Mr. Heikensten answers eight questions on monetary policy in Sweden
Speech by the Deputy Governor of the Bank of Sweden, Mr. Lars Heikensten, at The Economics
Association in Umeå on 19/2/98.
Introduction
During the 1990s monetary policy has been the subject of intensive discussion.
This is not surprising, given the serious crisis in the Swedish economy at the beginning of the
decade and the role that monetary policy played both then and as the crisis was building up.
Since that time, monetary policy has had an explicit role to safeguard independently the value of
money - a role that is new in Sweden in the post-war period. With a floating exchange rate, the
decisions currently made by the Riksbank on its instrumental rate are very real and important to
the behaviour of households and businesses and to economic growth.
The monetary policy discussion has evolved over time. Questions and statements
about monetary policy's basic objective of price stability that were very frequent a couple of
years ago are less so today. Understanding of the Riksbank's actions seems to have increased.
We are presently trying to evaluate this by asking the public how it views the Riksbank's work
and by following the media and newsletters written by the market's players. It is also possible to
form an opinion based on the market's reactions to changes in the instrumental rates as to
whether the policy is understandable.
In spite of the fact that knowledge and understanding of the Riksbank's policy
have gradually increased, I believe that from time to time there is a need to explain the basis for
the policy and some of the principles that guide it today. The purpose of today's speech is just
that. I will endeavour to answer seven of the questions that I have encountered most often in
recent years at meetings and in editorials and commentaries and that seem to permeate the
discussion of monetary policy continually. By way of conclusion I will comment on an eighth
question.
Question 1: Why is low inflation good?
The experiences of previous decades in Sweden and a number of international
examples show that high inflation is associated with economic costs. Moreover significant costs
ensue when one is compelled to gear down from high to low inflation - something that sooner or
later always happens.
It has been shown that high inflation is often associated with sharp fluctuations in
the relative prices of goods. Rapid and abrupt price changes create uncertainty about the future
for all the actors in the economy. It simply becomes more difficult to make long-range
decisions. Households and businesses are compelled in practice to take greater risks and both
then demand higher interest and profits. This reasoning is supported by research, which indicates
that the growth rate of the economy may be lower, because the increased uncertainty reduces
investment activity. In addition the risk of making erroneous investments increases.
(Diagram 1. CPI and Growth)
That Sweden in the 1970s and 1980s lost so much ground in terms of prosperity
in relation to many other European countries is certainly due in part to the stabilisation policy
then being conducted. Prices and wages were allowed to drive each other up, while budget
policy was far too weak. Devaluation followed devaluation, with low investment and weak
productivity growth as the result.
High inflation also leads to arbitrary changes in the distribution of income and
wealth in society. Wages and profits normally rise at the same rate as inflation. The value of real
estate and some financial investments rises even faster. At the same time nominal fixed interest
rates and transfers lag behind. The high profits made by the owners of houses and co-operatives
in the 1970s and 1980s occurred in practice at the expense of tenants and those with bank
savings. Between 1971 and 1974, for example, house prices rose by 50 per cent and agricultural
property by 80 per cent. In contrast those who had their savings in bonds or in the bank saw their
assets shrink by about a third in real terms.
CPI and Growth
Index: 1970=100
Growth 1997-1998 OECD forecast
Germany
210 210
Netherlands
190 190
170 170
Austria
150 150
Sweden
130 130
110 110
90 90
70 72 74 76 78 80 82 84 86 88 90 92 94 96 98
650 650
Sweden
550 550
450 450
Netherlands
Austria
350 350
250 250
Germany
150 150
50 50
70 72 74 76 78 80 82 84 86 88 90 92 94 96
Sources: Statistics Sweden and OECD
The problems are amplified by a regime of taxes and subsidies that are wholly or
partly indexed. Groups that have full indexing are favoured at the expense of others who do not
receive subsidies or do not get full compensation. Also the economic costs may rise when the
behaviour of businesses and households is negatively affected by taxes and subsidies in
combination with a high rate of inflation. Many good examples of this can be found in the
Sweden of the 1970s and 1980s. The American economist Martin Feldstein has estimated that if
inflation increases from 0 to 2 per cent, then the economic costs in the United States will amount
to the equivalent of 1 per cent of GDP, principally as a consequence of the disruption caused by
the interaction between the tax regime and inflation.
Let me conclude the answer to this first question by emphasising that my
reasoning is anything but new, even if some of the examples are, and there is new empirical
research to rely on. The Swedish Trade Union economist Gösta Rehn argued in the 1950s and
1960s that full-employment policies must be combined with a tight demand policy. Wage
formation could function well only if demand was restrained and the rules of the game were
obvious. He also waged a battle for many decades against inflation for reasons of distribution
under the slogan, "Hate inflation". Substantial, arbitrary changes in income and wealth pose a
threat to "the cement" in our society and thereby to the democratic system.
Question 2: Why has inflation been allowed?
Average inflation in Sweden has been low over a very long-term perspective.
That changed after the Second World War, both in Sweden and in the majority of other
industrial countries. During the 1960s, 1970s and 1980s, inflation was on a rising trend and at
the same time fluctuated considerably. Not until the 1980s was the growth in prices stabilised in
many parts of the western world. In Sweden, this stabilisation has come about in the 1990s.
(Diagram 2. Price Developments in Sweden Since 1880)
Price Developements in
Sweden Since 1880
Index: 1880=100
4500 4500
4000 4000
3500 3500
3000 3000
2500 2500
2000 2000
1500 1500
1000 1000
500 500
0 0
1880 1890 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990
Source: Statistics Sweden
Given what I have just said about the importance of low inflation, we may ask
ourselves how inflation could have been allowed to reach such heights in recent decades. Why
was there not a tighter policy all along the line to restrain inflation? Developments in other
countries of the western world appear about the same. This indicates that there is a common
explanation.
It is clear that economic thought has shifted in recent decades and the shift in the
price level trends that coincided with the Keynesian approach (which was not infrequently a
grossly exaggerated interpretation of what Keynes himself had written or said) had a dominant
influence on economic policy. The ambition to stabilise the economy and create full
employment using economic policy tools grew stronger and stronger. For a long time it was
believed that by allowing inflation to rise a little higher, less unemployment could be 'bought'.
Both actual developments up until the 1970s and the theory then prevalent supported this
approach.
This picture of how the economy functioned was modified in the 1970s. The
economies in many western countries at that time evinced both high inflation and high
unemployment. In fairness it should also be mentioned however that the oil price shocks also
contributed to the high inflation that decade; not all problems were a consequence of the failures
of stabilisation policy.
Now most economists and political decision-makers accept that only in the short
term is there a trade-off between inflation and employment. Real wages can be reduced owing to
unexpected inflation and employment will thereby be stimulated. But when this pattern is
recognised - as will very likely happen after a while - inflation expectations adjust to the new,
higher inflation rate. Then the positive effect on growth disappears and employment reverts to
its previous level. All that remains is a higher rate of inflation. In other words, in the long term
there is normally no positive relationship between employment and inflation. Instead
employment in the long term is decided by such conditions in the real economy as technological
and population developments or labour market efficiency.
However the temptation to use monetary policy to stimulate employment still
exists. Even for a government that knows that the long-term effects of increasing demand a little
too much are undesirable, it can be tempting in the short run. The very fact that this possibility
exists has made it more difficult to instil confidence in a policy of low inflation. Even in
countries in which the governments and the central banks have clearly switched to a policy
directed at achieving price stability, concern about a recurrence may persist. Such a concern is
not without costs to the economy. Households and businesses will reckon that there is a risk of
an increase in inflation. Consequently the interest rate level may be higher and economic
development in general may be worse than what would have been possible if all the actors in the
economy had had complete confidence in the anti-inflation policy.
Question 3: Why should central banks be independent?
This problem of building confidence in the anti-inflation policy may explain why
in recent years many western countries have changed their legislation or in other ways have
made their central banks more independent. There are basically two problems: the temptation to
resort to stimulating the economy in the short term may be too strong and inflation expectations
become built into the system and make the policy less effective. By giving the central bank an
independent status, the political decision-makers can demonstrate that they are serious about
their ambition to let monetary policy be conducted with a view to long-term goals. In such a
way price stability can be combined with better economic development.
There have been a good many studies showing that an independent position for
the central bank tends to have a favourable impact on inflation. In countries with relatively
independent central banks - that is, in which the political regime has only limited possibilities to
influence monetary policy immediately - the fight against inflation has been more successful.
However this should not be over-interpreted; the problem of inflation neither can nor should be
solved solely by a few simple changes in the law. The central bank's position certainly depends
on what the attitude to inflation is among the general public. It may very well be that in
countries with a strong aversion to inflation, they have elected to give the central bank a
comparatively independent position. (Diagram 3. The Relation Between a Central Bank's
Degree of Independence and Inflation)
In Sweden the Riksbank has, in practice, had a very independent standing in
recent years, which compares quite favourably with that in other countries. This policy has also
had a successful impact on price stability. This practice that has been developed has now
received support in the form of a broad multi-party agreement to strengthen the position of the
Riksbank. The agreement has led to a bill, which the Government introduced last November.
This bill provides, inter alia, for the price stability objective to be confirmed by law and for the
Riksbank to have a management that can formulate monetary policy independently.
The Relation Between a Central
Bank's Degree of Independence
and Inflation
14
SP
ITA
NZLD
12
UK
10 AUS
SWE
FRADEN
CDA
8
USA
BEL
6
JPN
NLD
GER
4
SWZ
2
0
0 1 2 3 4 5
Degree of independence
Source: SOU (Govt official reports) 1993:20
It should be stressed that an independent position for the Riksbank is not the same
thing as a monetary policy conducted without democratic control. The monetary policy objective
has been made law by those who are popularly elected. It is making the objective operational
and the ongoing work to secure the goal decided by the Riksdag that has been delegated to the
Riksbank.
Question 4: Why 2 per cent?
The question of how the monetary policy objective should be made operational
has several dimensions. By selecting a clear objective for monetary policy, it is possible to
monitor and evaluate it in an effective way. This is especially important when the Riksbank is
being given an independent status. A clearly defined inflation objective also has the advantage of
being able to function as an "anchor" for households' and businesses' expectations. This
function alone can be an important feature, not least when a regime of low inflation is being
established.
The objective for the Riksbank's monetary policy is inflation of 2 per cent
annually, as measured by the consumer price index. We have a stated tolerance interval of plus
or minus 1 percentage point that will catch deviations from the target.
Alan Greenspan, the Chairman of the US Federal Reserve, has said words to this
effect: Inflation should be so low that the actors in the economy do not need to concern
themselves with it when they make economic decisions. This seems reasonable, but what does it
mean in more concrete terms?
Most likely it is not advisable to aim at price stability defined as zero-inflation.
Some studies indicate that inflation as measured by the consumer price index is overestimated.
There are many arguments for that being the case, one being that goods may increase in price
because the quality has been improved and another that the items in the valuation basket whose
prices are measured may be obsolete. This is a problem of methodology and measurement.
Estimates for the American economy show that owing to errors in measurement, inflation tends
to be overestimated by up to 2 per cent. Estimates by Statistics Sweden for the Swedish
economy indicate a smaller error in measurement.
A very low inflation may also cause problems if the nominal wages are inflexible
downwards, which is often the case. Some degree of inflation can then function like oil in the
economic machinery. However price and wage rigidity do not follow any natural law,
independently of how, for example, economic policy is formulated. After a period of low and
stable inflation, it normally becomes more common and more generally accepted that prices and
wages not only can be raised, but also can be lowered.
In addition striving after absolute price stability with margins of error that are in
all likelihood valid will sometimes lead to price increase rates that may be negative. Such a
situation is not entirely free of risk, since it may be difficult to get out of a deflationary situation.
Should inflation then not be allowed to be higher than 2 per cent? The basic
argument against this assertion is that the disruption in the economy will be greater the higher
inflation is allowed to rise. In practice the fact that other countries in Europe, especially
Germany, have a criterion of 2 per cent for price stability has understandably had a decisive
influence in Sweden. Moreover corresponding assessments have also been made by the majority
of the countries outside Europe that work with explicit inflation objectives.
Question 5: Can't the Riksbank do something about unemployment?
Sometimes the view is expressed that low inflation is indeed good, but that it
leads to a very one-sided direction for monetary policy; the Riksbank should also have an
objective for employment.
From what I have said thus far, I hope that it has been clear that there is no
long-term conflict of interests between inflation and employment. On the contrary, there are
many indications that low inflation is a prerequisite for stable and high growth and for
favourable employment developments. Therefore, low inflation is the best contribution that
monetary policy can make to the fight against unemployment.
It is only in the short term that high inflation may lead to lower unemployment.
However to utilise such a trade-off has its risks, as the experiences from the 1970s and 1980s
that I spoke about earlier indicated. The mere concern that policy will be too expansionary and
that inflation may sprint ahead can push up a country's interest rates and results not in higher but
in weaker growth and employment developments. Therefore it is crucial for monetary policy
that confidence in the low inflation regime be preserved.
The very construction of the inflation objective implies that economic growth is
taken into account in a certain way. A weaker growth, which creates excess capacity in the
economy, normally means that inflationary pressures from the demand side will decrease. This
in turn produces room for a more expansive monetary policy - interest rates will be lowered and
demand will be stimulated. Conversely a very high demand signifies that production capacity
risks hitting the ceiling. Prices and wages will then be pushed up. In order to prevent such
occurrences, monetary policy must be tightened again and interest rates raised.
The time horizon over which the Riksbank strives to achieve the inflation target
also has an effect on growth and employment in the short term. A quite short time horizon
means that substantial changes in the interest rate are required in order to achieve the objective.
Such substantial changes may in turn result both in monetary policy appearing abrupt and in
undesirable and significant fluctuations in growth and employment. In contrast a very long time
horizon will bring greater short-term stability to growth and employment, but at the same time
lead to considerable fluctuations in inflation. These fluctuations may weaken confidence in the
price stability policy and lead to higher instrumental rates over time. Here monetary policy is
obviously faced with a balancing problem. The more credible the policy is, the more room there
is to manoeuvre in practice.
There may be reasons for completely abstaining from reacting to certain
inflationary impulses of a one-time nature. An example of such "one-time inflation" is indirect
tax hikes. If price disruptions are judged to have merely temporary effects on inflation and do
not affect expectations of future inflation, it would imply unnecessary real economic instability
to prevent the price increases from having an impact on the consumer price index.
Question 6: Doesn't the Riksbank itself "talk up" inflation?
Now and then the criticism is made that the Riksbank stresses the risks of
inflation in the economy and is thereby guilty of "talking up" inflation. When this is carefully
done the Riksbank - say some of the critics - can use the expected higher inflation (that we
ourselves have created) as an argument for making the interest rate increases we have wanted to
make all along. This type of criticism was common last autumn, for example, when the
Riksbank spoke in various connections about its inflation outlook and explained that interest rate
increases might be necessary.
I have the following answer to these criticisms. To begin with, the Riksbank's
focus on inflation developments is entirely natural. It is undoubtedly our task to show clearly the
reasons for our decisions. Without a candid accounting of monetary policy from the Riksbank's
perspective it would be more difficult for the political decision-makers and the general public to
evaluate monetary policy and our fulfilment of our objective. Think what type of debate we
would have and how monetary policy would be seen if the Riksbank only made its decisions
without commenting at all on the outlook for inflation and without giving reasons for its
policies.
Thus the need for the Riksbank to speak about inflation is obvious. Naturally it
cannot be ruled out that in doing so it will influence households and businesses in their views on
price developments, however our influence should not be exaggerated. The cause-and-effect
relationship is rather the reverse: the Riksbank reacts to inflationary developments, which in turn
are determined by a great number of decisions by businesses and households. However, of
course the Riksbank does not react in a mechanical manner to a measured change in inflation
expectations. The Riksbank currently monitors a number of indicators of future inflation
developments and, responses to its surveys about inflation expectations are just one of many.
By way of conclusion there is reason to call attention to the fact that inflation
expectations to an ever greater degree are being guided by the inflation objective and not by our
or others' discussions of the risks of inflation. The signs of this are clear. The expected inflation
has crept down markedly and has now been stabilised in the vicinity of the objective for most of
the groups currently monitored by the Riksbank. This is a profoundly positive development,
which actually facilitates the monetary policy task. (Diagram 4. Inflation Expectations of the
Players in the Money Market Agents)
Inflation Expectations of the Players
in the Money Market Agents
Per cent
5 5
Jan.'95
4 4
Feb.'.'96
CPI
3 3
Nov.'.'97
2 2
Feb.'.'98
1 1
Feb.'.'97
0 0
-1 -1
94 95 96 97 98 99 00 01 02
Source ces: : Statistics s Sweden n and d Prospera a Research h
Question 7: Is the policy asymmetrical?
It takes time before a change in the instrumental rate affects the economy and
inflation. Therefore monetary policy always has to be formulated with the aid of forecasts of
future inflation. When the Riksbank formulates monetary policy it is done with the aid of a
forecast one or two years into the future. A simple rule of thumb should be able to describe
monetary policy: if our overall assessment of inflation - assuming that the instrumental rate
remains unchanged - indicates that inflation will deviate from the objective for two consecutive
years, the instrumental rate must be changed in the corresponding direction.
Monetary policy is always adjusted with the aim of achieving the 2 per cent
objective. Occasionally the argument has been presented that the Riksbank should accept that
inflation has risen to the upper range of the interval around the objective. This argument is
difficult to reconcile with the conduct of monetary policy in general. To begin with, it is clear
that if the Riksbank did so, inflation would more often be outside the tolerance interval. In the
second place the rate of inflation would on average be higher than 2 per cent unless the Riksbank
had the same tolerance for inflation staying at the lower edge of the band in an economic
downturn. However such a policy would instead reinforce the real swings in the economy, in
contrast to a policy that is always focused on the objective. In upswings the Riksbank would
allow more growth and inflation and in downturns we would do the opposite.
There is not any asymmetry in monetary policy and there should not be any
either. One of the purposes of a clearly formulated objective is simply to inform what the policy
aims at. In such a way the inflation objective may anchor the price expectations in the economy.
The Riksbank should be evaluated in light of this objective. If the Riksbank systematically
aimed below the objective or always overestimated the risks of inflation, it would be manifested
over time by too low inflation on average.
That the Riksbank always aims at the objective of 2 per cent unfortunately does
not mean that the price increases will always be limited to 2 per cent. First knowledge of the
path leading from interest rate changes to their impact on inflation is insufficient to enable us
always to expect to be able to achieve the objective. Second price increases as measured by the
consumer price index will continually be affected by various kinds of temporary factors. There
may be, for example, changes in indirect taxes or external shocks in the form of changed oil
prices. Often such disruptions should not be counteracted (as long as they do not risk affecting
the long-term inflation process). In addition, there is a continuous flow of new information that
can change the inflation outlook. These factors can make the consumer price index diverge from
the target ex post, so to speak. This insight is the reason for the Riksbank's decision to establish
a tolerance interval around the inflation objective. (Diagram 5. CPI and Underlying Inflation)
In the Inflation Report of December, the assessment was that economic growth
would be around 3 per cent in 1998 and somewhat more in 1999. The rise in demand was
expected to result in a gradual reduction of the output gap in the coming years and in increasing
inflationary pressure. Given an unchanged repo rate, inflation was expected to rise gradually to
2.5 per cent during 1999. In order to avoid more drastic changes in monetary policy at a later
stage, we chose to adjust monetary policy in a somewhat less expansionary direction. The repo
rate was raised in December from 4.10 to 4.35 per cent. (Diagram 6. Inflation Forecast
December 1997)
CPI and Underlying
Inflation
annual percentage change
4.0 4.0
Underlying inflation
3.5 3.5
3.0 3.0
2.5 2.5
2.0 2.0
1.5 1.5
1.0 1.0
CPI
0.5 0.5
0.0 0.0
-0.5 -0.5
Jan-95 Jul-95 Jan-96 Jul-96 Jan-97 Jul-97 Jan-98
Sources: Statistics Sweden and the Riksbank
The current crisis in Asia was discussed chiefly in our risk scenarios. A small
reduction in the growth of exports was made in the main forecast. But it was primarily a possible
deepening of the crisis compared with the situation in December that, it was deemed, might have
substantial effects on economic and price developments in Sweden. Thus the Asian crisis was
taken into account in our risk assessment.
Since then the crisis in Asia has worsened, both in terms of its effects on the
financial markets and its likely consequences for real economic growth. For Sweden's economy
it means that the negative effects of the Asian crisis probably will be somewhat more extensive
and prolonged than we expected in December.
All in all, the prospects for inflation from the demand side look a bit better than
they did when the repo rate was last raised. Another positive sign is that the wage agreements
that have been concluded so far in 1998 indicate a rate of wage increases that is somewhat lower
than in the main scenario described in December. However the recent weakening of the krona is
a cause for concern. If it turns out to be permanent, it could affect inflation prospects.
In the Riksbank we are now finalising the next Inflation Report, in which we will
present an inflation forecast reaching into the first quarter of the year 2000. There, factors such
as the Asian crisis, the wage negotiations and the exchange rate developments will be weighed
and put into a larger context. The view of the inflation prospects that will result from this
process will form the basis for future monetary policy.
- 11 -
Inflation Forecast
December 1997
and
CPI
underlying inflation(UND1)
3,5 3,5
3,0 3,0
2,5 2,5
CPI
2,0 2,0
1,5 1,5
1,0 1,0
0,5 0,5
0,0 0,0
1995 1996 1997 1998 1999
3,5 3,5
3,0 3,0
UND1
2,5 2,5
2,0 2,0
1,5 1,5
1,0 1,0
0,5 0,5
0,0 0,0
1995 1996 1997 1998 1999
Sources: Statistics Sweden and the Riksbank