Barbro Wickman-Parak: The repo rate path - experiences three years on
Speech by Ms Barbro Wickman-Parak, Deputy Governor of the Sveriges Riksbank, at the
Danske Bank, Stockholm, 17 June 2010.
* * *
Around three years ago the Riksbank began publishing its own forecasts for the repo rate,
and there were many reasons for doing this. It made the forecasts more consistent and it
was now easier to evaluate the Riksbank's forecast in relation to those of other analysts. We
were also given an opportunity to describe alternative paths for economic developments,
which was a good educational tool that further contributed to increasing transparency.
Publishing a whole path for the repo rate was also one step towards becoming more open
and clear. It also improved the chances of steering longer term expectations . Experiences
so far show that the work on the repo rate and its publication have functioned well. The
monetary policy discussions focus more on long-term issues, and they now concern the
whole repo rate path rather than an individual decision. This is good. Today the repo rate
path is a natural part of monetary policy. Moreover, the repo rate path has served us well
during the crisis, in that we could clearly signal that the interest rate was expected to remain
low over a long period of time.
Market participants' expectations of the repo rate have rarely been exactly the same as the
Riksbank's expectations. My assessment so far is that the deviations have not been a
problem. It is not reasonable to believe that we and the market participants will always reach
the same conclusions. Inflation expectations are well-anchored around the target, which is
the most important indication that the market has confidence in monetary policy.
Why publish our own repo rate forecast?
To put it plainly: a forecast for growth and inflation requires an assumption about the interest
rate. The inflation target was introduced in 1995, and it was then assumed in the forecasts
that the repo rate would be unchanged during the forecast period. This had an advantage in
terms of clarification; if the forecast for inflation was that it would overshoot the target (be
higher than 2 per cent) a couple of years ahead, then the repo rate would be raised, and vice
versa. However, an unchanged repo rate throughout the forecast period was an unrealistic
assumption. The realisation came gradually that the forecasts needed to be based on a more
realistic view of the future repo rate. It was decided that the Bank would use market
expectations, as reflected in implied forward rates, as a base.1 From autumn 2005 the
Riksbank began working with this new assumption in its forecasts.
Once this "second step" had been introduced, a further question arose. Although a future
repo rate being in line with forward rates was a more realistic assumption than a constant
repo rate, situations could arise where the forward rate path did not agree with what the
Riksbank considered to be the "best" forecast for the repo rate. Moreover, it was difficult to
communicate how "appropriate" the forward rate path was as an interest rate forecast, and
the logical consequence of this was to quite simply go on to publish our own interest rate
forecast. The period with implied forward rates as a forecast assumption can therefore be
regarded as a learning process on the road towards publishing our own interest rate
forecasts, which has several advantages compared with using forward rates.2
When we began publishing our own repo rate path, this was the start of a learning process
for us at the Riksbank, but also for market participants. I believe that we have made a lot of
progress in this direction.
Monetary policy through "management of expectations"
The established view today is that a large part of the monetary policy effect is through
influencing expectations among participants in the economy. By publishing our own repo rate
forecasts we improve the opportunities to influence rates with longer maturities by influencing
the general public's expectations of future repo rates ("management of expectations"),
something that proved very useful during the financial crisis.
Figure 1 shows the development of the repo rate and market rates with different maturities.
We see that the Riksbank has considerable influence over developments in market rates with
maturities of up to six months. The repo rate path also has significance for developments in
long-term rates, although other factors than expected repo rates, such as international
events, may have significance in the development of long-term interest rates.
Figure 1
Interest rates at different maturities in Sweden
Per cent
Note. The interest rates refer to treasury bills and government bonds.
Sources: Reuters EcoWin and the Riksbank.
Greater openness and clarity from the Riksbank creates better conditions to govern
expectations in the corporate and household sectors. The publication of a repo rate path can
be regarded as a contribution to this. Any forecast for the Swedish economy made by any
reasonable type of model also generates a forecast for the repo rate. So why should one
then "hide the most central forecasting variable", as my Executive Board colleague
Lars Svensson put it.3
A particular advantage in publishing one's own repo rate path is the opportunity to describe
alternative scenarios for future economic developments and the consequences they would
have for monetary policy. This has made it easier for market participants and households to
judge how we Executive Board members will act with regard to the repo rate depending on
the different alternative paths for growth and inflation.
The Monetary Policy Report shows alternative scenarios, not merely for economic
developments, but also for the repo rate. The alternative scenarios for the repo rate show
different monetary policy alternatives. What would happen to the economy if the Riksbank
followed a repo rate path that was higher or lower than that in the main scenario? The
consequences of various monetary policy alternatives can thus be compared. This can
systematically justify the repo rate path chosen by the Riksbank.
Introduction of repo rate path not entirely uncontroversial
Many people welcomed the Riksbank's decision to introduce its own repo rate path.
However, there were also some misgivings. For example, there were fears that confidence in
the Riksbank might be harmed if the actual repo rate in the future deviated from the earlier
forecast. This was also the type of misgiving expressed when the Riksbank began publishing
forecasts for inflation and growth. In addition, there was concern that the Riksbank might
hesitate to change the repo rate forecast for reasons of prestige, even if circumstances
indicated this was necessary.
If there were fears that the Riksbank might be unwilling to change the repo rate path when
the situation required, this fear has come to nought. Autumn 2008 is a very good example of
this. Now, three years after its introduction, I believe I dare say that the repo rate path is
regarded as a natural part of the Riksbank's policy. I also believe that the discussion outside
of the Riksbank is characterised more by long-term discussions on monetary policy than on
individual decisions.
I shall now go on to briefly describe how the repo rate forecast is produced.
How is the repo rate path determined?
The publication of our repo rate forecasts makes greater demands than previously on the
internal preparation work. The new method of working requires a greater interaction between
the staff and the Executive Board, and the Board members are involved at an earlier stage of
the process. This is made easier by members of the Executive Board being full-time
employees and not merely being called together for monetary policy meetings. So what does
the practical work leading to the published repo rate path actually entail?
The monetary policy decision-making process normally follows an established preparatory
process.4 During a number of weeks employees in the Monetary Policy Department prepare
draft forecasts for economic developments, including the repo rate. After this there are
meetings together with the Executive Board of the Riksbank, and a main scenario for
economic developments, including the repo rate, is drawn up. Of course, the main scenario
is based on a combination of model-based forecasts and assessments.
During the forecasting process, the main scenario presented at the monetary policy meeting
has in practice become a scenario that is supported by a majority of the Executive Board
members. If there are any reservations against the main scenario or the monetary policy
decision, these are made clear at the monetary policy meeting.
Thus, the monetary policy decision is preceded by a long process. As the decision now also
includes the Board's view of the future repo rate, more in-depth and long-term discussions
are required than if it was merely a question of whether or not to alter the repo rate. The repo
rate path has entailed a fruitful change.
The role of the repo rate path during the financial crisis
When we began to make repo rate forecasts a few years ago, I do not believe anyone
expected a situation like the one we had when GDP fell by 5 per cent in 2009. During the
financial crisis several central banks were forced to cut their policy rates to close to zero.
This has entailed restrictions on future decisions, as the nominal interest rate has a lower
bound. The classical argument in favour of this lower bound is that the nominal interest rate
on cash is zero, and that a negative interest rate would mean that economic agents would
hoard banknotes. There are many discussions in the academic world as to whether the lower
bound lies at zero or slightly below.5 I will not go in to it here, but merely note that a majority
of us on the Executive Board has regarded the current repo rate as in practice being the
lower bound.
This zero interest rate problem received much attention in the academic world in connection
with the Japanese central bank cutting its policy rate to zero as a result of the economic
stagnation in the 1990s. One of the possible solutions if a central bank has cut its policy rate
to its lower bound, and wants to cut it further, is to promise a policy rate around zero for a
long time to come. Over time this would have a similar effect to cutting the interest rate to
below zero and then raising it to above zero.
The repo rate path facilitated communication
During the financial crisis, lessons from this research became surprisingly topical for a
number of countries in addition to Japan. The repo rate path fulfilled a central role here, as it
enabled the Riksbank to make clear its intentions for monetary policy during an uncertain
situation. When the Riksbank cut the repo rate to 0.25 per cent in July last year, the repo rate
path signalled a low repo rate for a long period ahead. I believe this gave us an advantage
over many other central banks, who tried to use purely verbal methods to signal that their
policy rates would be low for a long time.
Credibility plays an important role in monetary policy. One central issue in this context is the
inflation target. If a central bank "promises" low inflation, but the economic agents do not find
this credible, it will not have the desired effect. It is possible to inspire confidence in the
inflation target by the central bank being politically independent. What does this have to do
with the zero interest rate problem and the repo rate path? What I mean is that the existence
of a repo rate path in connection with cutting the repo rate to 0.25 per cent, provided credible
evidence that a low interest rate over a long period of time was what was needed to attain
the Riksbank's monetary policy objective of an inflation rate close to the target, and to
stabilise resource utilisation. One could say that we put our cards on the table.6
Figure 2 shows the relationship between market expectations according to forward rates and
the Riksbank's repo rate path in connection with the repo rate being cut to 0.25 per cent in
July 2009. The Riksbank's forecast indicated that the repo rate would remain at this low level
until the second half of 2010. The forward rates prior to the publication of the repo rate path
indicated that the repo rate would not be cut to 0.25 per cent and that increases in the repo
rate would begin as early as the end of 2009. Surveys carried out by Prospera indicated that
expectations were in line with the forward rates. Although the forward rates were adjusted
down after the publication of the repo rate path, the pricing still showed that expectations
were set at a first repo rate increase at the end of 2009. Where the Riksbank's forecast
indicated a first repo rate increase, the forward rate was already up at around 1.5 per cent.
This large deviation caused considerable discussion, partly concerning the current situation
and monetary policy, and partly more general as to whether it is a problem if market
expectations deviate from the Riksbank's forecast. As shown in Figure 2, however, market
expectations were lower than the Riksbank's repo rate forecast at the end of the forecast
period. Seen across the entire forecast period, therefore, the average deviation is not so
great. With hindsight, we can also note that in summer 2009 market expectations deviated
considerably from the repo rate outcome we can see so far.
Figure 2
The repo rate path and market expectations in July 2009
Per cent
Note. Market expectations are based on forward rates. "Before" are the closing rates on the
day before the repo rate path was published and "After" are the closing rates on the day it
was published. Prospera's survey covers money market participants.
Sources: Reuters EcoWin, TNS SIFO Prospera and the Riksbank.
A recurring phenomenon during the three years with our own repo rate path has been that
market expectations of the repo rate have from time to time deviated from the Riksbank's
repo rate forecast. Allow me to comment further on this.
Market expectations and the repo rate path
As I mentioned earlier, one important purpose of publishing a repo rate path is to influence
expectations among the participants in the economy. The established view at present is that
monetary policy has its main impact by influencing expectations of future interest rates. A
natural question here is if the Riksbank's repo rate path has differed from other agents'
expectations of the repo rate, and how large the deviations have been. What role do the
differences between market expectations and the Riksbank's forecasts play?
How large are the deviations...
As we have seen, the Riksbank, the market and other economic agents can have different
views on how the repo rate will develop. Sometimes the differences are small, and
sometimes they are large.
Figure 3 shows two summarising measures for the deviations between market expectations
according to forward rates and the Riksbank's repo rate forecast at the time of all
18 publications.7 We can see that the deviations have become larger since the financial crisis
erupted, which is natural as uncertainty increases. Looking at the whole period since 2007,
however, there does not appear to be any systematic deviation in any direction (the average
deviation is approximately zero for the whole period). It is important to point this out. One
question that may nevertheless arise is why market expectations deviate from the Riksbank's
forecast.
Figure 3
Deviations during the forecasting horizon between the repo rate path
and market expectations according to forward rates
Percentage points
Note. For a description of the calculations, see footnote 7.
Sources: Reuters EcoWin and the Riksbank.
...and what are they due to?
To begin with, I would like to make the reservation that market expectations cannot be
observed, they can only be estimated. Some of the deviations may thus be due to the fact
that we have not succeeded in adjusting the forward rates for various types of premium. In
addition to this, there are a number of other possible explanations for the deviations.
In one sense it may be natural that market expectations deviate from the Riksbank's repo
rate forecast. Market agents may have a different picture of future inflation and economic
developments as a whole, which would motivate a different repo rate in the future. Even if
market agents share the Riksbank's view of economic developments, there may well be a
deviation with regard to future interest rates. This can be due to different views regarding the
transmission mechanism, that is, the effects of the repo rate on the economy.
Are the deviations a problem?
As I mentioned earlier, one reason for publishing repo rate paths is the opportunity to
effectively steer market expectations. We have seen that market expectations sometimes
deviate from the Riksbank's published path. One reason for this is that the uncertainty over
future economic developments has been unusually great during the financial crisis. However, I
would like to tone down the importance of the deviation between market expectations and the
Riksbank's repo rate path. There has not been any systematic deviation in either direction, if
one looks as the average of the repo rate paths and market expectations over three years.
Inflation expectations are a decisive factor for credibility
My view is that the decisive factor for a central bank with an inflation target is inflation
expectations. Expectations should be anchored around the inflation target in the long run. I
say "long run", as inflation expectations in the short term vary considerably in accordance
with actual inflation. Figure 4 shows inflation expectations 1, 2 and 5 years ahead according
to Prospera's survey for money market participants. We can see that inflation expectations
5 years ahead have been around 2 per cent during the past 10 years. I interpret this to mean
that there is still unshaken confidence in the inflation target.
Figure 4
Money market participants' inflation expectations according to Prospera
Per cent
I have so far discussed our experiences of publishing repo rate paths. Let me now go on to
discuss the most recent repo rate path in the Monetary Policy Update published in April this
year.
Some aspects of the current repo rate path
Figure 5 shows the repo rate path from the Monetary Policy Update in April together with
market expectations of the repo rate. For the coming year both forward rates and survey
expectations were very close to the Riksbank's forecast. Expectations as expressed in the
surveys agree fairly well with the Riksbank's forecast, even in the longer run. However,
expectations according to forward rates were much lower than the Riksbank's repo rate path
in the longer run. The total deviation between the repo rate path and forward rates can also
be seen on the far right in Figure 3.
Figure 5
The repo rate path and market expectations in April 2010
Per cent
Note. Market expectations are based on forward rates. "Before" are the closing rates on the day
before the repo rate path was published. "After" are the closing rates on the day it was
published. Prospera's survey covers money market participants.
Sources: Reuters EcoWin, TNS SIFO Prospera and the Riksbank.
The real repo rate path
How expansionary is the monetary policy that follows on from the Riksbank's repo rate path?
One way to gain an idea of this is to look at the development of the real interest rate. The
real interest rate is the most important for the development of the real economy, as it is the
interest rate on which consumption and investment decisions are based. It is defined as the
nominal interest rate minus expected inflation. The Riksbank also publishes forecasts for the
real repo rate in its Monetary Policy Reports.
Figure 6 shows the Riksbank's forecast from the April Monetary Policy Update together with
different measures of market participants' expected real repo rate.8 Let us begin by looking at
the Riksbank's forecast for the real repo rate. We can note that the real repo rate is presently
below zero, and according to the Riksbank's forecast it is not expected to be above zero until
the end of this year. If the forecast proves correct, the real repo rate will have been negative
for a two-year period - this is very unusual in an historical perspective. The Riksbank's
assessment is that a long-term normal level for the real repo rate is around 2 per cent.9 Seen
from this perspective, the repo rate path thus indicates a very expansionary monetary policy.
We have previously seen that in April the market was expecting a lower nominal repo rate in
relation to the Riksbank's forecast. Figure 6 shows that this also appeared to apply to the
real repo rate.
Figure 6
The Riksbank's real repo rate forecast
Per cent
Note. See footnote 8 for a description of the calculation of the real repo rate expectations.
Sources: Reuters EcoWin, TNS SIFO Prospera and the Riksbank.
8
The real repo rate forecast is calculated as a mean value of the Riksbank's repo rate forecast for the coming
year minus the inflation forecast (CPIF) for the corresponding period. Prospera's interest rate and inflation
expectations are based on surveys carried out on 28 April and 28 April-7 May respectively. Interpolation has
been used for the interest rate and inflation expectations to produce the expected repo rate for the coming
year and inflation expectations for the corresponding period. "Forward rates minus Prospera inflation
expectations" shows nominal forward rates from 28 April for the coming year minus inflation expectations
according to Prospera for the corresponding period.
9
See the box "What is a normal level for the repo rate?" in the Monetary Policy Report, February 2010 for a
discussion of a normal level for the repo rate. See also Björn Lagerwall "Real interest rates in Sweden",
Economic commentary no. 5, 2008, Sveriges Riksbank, for a discussion of real interest rates.
Concluding thoughts
Publishing our own repo rate path was a further step towards openness and transparency in
the Riksbank's monetary policy. Our forecast for the repo rate is reported in the same way as
other important forecast variables. We can also use alternative scenarios to illustrate how the
Executive Board may respond with its monetary policy if economic developments deviate
from the main scenario.
When the Riksbank introduced the repo rate path there were fears that many analysts would
stop making their own forecasts and slavishly follow the Riksbank. The merit of having many
different assessments would be lost. However, this has not been the case. There was also
concern that we would avoid changing the repo rate path, even when this was motivated by
changed conditions. This has not happened either. "The repo rate path is a forecast, not a
promise", this has been a message that the Riksbank has communicated all along.
Experiences so far show that the work on the repo rate path and publication of the path have
functioned well. To crown it all, we have gained a monetary policy discussion that is aimed
more at long-term issues and not merely at whether or not the interest rate should be altered
a stage. My view is that our own repo rate path is quite clearly preferable to the other two
alternatives that were tested. I believe that this is also the predominant view of most of those
outside of the bank, now, three years later.
The repo rate path served us well during the crisis. We were able to clearly signal that the
repo rate will be low for a long period of time to alleviate the effects of the fall in demand and
to attain the inflation target. There have been slight differences of opinion among us
Executive Board members with regard to the time when an increase in the repo rate will
begin. But these have been only slight, the larger moves have been clear. It has been
necessary to have a low repo rate over a long period of time. In this context, changes in the
repo rate amounting to 0.25 percentage points slightly sooner or later do not make a
significant difference. According to our repo rate forecast in April, the real repo rate will have
been below zero for two years, and it will remain low throughout the forecast period.
There have been and are differences between the market agents' expected repo rate and the
repo rate path. However, there are also difficulties in measuring market expectations through
forward rates. This applies in normal cases and even more so in times of financial crisis.
Even if it is the case, we can probably note that the differences have been rather the rule
than the exception. There has been no systematic deviation in any one direction. All in all, I
think that with the aid of the repo rate path we have succeeded relatively well in steering
expectations.
In connection with the introduction of the repo rate path, there were discussions as to
whether there would be a confidence crisis if the market does not "buy" our repo rate path.
But, as shown, this does not need to be an expression of mistrust. And talking about
confidence, my view is that the final proof that households and companies have confidence
in the Riksbank's monetary policy is that inflation expectations are anchored close to the
target of two per cent. Surveys indicate clearly that inflation expectations in the long run are
very well anchored around the inflation target. I interpret this to mean that the general public
has confidence that the Riksbank will adapt its monetary policy to attain the inflation target.