SPEECH
DATE: 23 May 2024
SPEAKER:
Deputy Governor Aino Bunge
PLACE:
Fastighetsdagen Stockholm, Grand Hôtel
Light at the end of the tunnel - time to
start thinking about next time?*
Thank you for the invitation to come here!
The situation today is a little different than at the time of Fastighetsdagen
Stockholm last year. At that time, inflation was just below 7 per cent measured by
the Riksbank's target variable, the CPIF, and just over 8 per cent if one excludes
the contribution from energy prices, which had begun to fall back. To curb the rise
in inflation, the Riksbank and other central banks had raised their policy rates
substantially and rapidly. It is not surprising that this has had an impact on the
property and housing markets.
The interest rate increases have had a strong impact on businesses and
households, and I realise that for many in this room, it has been an acid test.
Overall, the Swedish economy and labour market have shown resilience, but we
have seen a major impact on household consumption, a dramatic fall in
construction investment, house prices have fallen and property companies have
in many cases had to restructure their balance sheets. All these parts of the
economy have in common that they are sensitive to interest rates.
Today the situation is somewhat brighter in many respects. Inflation is much
closer to the target, the economy has slowed down, but much less than most
people predicted a year ago, and all analysts, including the Riksbank, are
expecting lower policy rates going forward.
In my contribution at our last monetary policy meeting, when the policy rate was
cut for the first time in eight years, I said that the prospects for inflation look
*
Thanks to Mikael Apel and Karl Blom for help with the speech, a number of colleagues at the Riksbank for
valuable comments, Stefania Mammos for help with the presentation and Elizabeth Nilsson for translation.
Postadress: 103 37 Stockholm, Besöksadress: Brunkebergstorg 11
brighter with regard to the Swedish economy, but that there are still risks abroad
and linked to the weak Swedish krona.
According to the outcome in March, inflation was 2.2 per cent, which is close to
the target measured by our target variable CPIF. The outcome was significantly
lower than expected and shorter-term price changes continue to trend
downwards. The outcome in April also came in lower than expected at 2.3 per
cent.
The Swedish economy has slowed down, largely in line with our forecast. There
are signs of "a light at the end of the tunnel", but the increased optimism is also
likely to be based on expectations of future interest rate cuts. Moreover, the
improvements in several sectors are taking place from a weak starting position.
The labour market has been weakening for some time, and we now see rising
unemployment.
In my view, one important piece of the inflation assessment puzzle is the
continued positive signals we have received regarding companies' pricing
behaviour. There are now actually slightly fewer companies than normal that are
expecting increased sales prices in the retail trade over the next three months.
But at the same time, several factors clearly call for caution in monetary policy
and these factors primarily revolve around international developments. Market
expectations of future policy rates and their impact on the krona have fluctuated
considerably recently. This is a reminder of the existing uncertainty and that the
path to sustainably low and stable inflation is not necessarily straightforward. To
this can be added the ongoing geopolitical risks and associated risks for new
supply shocks, which could trigger new inflationary impulses in Sweden too.
Large and rapid rate cuts may also lead to a large increase in demand in Sweden,
which, particularly in combination with a weakened currency, may make inflation
rise again. We will keep this in mind when we make monetary policy decisions
going forward. We are in a much better position than last year, but we cannot
assume the danger has passed.
Recognising that it is therefore too early to close the book for this period, I would
now like to give my view of things so far, and raise a number of issues related to
both monetary policy and the property market that I believe are key for the
future. A common theme is that a better functioning housing and property market
is very important for Sweden's future economic stability.
The 2022-2024 inflation peak is unique - but could
return
It can often be useful to put a current event into a historical perspective. I would
therefore like to start with a look back at inflation over the last 75 years, from just
after the Second World War. Until very recently, there were two more distinct
episodes of high inflation during this period - a short-lived inflationary peak
associated with the Korean War in 1950-1953, and a longer continuous period
from the early 1970s to the 1990s crisis (see Figure 1). After the last one in
particular, inflation remained low and stable for a long time.
Figure 1. Swedish inflation 1949-2023
Annual percentage change
Source: Statistics Sweden.
The 2022-2024 inflation episode is thus quite unique from a historical
perspective. We have to go back more than seventy years to find a similar
shortterm inflation peak, although inflation was even higher then. Here I am assuming
that the current episode of high inflation is indeed coming to an end, and most
indications are that this will be the case.
It is also unique in that, unlike the two previous episodes of high inflation, this
time it was monetary policy that had the main responsibility for fighting inflation
in Sweden - through the policy of inflation targeting introduced in the early
1990s. In the context of the Korean War, the emphasis in the fight against
inflation was on regulation and fiscal policy measures, both in Sweden and
abroad. In the United States, for example, a price and wage freeze was
introduced.
Of course, the 2022-2024 inflation episode also differs markedly from the much
longer period of high inflation that preceded the 1990s crisis, often called "The
Great Inflation". There are several reasons why inflation remained so high for so
long, but an important one is that overall economic policy systematically became
too expansionary. Then too, monetary policy played a very limited role, as the
interest rate was in principle entirely tied to maintaining the fixed exchange rate.1
First real test for inflation targeting
This recent period of high inflation is likely to be analysed and discussed for a long
time to come. But it is likely that one conclusion will be that an important reason
why it was so short-lived was that central banks around the world reacted as
quickly and simultaneously as they did - although it could be argued that it would
have been even better if they had reacted a little earlier.
For Sweden and many other comparable countries, it has been the first really
major test with inflation far above the target during the period of inflation
targeting. The challenge was to keep inflation expectations anchored and avoid
something like "The Great Inflation" - while doing so without unduly impacting
the real economy in terms of a large decline in output and unnecessarily high
unemployment. We do not yet know whether inflation is permanently back on
target or how the economy will ultimately develop, but so far it looks quite
promising. We have had a slowdown in the economy, but it has been relatively
mild. So it seems that the inflation targeting regime has passed the first really big
test of really high inflation fairly well. It is of course good to finally have
confirmation that inflation targeting works, even when inflation rises far above
the target.
At the same time, developments in recent years are a useful reminder that even if
you have lived in an environment of low inflation and low interest rates for a long
time, you cannot expect it to last forever. I shall return to this shortly.
But if everything seems to be going reasonably well, why am I even bringing this
up? The reason is that my feeling is that, after all, we have had a narrow escape.
Not because I think there was an imminent risk that we would be stuck in a long
period of very high inflation, despite higher interest rates, but because the
development of the real economy could have been much worse. Especially if the
trend we saw of increased indebtedness in some sectors, including the property
sector, had continued for a number of years before inflation rose. And because I
am fully aware that those of you in this room, who work in the part of the
economy that you do, might not agree that the slowdown was particularly mild.
We should therefore start thinking now about how we would like it to be the next
time inflation and interest rates are low for a while and then suddenly rise
sharply. Because there will most likely be a next time, sooner or later.
Monetary policy is conducted according to certain basic
assumptions
To develop my reasoning on this, it may be worthwhile to first say something
about the conditions under which monetary policy is conducted. Since the
introduction of the inflation target in 1993, there has been broad political
agreement that the Riksbank's primary objective should be to maintain
sustainably low and stable inflation.2 The reason is a conviction among economic
policy-makers and researchers that an economy performs better in the long run if
there is a clear benchmark for wage formation and price-setting - that there is
what is usually called a nominal anchor.
An important factor in this context is that the general, global real interest rate has
fallen over a couple of decades, to a historically low level. To put it in economic
terms, the global real equilibrium interest rate has fallen. One driving force
behind this development, which is often emphasised, is the changes in global
savings and investment patterns, for instance, that ageing populations have led to
an increase in savings.3
Central banks cannot control the general level of real interest rates because it
depends on factors beyond the control of monetary policy, but they must take it
into account when setting their policy rates. One consequence of the fall in
interest rates is that an increasingly low policy rate has been required for
monetary policy to stimulate the economy. For example, a policy rate that would
have been highly stimulative 20 or 30 years ago would be contractionary today.
For the sake of simplicity, let us call the policy rate that neither stimulates the
economy nor has a contractionary effect the normal policy rate.4 Monetary policy
is thus expansionary if the policy rate is lower than normal and contractionary if it
is higher than normal.
One difficulty in talking about the normal interest rate - apart from the fact that it
is not constant - is that it cannot be read off any kind of statistics, but must be
estimated in various ways. All of these estimate are, of course, uncertain. In
practice, it is usually a matter of trial and error. If the policy rate appears to have a
contractionary effect on the economy, it is higher than the normal interest rate,
and vice versa. But while this makes things more complicated, it does not, of
course, change the fact that there is a normal level for the policy rate that has
neither a stimulating nor a contracting effect.
Of course, it is not possible to keep the policy rate constant at the normal level all
the time, regardless of what happens in the economy. The central bank must
react and make monetary policy expansionary or contractionary if, for example,
inflation risks deviating from the target over a longer period of time. Otherwise,
economic agents may start to expect that some level of inflation other than 2 per
cent will be the normal level, or perhaps even that there is no normal level but
inflation will just drift - that there is no nominal anchor in the economy. The
central bank would then obviously fail in its mission.
So how much should we expect the policy rate to need to vary? Over the past
decade, it has varied between -0.5 per cent and 4 per cent, i.e. a range of 4.5
percentage points. This does not appear to be a particularly wide range, especially
as inflation has varied between around 0.5 per cent as an annual average in 2014
and the pandemic year 2020 to almost 8 per cent in 2022, measured by the CPIF.
This range of interest rates is what one might call the range of action of monetary
policy, or at least it has been for the past decade.
These are conditions that the Riksbank can do little about. As I said, the general
level of interest rates is something that the Riksbank and other central banks must
take for granted and have to relate to.5 The variations in the policy rate required
to maintain the inflation target are given in about the same way and depend on
the strength of inflationary impulses, the way the economy functions and the
impact monetary policy has on it, other policies, and the degree of confidence in
the target. If the Riksbank were to choose to consistently "react a little less", this
would not be sustainable in the long run. For example, if interest rates are not
raised sufficiently when inflation is rising sharply, inflation could become
entrenched at a high level. This would mean that a much larger increase in
interest rates will be required at a later stage, with greater costs in terms of
increased unemployment and lost output.
Interaction with other policy areas is important
Developments over the past decade have highlighted a relationship that I believe
is central and to which I will devote the rest of my discussion. This is that the
economy must be sufficiently stable and well-functioning - resilient, if you like -
to be able to handle the fact that general real interest rates are low for long
periods, and it must also be able to handle the fact that the Riksbank needs to
raise the policy rate - sometimes relatively quickly and by a lot - so that inflation
can be kept stable at 2 per cent. Economic resilience requires an interaction
between monetary policy and other policies, not least because it is through
measures in other policy areas that we build this resilience.
Figure 2. Policy rates and inflation excluding energy in a number of economies
Per cent and annual percentage change
Note. The red bar shows the highest and lowest outcomes for the policy rate in the euro area,
the United States, the United Kingdom, Norway, Canada and New Zealand. The light blue area
shows the highest and lowest outcomes for inflation excluding energy for the same sample of
countries.
Sources: Eurostat, Statistics Sweden, Statistics Canada, Statistics Norway, Statistics New
Zealand, U.S. Bureau of Economic Analysis, U.K. Office for National Statistics, the respective
central bank and the Riksbank.
In some areas it has worked very well. For example, wage agreements have long
been in line with the inflation target. This has also been the case in recent years,
despite inflation being significantly higher than 2 per cent. As this has reduced the
risk of a wage-price spiral, it has contributed to the Riksbank being able to content
itself with policy rate increases at a relatively low level in international terms,
despite the fact that the rise in inflation in Sweden was relatively rapid and the
peak in inflation relatively high (Figure 2). This stability in wage formation has of
course been positive and favourable for the economy as a whole.
Another important interaction is that between fiscal and monetary policies.
During the recent upturn in inflation, this interaction has worked well, in the
sense that fiscal policy has not reinforced inflationary impulses. In that case, the
Riksbank would probably have had to raise interest rates more than it did. The
future interaction between fiscal policy and monetary policy more generally is
currently the subject of fairly lively debate, including in the Long-Term Survey
report published before the turn of the year, in which fiscal policy stabilisation
was a main theme.6 I will not say more about this other than that the Government
has set up a parliamentary committee to review the fiscal framework and the
surplus target in particular. It will report on its mission at the end of the year.
However, it is important to recognise that government debt cannot be evaluated
in a vacuum, but should be considered in conjunction with private sector debt, i.e.
corporate and household debt, and the risks that build up there.
This brings me to the housing market and another important interaction, which is
that between macroprudential policy and monetary policy. As I mentioned earlier,
the policy rate may need to vary within a certain range, and for many years
monetary policy had to be conducted in an expansionary direction to bring
inflation up to 2 per cent. One risk is that agents will take too much risk during
such periods, and end up in trouble when inflation and interest rates eventually
rise. Since general interest rates are now significantly lower than they were 20 or
30 years ago, it makes sense that asset prices and liabilities are higher than they
were then. But on the one hand, there is the risk of various economic agents
becoming overly optimistic when interest rates are very low, and on the other
hand, a high level of debt is in itself a vulnerability if the underlying conditions
change, for example if the general interest rate level rises in a way that was not
expected and the price of the property financed by the debt falls sharply. In my
view, macroprudential policy has an important role to play when interest rates are
low, by contributing to increased resilience and counteracting the build-up of
financial imbalances.
However, it is not only interest rates that affect how much asset prices and debt
increase in the economy. For example, Sweden and Finland have experienced the
same long trend decline in interest rates. But house prices have not risen nearly as
much in Finland as they have in Sweden. This indicates that structural factors may
play an important role. For example, the Riksbank has long emphasised that the
Swedish housing market suffers from very large structural problems, on both the
supply and the demand side. Addressing these problems requires action on
housing and tax policies. From my point of view, there is therefore potential for
development in the interaction between macroprudential policy, monetary policy
and fiscal policy, when we consider what is an optimal policy mix for managing
various risks, not least those linked to household indebtedness.
A committee is currently analysing the macroeconomic risks associated with
household indebtedness and how borrower-based macroprudential measures,
such as mortgage caps and amortisation requirements, can counteract the
macroeconomic risks associated with household indebtedness. The committee is
to report on its work by 31 October this year.
Build-up of risks and 'financial dominance' make price
stability harder to achieve
Now that I have talked a little about the conditions for inflation targeting and the
interaction between different policy areas, I would like to explain why a resilient
economy is an important prerequisite for monetary policy to focus on fighting
inflation.
There have long been clear examples of risk build-up in the Swedish economy, not
least in the commercial property sector. During the years of low interest rates and
very good access to finance, many property companies increased their borrowing
substantially, expanded their property portfolios rapidly through acquisitions and
new production and therefore took large financial risks. Much of the credit
expansion took place via the bond market (see Figure 3). One contributing factor
was that investors' demand for riskier assets increased in the general low interest
rate environment, as they wanted to maintain a good absolute level of returns.
The increase in demand was reflected, for example, in the large inflows into
corporate bond funds, which led them to invest increasingly in new bonds.
Figure 3. Property companies' loans
SEK billion
2 500 2 500
2 000 2 000
1 500 1 500
1 000 1 000
500 500
0 0
12 13 14 15 16 17 18 19 20 21 22 23
Bank loans Market funding
Other
This contributed to making bond financing relatively more favourable for property
companies. To be able to borrow more and more cheaply, an increasing number
of property companies wanted to enter the bond market, and many therefore
chose to obtain a credit rating from both established and new rating agencies.
During this period, property companies' loans increased significantly in relation to
their earnings - in other words, property companies' cash flows became
increasingly leveraged (See Figure 4).
Figure 4. Property companies' debts in relation to their operating profit
Ratio
18
16
14
12
10
8
05 07 09 11 13 15 17 19 21 23
Net debt in relation to EBITDA
Average
Note. Refers to volume-weighted ratio for 34 commercial property companies, with some
property companies being added over time. The ratio is calculated as the companies'
interestbearing liabilities minus cash and cash equivalents relative to their operating profit, weighted
by volume. Operating profit is a company's earnings before interest income and expense,
taxes, depreciation and amortisation (EBITDA). Data refer to the period up to the end of the
first quarter of 2024.
Sources: Sedis and the Riksbank.
Then, as inflation and interest rates rose, many property companies came under
pressure. Since rental agreements are often inflation-indexed, rental income
increased, but this could only partly compensate for higher financing costs.
Property values also started to fall, albeit slowly. At times, it was difficult for any
but the strongest companies to issue bonds.
As a result of the changing economic environment, many property companies
have had to take steps to strengthen their balance sheets. For example, they have
sold properties, issued new shares and reduced new construction and investment
in existing properties. Together with a higher operating profit, this has
contributed to a decrease in the net debt ratio among large property firms from
just over 17 to just under 14 since the beginning of 2022 (See Chart 4).
Expectations of lower interest rates have contributed to the improvement in the
financing situation of companies, not least on the Swedish bond market.
However, it is important to remember that things could have gone much worse. In
general, the Swedish banking sector was in good shape this time around and was
able to absorb a large part of the property companies' borrowing needs.7
To some extent, of course, reduced activity and lower prices in the property and
housing markets are a natural part of the monetary policy transmission
mechanism, as it is the intention that activity will slow down to reduce
inflationary pressures. High interest rate sensitivity - that is, large effects of
interest rate changes - is also not necessarily a problem and can even be an
advantage, as monetary policy then often has a faster impact and is more
effective. But if, for example, many property companies are unable to cope with
the Riksbank raising the policy rate to a level that is compatible with keeping
inflation low and stable, there is a risk of a credit crunch and instability in the
banking system - as the banks have such a large exposure to the sector.
More generally, an economy with high levels of debt may eventually find itself in a
situation where monetary policy is hampered by so-called 'financial dominance'.
This means that the central bank will find it difficult to raise interest rates to fight
inflation if the higher rate not only dampens demand in the economy, but also
risks causing problems in the financial system. One difficulty that arises if the
central bank tries to deal with the problem by not raising interest rates sufficiently
is - as I noted earlier - that inflation becomes persistently stuck at above-target
levels. The problems are then simply postponed. Sooner or later, when it is
necessary to try to bring inflation down, you will need to tighten monetary policy
more. Ultimately, this could lead to both higher unemployment and lower output
and financial instability, in the form of falling asset prices and higher loan losses,
further amplifying the downturn. Financial dominance is therefore a trap for
monetary policy and the economy as a whole that we must try to avoid.
We could end up in a similar situation again
But, as I said earlier, this is not something we seem to need to worry about at the
moment. On the other hand, there is reason to start thinking now about what we
want the Swedish economy to look like in the future. I believe that the
developments of recent years can be seen as a clear wake-up call.
As I mentioned earlier, the general level of global real interest rates has fallen
over the past few decades, to a historically low level. Several studies have tried to
estimate what will happen to real interest rates in the future. With only few
exceptions, they conclude that they will remain low.8 This would also mean that
the normal level of the policy rate will remain low from a historical perspective in
the future.
We at the Riksbank have said that we want to have a testing approach where we
evaluate the effect of the interest rate cuts on the economy to assess what
constitutes a contractionary monetary policy.9 But it cannot be ruled out that
central banks may once again have to grapple with the problem of how far the
policy rate can and should be cut when inflation is at risk of undershooting the
target, or economic growth is weak. We need to avoid ending up in a situation
where risk-taking becomes excessive, and instead strengthen resilience among
companies and households. Because there will also be periods from time to time
when inflation rises sharply and the policy rate needs to be raised quite a lot. Of
course, we don't know how often this will happen, but we shouldn't expect it to
take as long as it did recently, i.e. about fifteen years. Of course, we do not know
how much the interest rate needs to be raised in such situations either, but it
cannot be ruled out that it needs to be raised more than 4 per cent. It is therefore
important that economic agents and the economy as a whole are well equipped
to cope with such developments - i.e. periods where interest rates are raised
significantly after a long period of low interest rates.
Strengthening resilience requires work on several fronts
To address some of the risks associated with property companies' loans, I believe
we need to consider the important role that the corporate bond market currently
plays in property companies' financing. An important prerequisite for a stable and
well-functioning market is the correct valuation of credit risks. This is where the
increased use of credit ratings can play a role. However, the behaviour of credit
rating agencies in 2022 and 2023 - with rapid and large downgrades of property
companies in a short period of time - raised questions about the reliability of
credit ratings. In this regard, institutions may need to review their methodologies
so that the ratings become more robust.
The fact that the bond market has come to play an increasingly important role for
property companies is part of a broader trend, in which financial agents other
than banks, such as funds, have come to constitute an increasingly large and
important part of both the Swedish and the global financial system. However,
unlike the banking sector, there is no framework for macroprudential supervision
for these actors. The Riksbank considers it important to have such a framework in
place, and therefore welcomes the fact that the European Commission has
launched a consultation on introducing this within the EU.
In a Swedish context, corporate bond funds are important investors in property
companies' bonds. However, the funds are exposed to liquidity risks as there is a
mismatch between the liquidity of the assets in which they have invested and the
ability of unitholders to redeem their units. There is therefore a risk that funds
may need to sell corporate bonds quickly to meet withdrawals from their
shareholders. This could lead to stress in the bond market, impairing companies'
ability to raise financing there. We saw a real example of this during the beginning
of the pandemic. The Riksbank has long emphasised that fund companies need to
manage liquidity risks in corporate bond funds, and has recently also advocated
that the funds should implement adjusted sales and redemption prices, so-called
'swing pricing'. I note that the new additions to the EU directive regulating funds
will soon require them to provide and implement more liquidity management
tools to mitigate liquidity risks, including swing pricing.
Property companies themselves have work to do to strengthen confidence in the
sector as a whole. One way to do this is to increase transparency around the way
properties are valued. For example, it is currently difficult to assess whether
property values have been adjusted downwards sufficiently as a result of
thechanged economic environment. On the one hand, companies need to explain
more clearly the assumptions on which the valuations are based, and on the other
hand, the information about the transactions needs to be more detailed. In light
of this, it is positive that Finansinspektionen has taken the initiative to improve
the information base in connection with transactions.
On the household side, policy needs to act with reforms to reduce the structural
problems that exist on the supply and demand side of the housing market. If not, I
see that macroprudential policy will have to continue to play a central role.
Otherwise, we will leave the Swedish economy in an even more vulnerable
position. Al-though the measures come with some costs, the amortisation
requirements and the mortgage cap have curbed indebtedness and thus reduced
interest rate sensitivity among households.10
My key messages
Let me briefly summarise my most important messages. We started this month
with a cut in the policy rate and inflation is now close to the target. It is too early
to sound the all-clear, but we are in a much better position than we were a year
ago. The 2022-2024 inflation peak is unique in several ways. We have not seen
such high and short-lived inflation for more than seventy years and it was the first
really big challenge with high inflation during the period of inflation targeting, i.e.
when the main responsibility for fighting inflation rested with monetary policy. As
far as can be judged today, inflation targeting has passed the test fairly well, in
that inflation is broadly back on target, hopefully sustainably, without an
excessive slowdown in the economy and without causing financial stability
problems.
But even if things seem to be going quite well this time, there are reasons to try to
make the economy even more stable and well-functioning next time. It is very
positive that Sweden has secure and stable public finances that enable
investments for the future. But we also need to keep a close eye on private debt.
And this is particularly true among property companies and mortgage lending to
households. It is not unlikely that we will continue to see relatively long periods of
fairly low interest rates and inflation close to the target, interrupted from time to
time by episodes of rising inflation and a policy rate that needs to be raised,
possibly more than has been the case this time.
It is therefore important that periods of low policy rates are not characterised by
excessive risk-taking in certain sectors, which risks creating major problems when
the policy rate needs to be raised. In other words, there must be conditions for
monetary policy to do the job it is delegated to do, without major problems
arising in some parts of the economy - and, in the worst case, risks to the financial
system - as a result of excessively short-term and risky behaviour.
In an unfavourable scenario, the next time the interest rate needs to be raised
substantially, we will find ourselves in a situation where we in Sweden have not
done much to make the property and housing market more resilient to interest
rate increases. Then the problems could be much bigger than they were this time.
We should do our best to avoid this.
References
Andersson, Michael and Ted Aranki (2019), "Fewer vulnerable households after
stricter amortisation requirements", FI Analysis no. 17, Finansinspektionen.
Andersson, Michael, Ted Aranki, Matilda Gjirja and Niclas Olsén Ingefeldt (2018),
"The mortgage cap reduce