Irma Rosenberg: Monetary policy and financial stability - the Riksbank's
two main tasks
Speech by Ms Irma Rosenberg, First Deputy Governor of the Sveriges Riksbank, at Statistics
Sweden, Stockholm. 2 October 2008.
* * *
Many countries are currently in the midst of a financial crisis that has repercussions
throughout the global financial system. Headlines referring to problems in large US banks, to
rising risk premiums, poorly functioning markets and other consequences around the world
have been prominently featured on the first pages of many newspapers. Sweden has so far
been spared the worst. But now the financial markets here are also clearly affected by the
uncertainty and lack of confidence, which thus also affects the Swedish banks and other
financial agents. The Riksbank is working intensively on dealing with these events right now,
like most other central banks.
The Riksbank's task is to safeguard both price stability and financial stability. I am going to
talk today about current monetary policy and the deliberations at our most recent monetary
policy meeting in September. But the recent drama in the financial markets gives me reason
to devote some time to explaining what our task of safeguarding financial stability concerns
and to our assessment of the current situation.
Two tasks - monetary policy and financial stability
Some of the questions that have been the focus of attention are what the Riksbank and other
central banks can and should do about what is happening in the financial markets right now.
It is not surprising that these questions arise. But if they are to be discussed, it is important to
separate the two tasks the Riksdag (the Swedish parliament) has given us - monetary policy
and financial stability. This may not be so easy, as the areas in many ways affect one
another. However, I shall try to make things a little clearer.
Two different tasks...
What is happening right now is important, both with regard to financial stability and monetary
policy. The financial turbulence has also been included in our analyses of both areas, ever
since the problems connected to the mortgage market in the United States became apparent
last summer. However the perspectives are different. The stability perspective concerns how
the banks, the payment system and the financial system in general are affected by the
financial crisis. The monetary policy perspective concerns how inflation and developments in
production and employment may be affected.
... which are in many ways linked
As I recently mentioned, our two fields of activity are closely linked. The financial turbulence
that has spread around the world to a large extent has its roots in the problems in the United
States, linked to financial stability. This has led to extensive losses in the bank system in the
rest of the world, to considerable uncertainty and poorer functioning in the financial markets.
This is of course important to economic activity. However, economic activity in its turn affects
factors that are important to financial stability. For example, the number of company
bankruptcies and loan losses in the banks is usually higher when economic activity is low
and vice versa. There is also a fundamental relationship between our fields of activity. The
Riksbank's most important tool in conducting monetary policy is the repo rate. One can say
that we try to influence economic activity and inflation by steering the price of credit, that is,
interest rates. But to be able to do this, the payment system and our interest rate steering
system must function. Financial stability is therefore actually a necessary condition for being
able to conduct monetary policy efficiently.
With regard to financial stability, the Riksbank makes regular updated assessments. I shall
soon return to our views on current developments. But before I do so, I would like to say a
few words about what the task of safeguarding financial stability actually entails. Most people
are probably aware that we have an inflation target for monetary policy. But what do we
mean by financial stability?
What do we mean by financial stability?
Financial stability is not so easy to define. In the Sveriges Riksbank Act the Riksbank's task
that we commonly refer to as safeguarding financial stability is formulated as "to promote a
safe and efficient payment system". Put simply, this concerns working in different ways to
ensure that he financial system is stable and functions smoothly. This is important for many
reasons. The financial system fulfils a number of functions that are fundamental to society
and which most people probably take for granted. For example, individuals, companies and
organisations must be able to make and receive payments in an efficient manner. Goods are
transported to consumers via our usual infrastructure, for instance, the road or railway
networks. When one then pays for the goods, one can say that the money is sent to the
person who receives it via the "financial infrastructure" - the hub of which is our central
payment system, RIX. Almost all financial transactions include some form of payment via the
payment system. Without an efficiently-functioning financial infrastructure the economy will
come to a halt. Another important function is to be able to save via the financial system. The
funds saved become money that others can borrow. An efficiently-functioning credit market is
a necessity in a developed modern economy. The financial system also makes it possible for
those who invest to manage the risks that can arise. This is also very important for the
development of the economy and actually for society to function well on the whole.
How do we work to fulfil our task?
So how do we work to fulfil our task? For one thing the Riksbank monitors and analyses the
financial system, in particular the major Swedish banks, but also the efficiency of the
payment system as a whole. We identify possible risks and threats to the financial system
and evaluate the system's resilience. This is done for instance in our Financial Stability
Report, which is published twice a year, and in speeches held by Executive Board members.
We also try to influence market participants who are important to financial stability. Part of
this work includes regular contacts with the banks, other government agencies and our
central bank colleagues in other countries. Most of our work concerns preventing problems
and ensuring that the payment system functions as smoothly as possible. We can do this in
many different ways. Some concrete examples are the recent actions taken by the Riksbank
and other government agencies. I shall return to what these actions entail shortly.
We work to prevent financial crises from arising. But if they do nevertheless arise, it is also
our task to manage them. We have to be prepared to take action although we hope that we
will never need to do so. This preparedness includes, for instance, regularly holding crisis
exercises, both internally and together with other Swedish authorities, and sometimes
together with central banks and authorities in other countries. The work on financial stability
is reminiscent of fire safety work. We have to provide information about the risks, but it is
also our job to be prepared to put out the "fires". And to be able to do this efficiently, we must
have practised. In purely practical terms, we have the possibility to take a number of different
measures if this should prove necessary. But one should bear in mind that each situation is
unique and must be dealt with on the basis of the conditions prevailing at that time.
Worst case scenario
One fundamental function of a central bank is the role as "lender of last resort". If the
Riksbank's assessment is that financial stability is threatened, we have the possibility, in
exceptional circumstances, to contribute liquidity to Swedish banks and other financial
companies by granting liquidity assistance on special terms. However, this assumes that
these institutions are sound and that they are under the supervision of Finansinspektionen,
the Swedish Financial Supervisory Authority. Let us assume, for instance, that a bank that
meets the requirements and thus is assessed as having assets that are greater than its
liabilities, nevertheless experiences severe problems in financing and acquiring sufficient
liquidity to meet its payments. I shall briefly explain how such a situation can arise.
In general, the banks finance themselves by borrowing money in the short term and lending it
out on a longer term basis. When the banks lend to individuals and companies it is often on
long-term contracts, which means that the bank cannot get the money back earlier if this
should prove necessary. On the other hand, when the bank receives deposits from
individuals and companies, they usually have the possibility to withdraw the money whenever
they wish. Also when the banks borrow money in the financial markets this is often as
shortterm loans, that is with a short duration. If it should suddenly become difficult or very
expensive for the bank to borrow money, it may experience difficulty in meeting its payments.
The terms for the more long-term lending are largely restricted. In such a situation the
Riksbank can help to manage the bank's financing problems by granting liquidity assistance.
But we only do this on condition that the terms I recently mentioned are met and if our
assessment is that the stability of the financial system would be jeopardised if the bank in
question failed.
Another fundamental function that it is important to mention in this context "to keep the
different tasks separate" is that the Swedish banks can borrow overnight from the Riksbank
against collateral at an interest rate of 0.75 percentage points above the repo rate. They
always have this possibility and this is not what we mean by liquidity assistance.
But what if the bank suffering problems does not have larger assets than liabilities? Should
the Riksbank provide liquidity assistance? No, in such a situation it is a question for the
government, not the Riksbank, to decide. What the Riksbank can do is provide additional
liquidity under certain conditions. We do not have the task of managing a bank's problems
with its creditworthiness. Even in this hypothetical reasoning it is important to point out, that
in principle all those who have deposited money in the bank are protected by the deposit
guarantee in the event that a Swedish bank should default. This applies for amounts of up to
SEK 250,000 per customer and institution. It is only if the deposit has been made by another
financial institution or in some cases if the amount is frozen that the deposit guarantee does
not apply.
This reasoning concerned what we could do in a situation where financial stability is
threatened. Some central banks have recently been forced to take this type of measure. But
none of the Swedish banks has had problems with its liquidity in the way I described in my
example. So how do we view the current situation?
Recent developments
As I mentioned earlier, the financial turbulence has been included in our analyses for some
time now, both with regard to monetary policy and financial stability. The Riksbank has
regularly emphasised many of the risks in the financial system and what could happen if the
financial turbulence should grow worse. The Riksbank bases its assessment on an analysis
that focuses on the four major Swedish banks, as they account for around 80 per cent of the
market. The Swedish banks have considerable equity, good profitability and limited loan
losses. Our assessment is that there is a high degree of resilience to the international turmoil
that has prevailed for some time now. But this is not the same as saying that the Swedish
financial markets and banks are not affected by the situation. Of course they are.
The financial markets have been affected more noticeably
The international markets where the banks obtain funding by taking out bond loans have
been functioning poorly. Borrowing has become more expensive and more difficult. Normally
the financial market participants trade with one another and thus contribute to the smooth
functioning of the market. However, recently above all mutual distrust has meant that they
are more wary of lending money to one another. One can say that this has "thrown sand in
the wheels". Many central banks and other government agencies are trying to counteract
this, as I will discuss shortly. This has also affected the Swedish banks, although the
problems have been less serious here than in many other parts of the world.
We can observe that short-term interest rates have now risen substantially in Sweden, too.
This applies, for instance, to the interbank market, which is the market where the banks
borrow money from one another to cover their short-term liquidity needs. However, in this
context it is worth pointing out that the overnight market has functioned as usual and that the
overnight rate, the shortest interest rate in the economy, has remained stable around the
repo rate. In this way the Riksbank's system for steering the interest rate functions well,
which is of course important not least for monetary policy.
The market for mortgage bonds has also functioned less efficiently than normal. In times of
uncertainty investors often prefer to buy safe assets and sell those that are higher risk, even
if the latter have a higher return. So when the situation becomes uncertain the demand for
government securities with a short duration, such as treasury bills, usually increases. At the
same time the demand for less liquid securities considered to have a higher risk declines. As
an example, in the United States they have been selling off mortgage bonds, as these have
been regarded as particularly high-risk investments as a result of the US mortgage crisis. But
even in Sweden there has been a strong demand for treasury bills with a short duration, at
the same time as the supply of mortgage bonds has increased. This has occurred despite
the Swedish mortgage bonds having a very high credit rating. Normally these have an
interest rate just marginally higher than the rate for treasury bonds with a corresponding
duration. However, recently the interest rate differentials between these securities have been
much higher.
Measures to improve the functioning of the markets
The Swedish National Debt Office and the Riksbank have maintained a regular dialogue
regarding the money and bond markets and the need to counteract the effects of the US
financial crisis. To alleviate the problems here, the Swedish National Debt Office, in
consultation with the Riksbank, decided two weeks ago to increase the supply of treasury
bills through a number of additional auctions and at the same time buy, by reverse repo as it
is called, the corresponding amount of mortgage bonds. These measures mean in total that
the Swedish National Debt Office will probably have invested around SEK 150 billion in
covered mortgage bonds by the end of November. However, there is also a flexibility to
adjust the issue volumes on the basis of market developments. It is worth noting that the
Swedish market for mortgage bonds has been open during the whole period of financial
turbulence, although it has functioned less efficiently than before.
Just over a week ago the Riksbank also increased the possibility for credit for the participants
in the RIX payment system. The purpose of this is to facilitate the banks' payments to one
another during the day, where necessary. To oil the wheels a little, one might say. RIX
participants can now to a greater extent use their own covered bonds, or those issued by an
institution with close links, as collateral in the system. The collateral for a covered bond is
directly tied to a particular portfolio of mortgage loans with high collateral. This means that
the credit granter is protected, even if the institution issuing the bond were to collapse.
Covered bonds are therefore good collateral and many other central banks accept them to a
greater extent than the Riksbank. In our case, the permitted share was raised from 25 per
cent to 75 per cent. This measure meant, to put it simply, that participants in the RIX system,
were given the opportunity if necessary to use more collateral as a base for their loans from
the Riksbank.
Another preventive measure taken by the Riksbank has been to establish, together with
other central banks, a swap facility with the US central bank, the Federal Reserve. This
agreement entails the Federal Reserve supplying US dollars in exchange Swedish krona if
the need should arise. But it should also be pointed out that the Riksbank has a substantial
foreign currency reserve. The agreement is not the only means for the Riksbank to obtain
loans in US dollars, but it makes it easier for us to take action quickly. Right now, the
situation regarding short-term funding in USD has been very strained on many markets.
To increase access to liquidity in US dollars and to make the markets function more
normally, several central banks, including the Riksbank, have agreed on coordinated actions.
The Riksbank has decided to lend dollars to Swedish banks in two auctions during October.
The first was held yesterday and amounted to USD 7 billion. A second auction with loans
extending over the turn of the year will be held on 22 October and amount to USD 15 billion.
A large part of the collateral the banks pledge for these loans will probably be comprised of
covered mortgage bonds. The measures should therefore also have a positive effect on the
functioning of the mortgage market. Together with the measures taken by other central
banks, this should lead to better liquidity in the financial markets globally.
A further measure is that the Riksbank as recently as today decided to establish a loan
facility in Swedish krona to increase access to loans of longer duration.
There have thus been disruptions in the financial markets, but the Riksbank, other
government agencies and central banks have taken action to improve the functioning of the
markets. We will of course continue to follow developments very closely. We are constantly
updating our analyses and we are prepared to take action if necessary. In addition, as I have
already mentioned, we have close contacts with the banks, market participants, other
government agencies and our central bank colleagues in other countries.
Monetary policy
When the Executive Board met for our most recent monetary policy meeting on 3
September, the decision was to raise the repo rate by 0.25 percentage points to 4.75 per
cent. However, the forecast for how the repo rate would develop in future was lowered in
relation to the interest rate path that had been presented in July. The July forecasts
contained a fairly high probability for a further two raises during the autumn. But at the
September meeting the Executive Board's assessment was that there would not be any
more raises and that the interest rate might need to be cut during 2009. The decision was
reached by a narrow majority. Three members of the Executive Board supported the
decision, while three were against it, and the Governor's casting vote was decisive. I was
part of the minority who wished to hold the repo rate unchanged at the September meeting
and to see a slightly faster reduction in the rate in the future.
The main reasons put forward by the majority for raising the interest rate were that inflation
had continued to rise and was far above the target, that inflation expectations remained high
and that cost pressures had increased. The majority assessment was that it was necessary
to raise the repo rate to prevent the increases in energy and food prices from spreading to
other areas. The reasons for lowering the interest rate path included the fall in the oil price
and other commodity prices over the summer. Another reason was that growth had slowed
down more than expected, both in Sweden and abroad. The turmoil in the financial markets
was of course also included in the picture.
My own assessment
I personally had entered a reservation as early as July against the forecast that it would be
necessary to raise the repo rate a couple more times during the autumn. At the September
meeting I considered that the arguments against further interest rate raises were even
stronger. Although inflation was high and far above the inflation target, the information
received during the summer indicated that inflation would be weaker in the future than we
had predicted in July and my assessment was that the risk of contagion effects had also
declined. Let me explain my reasoning at the time.
There were three main areas where my assessment differed from that of the majority. These
were economic activity in Sweden and abroad, the risk of contagion effects from the
increases in oil and commodity prices in the world market and to what extent the weak
productivity risked leading to inflation effects.
Oil and food prices
Oil and food commodity prices had fallen slightly during the summer, but were still a good bit
higher at the time of the September meeting than they had been a year previously. There
was also considerable uncertainty over how they might develop in the future. But my view
was that the risk of these prices rising again had declined as a result of the clear weakening
in economic activity both in Sweden and abroad. I also assessed that the risk of contagion
effects on wages and prices in other areas had declined. I therefore considered that no
further increase in the interest rate was necessary to counteract these effects.
I would like to take the opportunity to answer the criticism against us that we care too much
about the price of oil and food commodities in the world market when we make our monetary
policy decisions. The reason given is that we cannot affect these prices with our monetary
policy. Of course it is quite true that we cannot affect world market prices. But nor have we
tried to stop the direct effects of the upturn in oil and commodity prices. If this had been our
aim, the interest rate would have been much higher than it is now. Inflation is also much
higher now than our target, because of the direct effects of higher commodity prices. The
reason we have not tightened our monetary policy severely is out of consideration to the real
economy, production and employment. However, what we are anxious to see is that the
indirect effects of the increases in oil and food prices are not allowed to push up inflation
more permanently. We conduct a flexible inflation-targeting policy. If shocks occur that mean
inflation will deviate from the target, we can allow it to take some time to attain the inflation
target. The normal time horizon is a couple of years, but sometimes it may be sooner and
sometimes it may need to take a little longer.
Weaker growth
With regard to growth in Sweden and abroad, my views were more pessimistic than the
assessment presented in the September Monetary Policy Update. Developments in the
United States appeared particularly uncertain. The crisis in the housing sector, together with
falling employment and weaker growth in real wages meant that I found it hard to believe that
the US economy would turn upwards as quickly as assumed in the forecast. Moreover, the
forecast for global growth assumed that there would not be any substantial slowdown in
economic activity in the emerging economies. However, my assessment was that growth
would also weaken there. The rises in energy and food prices entail cost increases and
reduce purchasing power in these countries too. I also pointed out the rapid slowdown in the
growth rate in the euro area. All in all, I considered there were risks that economic activity
abroad would weaken more than was forecast in the September Update.
In Sweden, there were clear signs of an economic downturn as early as the monetary policy
meeting in July. In September we could see that growth in the second quarter had slowed
down much sooner than expected. The situation in the Swedish labour market remained
strong, but even here there were indicators, such as labour shortages, the number of job
vacancies and redundancies, pointing to a cooling down.
Productivity and inflation
Productivity in Sweden has been weak since the beginning of last year. This means that unit
labour costs as measured in the National Accounts are increasing more quickly. There is
thus a risk that companies will try to pass on their cost increases to consumers, which would
result in higher inflation. However, I considered that this risk is slight at present, now that
economic activity is slowing down. The labour market usually lags behind production in the
economic cycle. Employment has risen rapidly in recent years and when demand and
production slow down as quickly as they are now, my assessment was that companies are
more likely to cut their workforces rather than raise prices substantially. The redundancies
announced at the beginning of the autumn may be an indication that many companies have
had to reduce their labour forces.
To summarise, my assessment was that inflation would slow down sooner than was
assumed in the Monetary Policy Update. It was therefore my conclusion that no further
interest rate increase was necessary to bring inflation back on target within a reasonable
period of time. Further, my assessment was that the repo rate might need to be cut more
than indicated by the proposed interest rate path and I therefore entered a reservation
against the new interest rate path.
Some concluding thoughts
The Riksbank, like many other central banks around the world, is currently facing difficult
challenges. But although they are difficult, we are well-equipped to meet them. For instance,
we have an entirely different starting point from that during the finance crisis of 1992, which
largely concerned problems that had originated here at home. Today we are suffering
contagion effects from problems in the US mortgage market, a market to which the Swedish
banks have only small direct exposures. The situation with regard to monetary policy is also
quite different from during the early 1990s. The inflation target and the current regulations
regarding monetary and fiscal policy together with sound public finances provide a stable
base on which to stand and meet the coming economic downturn.
Even if the Swedish banks are affected by current events, they have good capital buffers and
good earnings, and are therefore well-equipped to meet the turmoil in the financial markets.
The biggest problem for the banks at present is to borrow at longer durations. The Riksbank,
together with other government agencies and central banks, has taken measures to improve
the situation. We are also prepared to take further measures if necessary.