
accepted that an inflation targeting policy in which target attainment is measured using a
large number of different measures of inflation does not work very well. It is often possible to
find a measure of inflation that is reasonably close to the target and almost any monetary
policy can be justified with the help of a clever choice of index. Therefore, if the target and
target attainment are to mean anything, one measure of inflation must primarily be used.
Similarly, I also believe that it does not work well to use a large number of different measures
of resource utilisation. It is also often possible to find at least one measure that comes fairly
close to normal resource utilisation and almost any monetary policy can be justified with the
help of a clever choice of the measure of resource utilisation. This problem is in fact worse
for resource utilisation than for inflation. This is because measures of resource utilisation also
require us to make an assessment of the normal level for the measure concerned. For the
output gap and the hours gap it is a case of determining the level and forecast for potential
GDP and potential hours worked. This can be done using several different methods and
assumptions. These are far from transparent and leave a lot of scope for arbitrary
judgements. A particular monetary policy can therefore be justified by making a clever choice
of both measures and the normal levels used. This is why we should mainly stick to one
measure.
Let me illustrate the problem of estimating potential GDP by comparing the Riksbank's
estimate and forecast for Sweden's potential GDP with the estimate and forecast for the
United States' potential GDP produced by the Congressional Budget Office (CBO).
According to the CBO's estimate and forecast, potential output in the United States largely
follows the previous trend for the United States' GDP (Figure 5).2 The output gap between
the United States' GDP and potential GDP is therefore large and negative for several years
ahead.3 According to the Riksbank's estimate and forecast in February 2011, Sweden's
potential GDP is on the other hand curving downwards and is below the previous trend for
Sweden's GDP. Sweden's output gap is therefore closing rapidly according to the Riksbank's
forecast.
How can the estimates and forecasts for potential GDP in the United States and Sweden
differ so greatly while the level now and forecasts for actual GDP are rather similar? Why
should the development of Sweden's potential GDP be much worse than that of the United
States? The United States has been subjected to structural shocks in the housing,
construction and finance sectors and has major structural problems in these sectors. The
United States also has substantial structural current account and budget deficits. Sweden
has been exposed to a major demand shock with a collapse of exports and a loss of demand
in the export sector. Exports are now recovering again. Sweden does not appear to have any
structural problems in the finance sector, or in any other sector, and has no structural budget
or current account deficits. This being the case, I think one could claim that the development
of Sweden's potential GDP should in fact be better than that of the United States, not worse.
The difference in potential GDP underlines the difficulties and the element of arbitrariness in
these calculations.
Figure 6 compares the Riksbank's estimates and forecasts for potential GDP from two
different points in time, namely September 2008 shortly before the investment bank Lehman
Brothers went bankrupt and February 2011. The September 2008 forecast for Sweden's
potential GDP is rather similar to the CBO's latest forecast for potential GDP in the United
States in Figure 5. We can see in Figure 6 that the February 2011 assessment of potential
GDP in the longer term is approximately 4 per cent below the corresponding assessment in
September 2008. Why should a pure demand shock in the absence of structural problems
lead to such a significantly lower potential GDP in the longer term?
My conclusion from this discussion of Figures 5 and 6 is that the estimate of Sweden's
potential GDP is not reliable and that the output gap is thus not a reliable indicator of
resource utilisation.
I believe instead that the unemployment gap is the most appropriate measure of resource
utilisation. There are several reasons for this. Unemployment is measured often and is not
revised. GDP on the other hand is measured less often and is highly uncertain, and major
revisions are made. Unemployment is also directly related to welfare - one of the worst
things that can happen to a household is that one of the members of the household loses his
or her job. Unemployment is also the indicator of resource utilisation that is best known and
easiest for the public to understand. The preparatory works for the Sveriges Riksbank Act
state that the Riksbank should support the objectives of general economic policy. One of the
main objectives of economy policy in Sweden is to limit unemployment, for example by
improving the functioning of the labour market and increasing the incentives to look for work.
The difficult thing about using the unemployment gap as an indicator of resource utilisation is
to determine the sustainable rate of unemployment. However, this is not more difficult, in fact
it is probably easier, than determining potential output and potential hours worked. On closer
inspection, it can be seen that the sustainable rate of unemployment has several advantages
compared to other measures of normal resource utilisation.
The sustainable rate of unemployment can be expressed as a stable percentage - for
example 5.5 or 6 per cent. It changes slowly and lies within a limited range. Estimating
potential GDP is, in comparison, like shooting at a moving target. It grows over time, and in
the view of many, can be seen as a random process, similar to a so-called random walk with
drift. The sustainable rate of unemployment can be determined using several different
methods - structural search models similar to those developed by the Nobel prize-winners
Diamond, Mortensen and Pissarides, so-called UC-models, DSGE models and NAIRU
estimates. The results of these different estimation methods can be compared and their
robustness and reliability assessed. We can then calculate the average of the estimates and
weight this with the assessed reliability of the various estimates. When estimating the
sustainable rate of unemployment it is also important to include the assessed effects of
labour-market reforms (Forslund 2008).
Assessments of the sustainable rate of unemployment can be made and discussed in an
open debate within and outside the central bank, with internal and external economists who
are specialists in the field of labour market research using micro and macro methods. A
major advantage in this context is that Sweden has a tradition of outstanding labour market
research at universities and research and evaluation institutes.
It will also be simple and transparent to perform sensitivity analyses in the form of various
assumptions about the sustainable rate of unemployment. If different members of the
Executive Board of the Riksbank make different assessments of the sustainable rate of
unemployment, they can simply and clearly explain how this affects their decisions.
It is of course inappropriate for the central bank itself to calculate the price index that is used
to assess the attainment of the inflation target, and it is a major advantage if this index is
calculated by another, independent organisation or authority, like Statistics Sweden in
Sweden's case. For the same reason, it is inappropriate for the central bank to have a
monopoly on calculating the normal level for the measure of resource utilisation used to
evaluate target attainment. In practice it is impossible for outsiders (and most people at the
Riksbank, including the members of the Executive Board) to verify and assess the
calculations of potential production and hours worked that are performed. It is very difficult to
determine whether the measures are reasonable and reliable. Compared to other measures
of resource utilisation, the unemployment gap offers the best possibility for external and
internal verification and assessment of the assumptions about, and the calculations of, the
sustainable rate of unemployment.
One may ask, however, whether the independence of the Riksbank would be put at risk if
external parties were involved in determining the right sustainable rate of unemployment. Nor
would I go so far as to propose that another authority should decide on the appropriate rate
of sustainable unemployment. I do, on the other hand, think that it would be a good thing if
the Riksbank's estimate of the sustainable rate of unemployment could be debated freely
and assessed by external analysts, evaluators and authorities. This is in practice not possible
with the other measures of resource utilisation.
The fact that the Riksbank tries to stabilise both inflation and unemployment does not mean
that it disregards the fact that the inflation target takes precedence. As inflation is stabilised
around the inflation target, inflation will on average be equal to the target. The Riksbank
fulfils in this way its mandate to maintain price stability at the same time as it can be said to
be supporting the objectives of general economic policy through its endeavours to stabilise
unemployment around a sustainable rate.
The mean squared gap: a measure of stability
A well-balanced monetary policy normally thus entails achieving a balance between the
stabilisation of inflation and the stabilisation of resource utilisation. But what is meant by a
lesser or greater stability of inflation and resource utilisation? Determining this requires a
quantitative measure of stability, the mean squared gap. The mean squared gap for inflation
measures how much the inflation forecast deviates from the inflation target. The mean
squared gap for unemployment measures how much the rate of unemployment deviates
from the sustainable rate. A smaller mean squared gap entails better stability.
Panel b in Figure 7 shows the mean squared gaps from the latest monetary policy decision.
They are calculated by taking a mean value of the sum of all the squared deviations for the
respective target variables and calculating the size of them. The closer to zero the mean
squared gap is, the better the stabilisation of the respective target variables; that is, the
better the target attainment.
Normally, it should be the case that it is not possible to stabilise one of the target variables
better without stabilising the other variable less well. Otherwise, monetary policy is not
"effective". Which interest-rate path is chosen then depends on the relative importance one
attaches to stabilising the respective variables. Different members of the Executive Board
may attach different levels of importance to the two variables and thus advocate different
repo-rate paths. The point of the mean squared gaps is that they give us clarity and
transparency regarding the various monetary policy alternatives.4
The mean squared gap takes into account target attainment throughout the forecast period
and not just target attainment at a certain horizon, for example 8 or 12 quarters. This is an
advantage. This is reasonable as focusing on target attainment at a certain horizon leads to
a classic time-consistency problem which means that monetary policy is not consistent over
time.5
Monetary policy must not become unclear
Many analysts seem to believe that, in practice, Riksbank monetary policy now focuses on
more things than just stabilising inflation and resource utilisation. It is also undeniable that
other factors have been referred to in our press releases and minutes, for example growth,
housing prices, household indebtedness, financial imbalances and interest rate levels. In the
media and market newsletters, there has been a keen discussion of a new focus for
monetary policy on factors other than inflation and resource utilisation.6 In several cases,
repo rate increases have been applauded with reference to the fact that they would help to
stabilise house prices and indebtedness.
What I am objecting to here is not that the forecasts are adjusted with assessments that take
into account factors that affect the forecasts but are not captured in the usual models. On the
contrary, I have always advocated such an approach and have even discussed how this can
be done more systematically in a number of research papers.7 I think that it is quite correct to
take into account house prices, indebtedness, imbalances and so on to the extent that they
affect the forecasts for inflation and the real economy. All information that affects the
forecasts is relevant. The problem arises when one allows these factors to undermine target
attainment for inflation and resource utilisation. In practice, this gives them the status of
separate targets for monetary policy. This makes monetary policy unclear and hard to
understand. Moreover, as I see it, the Sveriges Riksbank Act and its preparatory works do
not provide scope for any other targets for monetary policy than inflation and resource
utilisation.8 I believe that it is important that the Riksbank's decisions and communication in
the future do not give the impression that monetary policy is focused on anything other than
inflation and resource utilisation.
In their 2006 evaluation of Swedish monetary policy in the period 1995-2005, Giavazzi and
Mishkin (2006) also say that the Riksbank's statements on housing prices led many people
to perceive the Riksbank's message as confusing, which made things unclear and
10
undermined confidence in monetary policy.9,
Growth has certainly been high over the last 12 months, so isn't this a reason for tightening
monetary policy? Here it is important to remember that monetary policy does not aim to
stabilise growth. It aims to stabilise inflation and resource utilisation. The impact of increased
growth on monetary policy depends on the impact of this growth on the forecasts for inflation
and resource utilisation. Whether high growth indicates higher or lower resource utilisation
depends on the reasons for the higher growth. In this respect there is no difference between
growth and other indicators of the state of the economy. The extent to which they affect
monetary policy depends solely on how they affect the forecasts for inflation and resource
utilisation.
If monetary policy is well-balanced in the initial position - a strong assumption - and growth
shifts both the inflation forecast and the resource-utilisation forecast upwards, then increased
growth is a reason for tightening monetary policy. However, if monetary policy is not well-
6
See for example Dagens Industri (2011), Eklund and Svensson (2010), Financial Times (2011a, b) and Frisén
(2010).
7
See Svensson (2005) and Svensson and Tetlow (2005).
8
One possible exception may be if the repo-rate path were to pose a threat to financial stability and there were
no other means that could be used to tackle the problem. See the discussion in Svensson (2010b, c).
9
See Giavazzi and Mishkin (2006) and Mishkin (2010).
10
I also believe that the policy rate is an inappropriate instrument for handling problems relating to rising housing
prices and indebtedness. There are several other, more appropriate instruments, for example loan-to-value
ceilings, limiting tax deductions for mortgages, property taxes and so on. Extensive research has also shown
that the costs to the real economy will be unreasonably high if one attempts to reduce housing prices with the
help of the policy rate. In addition, there are no signs that Swedish housing prices constitute a bubble, that is
that they are incompatible with fundamental factors such as high demand and low supply as a result of limited
construction. It can also be demonstrated that the current level of indebtedness is not a problem in relation to
the household's ability to service their debts and to their assets. For a more detailed discussion, see Svensson
(2010b, c).
balanced in the initial position, for example if it appears that both inflation and resource
utilisation will be too low, then increased growth is not a reason to tighten monetary policy.11
Growth can lead to bottlenecks and a shortage of labour in some sectors. Are these reasons
for increasing the repo rate? Yes, but only if they increase the inflation forecast.
Circumstances such as bottlenecks and shortages are important when it comes to assessing
the effects on wages and inflationary pressures, and to forecasting wages and inflation.
However, it is important to distinguish between the role of resource utilisation as a target
variable and its role as an indicator of inflationary pressures. With regard to its role as target
variable, it is the unemployment gap between the rate of unemployment and the sustainable
rate that is relevant. But with regard to its role as an indicator of inflationary pressures and as
a basis for forecasts for wages and inflation, various short-term situations, shortages and
bottlenecks may be significant, but will not normally affect the sustainable rate of
unemployment. One way of expressing this is to say that the unemployment gap in relation to
the sustainable rate of unemployment is a target variable, but that the gap in relation to the
short-term equilibrium rate of unemployment may be an indicator of inflationary pressures
that is important in forecasting the inflation gap, the other target variable.
The most recent decision
The reason I chose to enter a reservation against the repo-rate path chosen by the majority
at the latest monetary policy meeting is that, in my opinion, it does not represent a
wellbalanced monetary policy. This is because the repo-rate path adopted by the majority entails
a CPIF forecast under the target and an unemployment forecast higher than a reasonable
sustainable rate throughout almost the entire forecast period. I believe that target attainment
can be improved for both inflation and unemployment with a lower repo-rate path.
The repo-rate path chosen by the majority does not meet the well-known necessary but not
sufficient condition for a well-balanced monetary policy formulated by the Deputy Governor of
the Norwegian central bank Jan Qvigstad (2005). Applied to inflation and unemployment, this
condition means that the inflation gap (the difference between inflation and the inflation
target) and the unemployment gap should have the same sign. As the inflation gap is
negative and the unemployment gap is positive for the majority's repo-rate path for most of
the forecast interval, this condition is not met. With a lower repo-rate path, on the other hand,
the gap for both would be reduced and target attainment for both inflation and unemployment
would thus increase.
The fact that monetary policy is not well-balanced for the majority's repo-rate path is clearly
demonstrated if one uses mean square gaps to measure target attainment as in Figures 7
and 8. Figure 7 shows the forecasts for the CPIF and unemployment that are compatible with
the main scenario's repo-rate path and the higher and lower repo-rate paths published in
Chapter 2 of the Monetary Policy Report in February. Panel b shows that the repo-rate path
of the main scenario does not meet the Qvigstad condition. Neither is it effective, as a lower
repo-rate path stabilises both inflation and unemployment better. Figure 8 shows the main
scenario's repo-rate path and the lower path that Karolina Ekholm and I advocated at the
meeting. The forecasts for inflation and unemployment are calculated under an assumption
that we believe to be more realistic and more compatible with how the exchange rate is
determined. This assumption is that foreign exchange rates will develop in line with prevailing
market rates (more specifically in line with the paths indicated by foreign implied forward
rates). We can see in panel b that the lower repo-rate path leads to a better stabilisation of
both inflation and unemployment.
The mean squared gaps in Figures 7 and 8 are calculated assuming a sustainable rate of
unemployment of 5.5 per cent. This is currently my best assessment of the sustainable rate
of unemployment in Sweden after having read a number of papers on the subject and having
discussed the issue with several specialists in the field of labour market economics.12 The
lower repo-rate path is also better if one assumes a level of 6 per cent.13
At a press meeting on 3 March, the Minister of Finance, Anders Borg, announced that the
Ministry's assessment of the equilibrium rate of unemployment has been revised downwards
from 6 per cent to approximately 5 per cent by 2015.14 The Ministry of Finance plans to
publish its calculations in a ministry memorandum in connection with the spring budget bill
2011.
One could perhaps object that it is not certain that the lower repo-rate path in panel a of
Figure 8 is necessarily the best repo-rate path. It does, however, appear to fulfil the Qvigstad
condition in that the inflation gap in panel c is mainly positive and the unemployment gap in
panel d is also positive (for the entire forecast period if the sustainable rate of unemployment
is 5.5 per cent and for most of the forecast period if it is 6 per cent). One can show that an
even lower repo-rate path leads to a lower mean squared gap for unemployment but to a
higher mean squared gap for inflation. It is thus no easy matter to stabilise both better.
However, a somewhat different profile for the low repo-rate path may perhaps provide a
better result. It is possible that reasonable weights for the stability of inflation and resource
utilisation justify higher inflation and lower unemployment. Due to the limited resources
available it has not been possible to investigate these factors prior to the monetary policy
decision. In my opinion, however, one should not engage in too much fine-tuning. The best
should not become the enemy of the good. The important thing here is that the lower
reporate path clearly leads to a better target attainment than the path in the main scenario.
The path that Karolina Ekholm and I advocated at the meeting in February is somewhat
higher than the path we advocated at the meeting in December. The main reason for this is
that foreign interest rates shifted upwards between December and February. It is natural that
the repo-rate shifts along with foreign interest rates to some extent to limit the effects on the
exchange rate. I discussed the role of foreign interest rates for monetary policy in more detail
in the speech I gave in November 2010 (Svensson 2010b).
Summary
To summarise, the arguments I have presented today are thus based on the document
Monetary policy in Sweden, which stipulates that the Riksbank should pursue flexible
inflation targeting in which monetary policy focuses on stabilising inflation around the target
and resource utilisation around a normal level. I believe that the existing framework for
monetary policy can be improved by making the operational measures of inflation, resource
utilisation and their stability more precise. For several reasons, I think that only one
operational measure of inflation and only one operational measure of resource utilisation
should be used. The inflation target is formulated in terms of the CPI, but I believe that the
most appropriate operational measure of inflation is the CPIF. This would entail the
stabilisation of the CPI in the slightly longer term. I also believe that the unemployment gap
between the actual rate of unemployment and the sustainable rate of unemployment is the
most appropriate measure of resource utilisation. Moreover, I believe that the mean squared
gap is the most appropriate measure of the stability of inflation and resource utilisation.
In my opinion, making the monetary policy framework more specific in this way would make
monetary policy, simpler, clearer and more robust. The preparations before each policy
meeting could focus on calculating forecasts of CPIF inflation and unemployment for different
repo-rate paths. These forecasts, together with an assessment of the sustainable rate of
unemployment, would summarise all the information the members of the Executive Board
would need to make their decisions and choose between the various repo-rate paths. The
decisions would be easy to explain and the explanations would be clear. This would also
make it easy to evaluate monetary policy. It would become more robust because all the
information and all the assessments that affect the forecasts and the sustainable rate of
unemployment could be incorporated into the decision-making process in a systematic way.
In order to avoid monetary policy being unclear in the future, I believe that the Riksbank's
decisions and communication should not give the impression that monetary policy has any
objectives other than stabilising inflation and resource utilisation.
On this basis, I entered a reservation at the latest monetary policy meeting and advocated
leaving the repo rate unchanged and then a lower repo-rate path than the path in the main
scenario, as such a lower path would better stabilise inflation measured in terms of the CPIF
and resource utilisation measured in terms of the unemployment gap.
References
Barro, Robert J., and David B. Gordon (1983), "A positive theory of monetary policy in a
Journal of Political E