Lars Nyberg: The Riksbank's monetary policy strategy
Speech by Mr Lars Nyberg, Deputy Governor of the Sveriges Riksbank, at the Foreign Banker's
Association, Stockholm, 14 September 2006.
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Introduction
Let me begin by thanking you for the invitation. It is a pleasure to be able to come here and talk about
the Riksbank and our monetary policy.
When conducting modern monetary policy, it is important that the principles guiding interest rate
decisions are known to all. Monetary policy largely has an effect through its influence on expectations
of future inflation and interest rates. Therefore, we regularly describe our views on economic
developments in our Inflation Reports and publish the minutes of our monetary policy meetings to
enable everyone to understand the considerations we make. In addition, twice a year the Governor of
the Riksbank holds a public speech for the Riksdag (the Swedish Parliament) Committee on Finance
and responds to questions from members of parliament and journalists. Moreover, we Executive
Board members hold a large number of speeches, in which we discuss various aspects of the Swedish
economy and explain our interest rate decisions. I should say that a continuous debate on monetary
policy and its terms is a necessary condition for the policy to function satisfactorily.
One difficulty with monetary policy is that it does not have an immediate impact. It is therefore
necessary to base monetary policy decisions on forecasts of future inflation and developments in the
real economy. Of course, these forecasts are uncertain and can also be made in different ways. One
of the main purposes of the Inflation Reports is to explain how we make them, so that others can
question us and discuss our methods. I shall return to the forecasts, as we have recently changed our
methods in this area.
During the spring I and my colleagues on the Executive Board described in a number of speeches the
principles that guide our monetary policy. In May we also published a special document where we
described these principles.1 One of the reasons why we considered it important to publish such a
document was that there had been a lively debate on monetary policy for some time with disparate
opinions. For instance, some people considered we should have more than one objective for monetary
policy, in addition to the inflation target. Others claimed that we already had more than one objective,
while some debaters pointed out that more than one objective risked creating confusion.
Although the debate has not been quite so lively since then - which may of course be connected with
the fact that we have had a long, pleasant summer that may have turned people's thoughts to other
matters than monetary policy - I see that monetary policy is still sometimes described in a way that I
do not really recognise. Two questions in particular tend to arise: Do we only take into account
inflation, or do we also care about the real economy, for instance, the employment situation? And what
do we think of the rapid increase in household indebtedness and in property prices?
The aims of monetary policy
To understand the monetary policy decisions, it is of course essential that there is no uncertainty
regarding the objective of monetary policy. There is only one statutory objective for monetary policy
and that is to maintain price stability. We at the Riksbank have then chosen to specify this objective in
terms of an explicit inflation target. This entails an annual change in the consumer price index (CPI) of
2 per cent with a tolerance interval of ± 1 percentage point.
One might ask why we allow a certain measure of inflation when Parliament has given us the task of
maintaining price stability. One reason why we have chosen not to set the inflation target at zero is
that an inflation target that is too low can under certain circumstances create adverse conditions for
employment. There is an inbuilt resistance within the economy to nominal reductions in prices and
wages and a certain measure of inflation can therefore make it easier to implement necessary
changes in relative prices and wages. A consensus has developed among the countries with
economic policy aimed at price stability that a reasonable rate of inflation is around 2 per cent. At the
same time, I would like to point out that there are no scientific grounds for determining exactly how an
inflation target should be formulated.
Of course, it is impossible to have the ambition that inflation should always be close to two per cent in
all situations. The economy is exposed to unexpected shocks and these cannot be immediately
counteracted as monetary policy's impact comes after a time lag. An attempt to bring inflation back on
target too quickly may also lead to unnecessarily large costs for the real economy. Let me explain
what I mean here.
Monetary policy cares about the real economy
If inflation is for some reason above or below the inflation target, it is necessary to decide how quickly
it should be brought back on target. In these situations we have good reason and good opportunity to
take into account developments in the real economy and not merely in prices. If, for instance, an
increase in the price of energy has brought inflation well above two per cent, it would be possible to
use a large interest rate hike to quickly bring inflation back on target. However, this has a price in the
form of slowing down economic growth. If high productivity growth and low import prices were instead
to lead to inflation being well below two per cent, it might be possible to correct the problem quickly by
cutting the interest rate. However, this would risk stimulating the economy in a way that would not
always be desirable. By bringing inflation back on target at a slower rate, the real economy will
develop in a more stable manner. We can thus contribute to stability, although monetary policy cannot
affect the long-term growth rate in the economy.
It is not stated in the law that the Riksbank should take developments in the real economy into account
in addition to the price stability target. On the other hand, it was stated in the preparatory works for the
Sveriges Riksbank Act that the Riksbank, without prejudice to the price stability target, should support
the goals of general economic policy with a view to maintaining a sustainable level of growth and
employment.
Not having the ambition of bringing inflation back on target as quickly as possible thus creates
flexibility in formulating monetary policy that provides scope to take into account developments in the
real economy. At the same time, it is important that this flexibility should not give rise to doubts about
maintaining the inflation target in the long term. This is why we have chosen to specify a time horizon,
which states that monetary policy should normally be aimed at achieving the inflation target within two
years. The two-year horizon should be interpreted as a restriction as to how much consideration can
normally be given to real economic developments. It is a restriction that we have imposed upon
ourselves - like the specified inflation target - to create credibility for the price stability target. Similar
reasoning lies behind the set tolerance interval we have chosen around the target. While the tolerance
interval provides an interval within which inflation can normally be expected to fluctuate as a result of
unexpected shocks and insufficient knowledge of exactly how monetary policy affects the economy, it
provides a limit as to the size of the deviations that can be tolerated.
However, let me point out that there can be certain situations where the shocks to the economy are so
great that there is reason to allow even longer than two years to bring inflation back on target. If our
assessment was that such a situation had arisen, we would make this clear when publishing our
monetary policy decisions. One condition is that we do not find ourselves in a situation where we
would risk undermining confidence in the inflation target or in monetary policy.
These thoughts on how to take into account developments in the real economy are of course not
unique to the Riksbank. Although the guidelines for inflation-targeting monetary policy vary slightly
from one country to another, all central banks with inflation targets conduct monetary policy that to
some extent takes into account the real economy. This is usually termed flexible inflation-targeting. In
other words, we are not "inflation nutters", who want to bring inflation back on target as quickly as
possible, whatever the cost.
The importance of inflation forecasts for interest rate decisions
Let me move on to talk about the assumption for the repo rate that we use when making forecasts in
our Inflation Report.
The forecasts in the main scenario in the Riksbank's Inflation Report have been based over the years
on the assumption that the repo rate is held unchanged during the forecast period. This assumption
had the advantage of providing a very simple and clear policy rule for monetary policy: If the forecast
for inflation at the end of the forecast period was below two per cent, the repo rate would normally be
cut, and if it was above two per cent the interest rate would be raised. If the forecast was very close to
two per cent the repo rate would remain unchanged. Of course, this rule could not capture all of the
nuances in the monetary policy discussion, but it provided a rough explanation of the monetary policy
decisions.
However, there were several disadvantages with the assumption of a constant repo rate. In situations
where the market expected clearly rising or falling interest rates, it was difficult to compare our
forecasts based on the assumption of a constant repo rate with those made by other forecasters. One
reason was that the assumption of a constant repo rate often resulted in our forecasts for inflation
differing from those of other forecasters; being higher when inflation was rising and lower when
inflation was declining. This caused confusion in the discussions on monetary policy.
Since October last year, our forecasts are instead based on the technical assumption that the repo
rate will develop in line with market expectations regarding the future repo rate, as expressed in the
implied forward rates. This has made it easier to compare ourselves with other inflation forecasters
and also to assess our monetary policy.2
The new interest rate assumption we now apply means that we can no longer use our old policy rule. If
the forecast with a constant repo rate was close to two per cent, the repo rate would be held
unchanged according to the old policy rule. If the forecast according to the new outlook shows inflation
close to two per cent, the repo rate will normally develop in the way reflected by market expectations.
This could mean that the repo rate, given the underlying inflation forecast, should be raised or lowered
in a number of stages over the coming two-year period.
The new outlook thus means that the monetary policy discussion is based on an interest rate path
throughout the entire forecast period, while the old policy rule only took into account what should be
done at the time the decision was made. I have seen several examples where the old policy rule is
used in discussions concerning the new interest rate path. This is fatal, as it can lead to entirely wrong
expectations of monetary policy. The old policy rule is dead and the market now needs to bury it.
Even with the new outlook we care about developments in the real economy when making monetary
policy decision. If, for instance, the forecast inflation rate were to be close to target two years ahead,
but showed a rapid acceleration at the same time as growth in the real economy was high, it is
possible that the implied forward rate path could not be expected to reflect a desirable development in
the repo rate. In this type of situation it is possible that the repo rate would need to be raised more
quickly at the beginning of the forecast period. When we make our decisions regarding the repo rate,
we thus do not merely look to see whether inflation is close to target two years ahead, we take into
account the entire development paths for inflation and the real economy. A desirable monetary policy
is characterised by inflation under normal circumstances being close to the inflation target in a
twoyear time perspective while at the same time the paths for inflation and the real economy do not
exhibit excessively large fluctuations.
For the record, I would like to point out here that the forecast assumption that the repo rate will follow
implied forward rates does not of course entail any commitment from the Riksbank that this will be the
case. We have no unique information about the future. We cannot in advance commit monetary policy
to a particular sequence of future interest rate changes, as future economic developments are
uncertain. The stand we take regarding the development of the repo rate at our monetary policy
meetings is based on the information available at the time the decision is made. Our considerations
can and should change if the economy develops in a manner different to that we had expected.
Managing risks in monetary policy decisions
As monetary policy must be based on uncertain forecasts of the future, there is a need to manage the
risk that the economy will develop in a way different to what was expected by the central bank. The
former Federal Reserve Governor Alan Greenspan called this the risk management approach to
policy. Given this way of thinking, our Inflation Reports contain a special section where we discuss
alternative scenarios for inflation and the real economy and the probability that these will materialise. It
is the forecast of inflation and the real economy taking into account the risks of alternative scenarios
that forms the basis of our monetary policy decisions.
Of course, it is not appropriate for a risk analysis to take into account all imaginable risks; not even all
those that would have dramatic consequences if they were to materialise. For instance, it is not
reasonable, in my opinion, to allow monetary policy decisions to be governed by the risk of global
imbalances, as we are unable to affect this development through our own monetary policy.3 On the
other hand, I consider that it is important to always take into account risks that arise from the monetary
policy conducted, even if it is sometimes difficult to quantify these risks and calculate their
consequences.
One problem faced by many central banks with inflation targets, and which relates to this, is the risk of
unfavourable developments in property prices and household indebtedness as a result of a long
period of expansionary monetary policy. Sweden is no exception here.
Both cyclical and structural factors justify the growth rate in household debts and property prices being
high over a period of time in Sweden and there is thus reason to take this into account in the normal
analysis and forecasting work. Rising house prices lead to wealth effects that influence decisions
regarding consumption and saving. Developments in debt affect the impact of interest rate changes on
consumption. This does not necessarily entail any dramatic consequences. However, when the rates
of increase remain at a high level for a long period of time, there is an increased risk of imbalances in
the build up of debt and in house prices. This could in a worst case scenario lead to large fluctuations
in both inflation and the real economy further ahead. The question is how to manage the risk of this
type of imbalance occurring.
One way of managing this and similar risks is to make a change in the repo rate sooner or later than
would otherwise be assessed as the most appropriate timing, given the forecasts for inflation and the
real economy. Let me illustrate this with a brief summary of our reasoning in connection with the
monetary policy decision made in February this year.
We then raised the repo rate, despite the fact that the inflation forecast in itself could have warranted
waiting some time before implementing an increase. Our assessment was that there were other
circumstances that indicated the repo rate should be increased in February, but that it could thereafter
be raised at a slightly slower rate. The very expansionary monetary policy conducted in recent years,
together with the weaker krona, has stimulated the economy considerably. It has contributed to our
now being in a situation where household indebtedness and house prices have increased at a more
rapid rate than can be regarded as sustainable in the long term. Our assessment at the monetary
policy meeting in February was that a slightly earlier increase in the repo rate would reduce the risk of
an abrupt adjustment in house prices and household indebtedness further ahead, which might have
adverse consequences for both inflation and the real economy. One could say that, bearing this risk in
mind, we discussed the appropriate timing of an interest rate increase that we anyway considered
necessary with regard to the inflation target.
I and my colleagues on the Executive Board of the Riksbank have pointed out in several different
speeches that this procedure does not mean that we have introduced other objectives for monetary
policy in addition to the price stability target and the aim to contribute to subduing fluctuations in the
real economy. We expressed this quite clearly in the special document on monetary policy strategy we
published prior to the summer. It therefore surprises me when I still see monetary policy described in
some contests in a way that implies that we have other objectives besides price stability when making
decisions on the repo rate.
I would also like to emphasise that our management of the risk of an adverse development in house
prices and household indebtedness does not in any way mean that we consider that these aspects
have greater relevance for what is regarded as desirable monetary policy than, for instance, the
situation in the labour market. From time to time situations will arise where we will need to take into
account, in a different way than the usual, the risks of adverse economic developments that are
difficult to quantify. Recently this has been house prices and household indebtedness, but in the future
it could be other variables. This is an important dimension of the flexibility in our inflation-targeting
policy.
The current situation
Let me conclude with a few comments on our most recent monetary policy decision. A more detailed
account is provided in the separate minutes of the monetary policy meeting, which were published the
day before yesterday.
We chose at our monetary policy meeting on 29 August to raise the repo rate by 0.25 percentage
points. Now that we have chosen to conduct less expansionary monetary policy, this is because we
have made the assessment that it is necessary to avoid inflation being above target a couple of years
ahead, while at the same time it contributes to a balanced development in the real economy. The
increase in the repo rate is in line with the repo rate path expected by the market and which was used
as a basis for the inflation forecast.
On the one hand, the high GDP growth indicates that inflation could rise more quickly in future than we
assumed in June. But on the other hand, productivity has been slightly stronger than expected, which
has contributed to holding back cost developments and the rate of increase in unit labour costs. This
has a dampening effect on inflation.
However, there are indications that the labour market is beginning to strengthen, which should
contribute to rising cost pressures. Our overall assessment was that inflation will increase and will be
in line with the target a couple of years ahead, given that the repo rate is increased approximately in
line with market expectations.
Our assessment at the monetary policy meeting was that the upside risks and downside risks were
roughly equal. Among the upside risks we mentioned were higher energy, oil and electricity prices,
with a risk of contagion effects and a higher rate of wage increase following on from good growth in
the economy. The downside risks included the continued strong domestic productivity growth and
international price pressures. With regard to household indebtedness and house prices, we expect
that the growth rates will slow down, but we have not yet seen any certain signs of this.
The picture painted earlier in the year still remains largely unchanged. Our assessment throughout the
year has been that the outlook for inflation and the economy over the coming years indicates that it is
reasonable to assume the repo rate will need to be gradually increased. In accordance with this view,
we have raised the repo rate four times so far this year and my assessment is that the repo rate will
need to be raised further in future. However, as I mentioned earlier, we both can and should change
our assessment if the economy develops in a manner we had not expected.
Thank you!