Lars Heikensten: Monetary policy and the economic situation
Speech by Mr Lars Heikensten, Governor of the Sveriges Riksbank, at Handelsbanken, Karlstad,
26 January 2004.
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It is nice to meet a group of representatives of the business and social community in this way in
Värmland. I would therefore like to begin by thanking the organisers of today's lunch meeting.
When I took office as Riksbank Governor last year I decided that I would leave Stockholm shortly
before each monetary policy meeting and visit different parts of the country; both to learn more about
developments in various parts of Sweden and to explain the Riksbank's work and actions. My visit to
Karlstad today is the first of these trips. During the morning, I visited the university and spoke about
how the Riksbank works. Later this afternoon I will first be visiting coffee manufacturer Löfbergs Lila
and thereafter be discussing labour market conditions at the county administrative board. We at the
Riksbank make these visits in order to meet the Swedish people and increase understanding for our
policy, something that is particularly important today given our statutory independence.
In Sweden we have an inflation target, which the Riksbank has defined as 2 per cent with a tolerance
interval of plus/minus one percentage point. As I see it, our policy of inflation targeting has worked
well. We managed to gain respect for our conduct of monetary policy a lot quicker than many other
countries. Moreover, in the ten years that have passed since the introduction of the new regime,
average inflation has been very close to our target. At the same time, growth has been higher than in
previous decades. Prospective inflation has also been remarkably stable for the past 6-7 years despite
periods of rather large transitory fluctuations in actual inflation. The stable inflation expectations have
been particularly important for wage negotiations, which have been able to proceed against a
completely different, more secure background than during the 1970s and 1980s.
When we conduct monetary policy, we do so on the basis of forecasts of inflation for primarily the
coming 1-2 years. The reason we work with this time perspective is that the effects of our actions are
exerted mainly during this horizon. When our forecasts indicate that inflation in the relevant time
horizon will be above target, there is normally reason to raise the repo rate, and vice versa.
Particularly when it comes to debate situations such as that we have been involved in recently, it feels
secure to gain a foothold in the clear framework that we have developed for our work in the past ten
years. Although we do not mechanically set the repo rate in relation to our inflation forecasts, everyone
that is interested in our work methods knows that our forecasts play a decisive role for our actions.
Permit me now therefore to move on and say something about my current views on inflation
perspectives before I comment on monetary policy.
The international recovery is progressing
It is natural to begin a survey of inflation perspectives by touching upon the international economy. At
the end of 2002, the Riksbank and other forecasters expected world economic activity to embark on
an upturn. However, during spring 2003, we gradually had to revise down our growth forecasts. While
a recovery in the world economy was still expected, it was now judged to occur at a later stage. The
weak growth, however, prompted a shift to more expansionary economic policy in many countries.
Both the European Central Bank (ECB) and the US Federal Reserve, as well as the Riksbank and
other central banks, continued to cut key interest rates to historically very low levels.
However, most factors now indicate that both the Riksbank and other forecasters were somewhat
overly pessimistic in connection with the Iraq war, particularly regarding the view of economic
developments in the US. During the second half of 2003, we have had reason to again revise up our
growth forecasts for the world economy.
What has happened then since December, when the Riksbank published its latest Inflation Report and
forecasts? The most apparent and perhaps the single most important change in the world economy
has been the sharp depreciation of the dollar, mainly against the euro.
It is likely that the dollar's weakening against both the euro and the yen is an effect of the US current
account deficit, coupled with a growing deficit in the US federal budget. Concern over how to resolve
these problems has overshadowed factors that have been pointing to a strengthening of the dollar,
mainly the relatively favourable US growth and the investment opportunities that this is likely to bring
about.
The weaker dollar can be assumed to have implications for the euro area and Japan, where growth
has been fuelled in recent years by high net exports. A substantial appreciation in the exchange rate
similar to what we have seen now will make it more difficult to increase exports, which means that
growth will have to come from domestic demand to an even greater extent than today. At the same
time, we must not forget that the depreciation of the dollar has occurred from levels that were
generally deemed much too high, and that a change in the dollar exchange rate is likely to be a
precondition for resolving the problem of the high US current account deficits in the long term.
There has also been some new data on the real economy. As regards the US, the data suggest that
economic growth there last year - once again - may have to be revised up. For example, housing
construction reached record highs in October and November. In addition, consumption growth was
stronger than expected during the same period. One reason for this was that households chose to
save a smaller proportion of their income than expected. A pattern can be discerned here; on several
occasions before we have underestimated US consumer demand, in spite of rather optimistic
forecasts. Thus, there may be reason to revise down the forecast of households' saving ratio in the
coming years, which if so would point to higher consumption growth. The increasingly weak dollar and
stronger euro should also boost US exports, particularly in Europe. In the short term, there is really
only one serious concern in the US economy: that employment growth continues to be weak. This
could create uncertainty among households and contribute to subduing consumption. But it is hard to
believe that it would derail the current upswing.
Also with regard to Europe, we began to see signs of somewhat more robust growth and greater
optimism at the end of last year. In our assessment in December, we forecast a rise in growth in the
years ahead. New data received since December broadly supports this assessment. Business
tendency surveys for manufacturing indicate that optimism has continued to increase while industrial
production has now begun to rise slowly, although for the euro area as a whole the picture is still not
as unambiguous as in the US. The strong performance of the euro could also result in higher imports
and lower exports than expected, which of course would have an impact on demand in the economy
and growth.
To sum up, as I see it there is no reason to change the main features of the assessment we presented
in December regarding international economic activity and price developments. It could perhaps be
argued that the upswing in Europe may be somewhat weaker as a result of the stronger euro, whereas
the opposite may prove to be the case in the US. Therefore, there is neither any strong reasons to
change our view of Swedish export market growth compared with December. In the period ahead, the
rate of growth can still be expected to accelerate in the world economy and in Swedish export
markets.
Developments in equity markets also indicate expectations of a continued strengthening of economic
activity in the period ahead. The rise in equity prices around the world, which began in the spring last
year, has continued. At the same time, long-term international interest rates have fallen recently. It is
difficult to determine how much of this is due to lower optimism about growth in the coming years or if
it perhaps is more indicative of lower expectations of inflation. Looking ahead, there is reason for some
concern regarding developments in long-term interest rates, partly against the background of the weak
US public finances.
Upswing also evident in Sweden, but the picture is not entirely clear
With that, I am now ready to discuss the Swedish economy. Allow me to begin by noting that the
Swedish economic outlook last year changed in approximately the same way as internationally. During
the first half of the year, the economic outlook became increasingly pessimistic. In Sweden, it was
mainly investment that was weaker than expected. The weak economic activity was also reflected in
the Riksbank's forecasts of inflation. This in turn was a contributory factor in the Riksbank's decisions
to cut the repo rate on three occasions for a total of one percentage point. During the latter part of the
year, however, the outlook became somewhat less pessimistic. In Sweden, the weak investment was
countered by favourable growth in consumption, both private and public, and a rise in exports. The
assessment at the end of the year was that growth had increased gradually in 2003 and would reach
1.5 per cent. Growth in 2004 and 2005 was forecast to be approximately 2.5% both years, which on
the whole is somewhat faster than what the Riksbank considers to be possible in the long term without
giving rise to inflation.
New Swedish data support this scenario, but the picture is still not entirely unambiguous. The National
Accounts for the third quarter showed higher growth compared with previous quarters. Household
consumption also rose, as did exports. At the same time, business tendency data are indicating
growing optimism among firms during the latter part of the autumn, while retail sales continue to grow
at a historically high level. But growth in industrial production was relatively weak in October and
November while there was a reduction in the number of new orders. Moreover, new estimates of the
public finances indicate that public consumption this year may be somewhat weaker than assumed in
December. This is mainly due to the financial situation of municipalities. The municipal sector as a
whole is running a deficit, which must be redressed in the years ahead.
One issue that has been debated recently is the effects on the Swedish economy of the weaker dollar.
It is true that the dollar's performance has been weak, but this is not the whole picture. In
tradeweighted terms (TCW), the krona has not strengthened recently. This is mainly because the krona -
quite contrary to what many had expected - rather has weakened slightly against the euro. So for
foreign trade as a whole, the currency developments should not constitute any great problem. Another
issue of course is if the weaker dollar, primarily in relation to the euro, could jeopardise the revival in
the world economy. Neither does this appear likely as long as the adjustment is fairly orderly. As I
mentioned earlier, it is probable that growth in Europe will be slowed down somewhat, but on the other
hand it is likely to be more robust in the US. Moreover, the most recent data for the National Accounts
and foreign trade indicate that we so far rather have been slightly too pessimistic about Swedish
exports.
The most palpable concern is the labour market, where growth has been weaker than expected
particularly towards the end of 2003. Employment was indeed somewhat higher in 2003 as a whole
than we expected at the beginning of the year. But this was primarily because the unexpectedly robust
growth in the public sector countered weak growth in the private sector. We have no reason to expect
any such pattern during 2004. The strained financial situation in the public sector points to weak
employment growth in the public sector, while the economic upswing is likely to be reflected to a rather
small extent in a rise in employment during 2004 in the private sector. Of course there is a risk that the
weak labour market growth will affect households' expectations of the future and propensity to
consume, which is a risk that we highlighted back in December. The higher the rate of unemployment,
the more cautious households are likely to be when it comes to purchasing and consuming. This in
turn could entail a risk of lower growth in 2004.
Nor as regards domestic economic activity is there now reason to make any large revisions compared
with our assessment in December. A number of factors are indicating possibly weaker growth, but at
the same time there are factors that are pointing in the opposite direction. Compared with the picture
we had in December, however, developments in the labour market at the end of the year constitute a
somewhat greater risk to economic activity at least in the coming year. Our growth forecast entails that
resource utilisation is still expected to rise only weakly and thereby remain relatively moderate during
2004 and 2005.
Signs of lower domestic cost pressure
Last year employment growth in the business sector was weaker than expected, while economic
growth was approximately in line with expectations. This means that productivity growth exceeded our
expectations. The most recent National Accounts figures also indicate stronger productivity growth last
year than was assumed in December. It is likely that this has contributed to lower inflationary pressure
during 2003. However, of greater interest for monetary policy is what this says about the future; is
what we're seeing an indication of permanently higher productivity growth? We don't know this yet of
course. There are many problems associated with the data in this area and even if this were not the
case, it would be difficult to determine what had caused the developments we have seen recently. But
this uncertainty is no reason to completely disregard the new information we have received. Just like
the latter part of the 1990s, when productivity was also unexpectedly positive, there is now perhaps
cause for a somewhat more optimistic view of supply conditions in the Swedish economy.
One important, perhaps decisive question is what consequences the weak labour demand and the
strong productivity growth will have for the outcomes of wage negotiations. It is clear that labour
market conditions suggest moderate wage rises. As opposed to the situation in the two most recent
wage bargaining rounds, unemployment has risen recently. There is neither any shortage of labour
other than within very limited areas. It is also positive that the rate of wage increases last year was
decelerating and that this was also the case for expected inflation. With the currently low rate of
inflation, even limited nominal wage increases would imply higher real wages. The demands that have
been put forward are also lower than what has been the case in recent years. At the same time, there
is always the risk of disturbances from the negotiation process itself. Neither is it inconceivable that
some of the productivity gains will be taken to justify a higher wage-payment capacity.
In December, the Riksbank revised down its forecast of unit labour costs somewhat. Behind this was
both a marginally more positive view of productivity growth and a small decline in the rate of wage
increases. The data that has been received since December reinforces this picture. As I see it, there is
probably reason now to further revise down the forecast of unit labour costs somewhat and thereby
also the forecast for domestic inflationary pressure.
Inflation and monetary policy
That brings me to the inflation assessment. In 2003 average inflation was somewhat above target.
However, the situation changed considerably over the year. Inflation rose from just over 2 per cent at
the end of 2002 to just below 3.5 per cent in February, after which it fell back again. One reason that
inflation rose so sharply at the beginning of the year was that electricity prices increased due to
weather-related supply problems in hydroelectric power stations, while oil prices increased at the
prospect of war in Iraq. During the spring energy prices then declined, as did inflation.
However, it was not only developments in energy prices that caused inflation to decline during the
year. The fall in prices was broader and probably due in part to lower resource utilisation and higher
productivity growth. Of even greater importance, however, were falling import prices, which were a
result of both weak international economic activity and the appreciation of the krona.
Our forecast at the end of last year was that inflation would continue to fall over the coming months
due to a return of energy prices to more normal levels. In the late spring 2004, however, inflation was
expected to rise again, partly because the restraining effect of energy prices on inflation would
diminish. The rise was also due to expectations of a slight rebound in import prices. However,
domestic cost pressure was only expected to contribute marginally to the increase. UND1X inflation
excluding energy, which at the time was considered to be the best indication of the more cyclical
inflationary pressure, was forecast to be in line with the inflation target both one and two years ahead.
Thus, the Executive Board decided to leave the repo rate unchanged.
However, the decision we made in December was not clear-cut. Factors supporting an unchanged
repo rate - as I see it - were mainly that new economic data indicated that the upswing was proceeding
as expected, not least internationally, and that this in due time was likely to affect both growth and
inflation in Sweden. What advocated a rate cut was that our forecasts were below target in the short
term. Moreover, a new factor in the balance of risks in December was signs that domestic cost
pressure may be lower than expected; these signs included unexpectedly robust productivity growth,
the fact that underlying inflation adjusted for energy prices had risen less than expected during the
year and the weak growth in the labour market. However, these signs were still fairly new and I
personally found reason to await further information to confirm this picture before I was prepared to
take action. Thus, at the meeting, I stressed the importance of monitoring that economic activity was
strengthening as expected and also monitoring how supply conditions were developing in the period
ahead in order to ascertain whether a repo rate cut in February would be warranted.
As I see it now, the data that has been received since December has largely confirmed the picture of
international and domestic economic activity that was presented in the Inflation Report. We are some
way into a cautious upswing both in the world economy and the Swedish economy. There is possibly a
risk that labour market conditions in Sweden could result in a somewhat weaker economic upswing
than we expected, mainly in the current year. As regards the view of domestic cost pressure, there are
reasons to be somewhat more optimistic. It appears possible that the rate of wage increases could be
slightly lower. At the same time, productivity was unexpectedly positive last year. Inflation in November
and December has also been slightly lower than we expected in our last forecast. One of the risks of
higher inflation that we stressed - that rises in electricity prices would filter through to other areas of
the economy - also appear now to be somewhat lower. This is both because electricity prices have
fallen sharply and that those rent negotiations that have been concluded have not resulted in such
high outcomes as could have been feared. So it is a case of small adjustments to our assessment on
a few points that, on the whole, imply somewhat lower inflation. But as the inflation outlook as early as
December was judged to be fairly benign, even a small revision as I now see it could be significant for
the monetary policy decision we will make at the beginning of February.
By way of conclusion, there is, as always, reason to underline the fact that new data is being received
every day and that any decision on interest rates at the next monetary policy meeting can not be made
now. This must be taken in the light of all the information that is available at the time. For my part, I will
also look forward with great interest to what my colleagues have to say.
Thank you.