Stefan Ingves: The economic situation in Sweden
Speech by Mr Stefan Ingves, Governor of the Sveriges Riksbank, at a meeting arranged by
Handelsbanken, Malmö, 12 October 2006.
* * *
Introduction
Thank you for the invitation to come here and speak in Malmö! It gives me great pleasure to visit
different parts of the country and explain what we do at the Riksbank. Today I intend to begin with a
few words on the current situation in the Swedish economy and on inflation prospects. The Riksbank
will provide a more in-depth analysis when the next Inflation Report is published, two weeks from now.
I also intend to describe in more general terms how we conduct our monetary policy, that is, the
Riksbank's monetary policy strategy. In connection with this I shall take the opportunity to discuss the
role of asset prices in the analyses. It has sometimes been claimed in the general debate that the
Riksbank puts too much focus on asset prices and too little on inflationary pressures from the labour
market, and I would like to refute this claim. I shall then briefly discuss financial stability, an area in
which I have been active for many years, both at the Riksbank and during my time at the IMF in
Washington. My hope is that you will today gain an idea of now we think and work to attain our
statutory objective, maintaining price stability in Sweden. Let me begin with my views on the current
economic situation.
The current situation in the Swedish economy
In the June Inflation Report we envisaged continuing good international economic activity. We
assessed that growth would remain high in Asia, which has developed strongly in recent years. The
strong growth in China is one explanation for the upswing in Asia. The expansion in China has
contributed, for instance, to the recovery we now see in Japan. At the same time, the US economy has
remained an important driving force behind the world economy as a result of its size. In the euro area,
however, developments have been weaker, but we saw clear signs of an improvement in the forecast
we published in June.
At the same time as growth in demand in the world economy has been strong, price pressures have
been held back. Although oil and other commodities have become significantly more expensive for
consumers, the general price increases have been relatively small on the whole. One explanation for
this is probably the stiffer international competition. Another is that monetary policy in many countries
is now aimed at low inflation. The strong global economic activity has been beneficial for
developments in Sweden. The Swedish economy has shown high growth rates in recent years.
Despite this, inflation has also been low here in Sweden. This is mainly because import prices
excluding oil have not risen and strong productivity growth has held down cost pressures.
New data received since June shows that the international economic prospects still appear favourable.
However, the signals from the US economy are slightly mixed. In particular, the cooling in the housing
market points towards weaker growth than expected next year. The picture of the euro area and other
parts of the world is that developments have rather been slightly stronger than we assessed in June.
Back in June, we envisaged fairly high growth in Sweden over the coming years. The statistics
received since then confirm that the economy is growing at a good rate. Household consumption and
housing investment have grown more rapidly than expected. However, both the number of persons
employed and the number of hours worked have been lower than expected. This reflects the fact that
productivity growth has been surprisingly high again. Companies have thus been able to increase
production without needing to take on so many new employees. Most indications are nevertheless that
the labour market will continue to improve. Generally high lending and the fact that household
indebtedness and house prices are continuing to rise rapidly support the picture of strong demand.
Rapid increases in energy prices have contributed to inflation being higher than the Riksbank's
forecast over the summer. However, the oil price has fallen during the autumn, although it is as usual
difficult to know whether this trend will continue. The oil price, like other energy prices, has a tendency
to fluctuate considerably. There has been a recent downward adjustment in expectations of future
energy prices.
The strong productivity growth will contribute to unit labour costs being low this year. When
employment increases it is reasonable to assume that cost pressures will also rise. Our assessment is
that energy prices will not push up inflation in future, but that rising unit labour costs will contribute
increasingly to inflation.
Our assessment throughout the year has been that the outlook for inflation and the economy indicates
that it is reasonable to assume the repo rate will need to be gradually increased. This will ensure that
inflation is close to the target and that developments in the real economy are balanced. Given this, we
chose to raise the repo rate by 0.25 percentage points at our monetary policy meeting in August. We
have thus raised the repo rate four times so far this year and my assessment is that it is reasonable to
assume that further increases will be necessary. However, it is a couple of weeks until my Executive
Board colleagues and I meet to discuss the monetary policy stance. In connection with this meeting
we will publish a new Inflation Report containing new forecasts for inflation and growth over the
coming years.
Let me now move on to the more general discussion on how we conduct our monetary policy. In May
we published a new document on our monetary policy strategy entitled "Monetary policy in Sweden",
which described the Riksbank's objective and strategy. So what does this document contain, and why
did we decide to publish it? I intend to discuss these questions now.
The inflation target and consideration of the real economy
Since the inflation target was formulated in 1993, the reasoning regarding the monetary policy strategy
has gradually developed. It has been affected by both practical experiences in Sweden and other
countries and new research results from the academic community. The primary reason for our new
monetary policy strategy document is to increase understanding of the inflation target and of how we
decide the monetary policy stance required to attain this target, while giving consideration to
developments in the economy as a whole.
How have we then chosen to conduct monetary policy to meet our commitments in the best possible
way? The Riksbank has the statutory objective of maintaining a low and stable inflation rate, or of
maintaining price stability as it is expressed in the Sveriges Riksbank Act. We have specified this task
as ensuring that CPI inflation is around 2 per cent a year, with a tolerated deviation interval of +/1 one
percentage point. As long as confidence in the inflation target is not threatened, the Riksbank also has
the possibility to take into account developments in the real economy, such as production and
employment.
Although the latter has not been written into the Act, it was stated in the preliminary work to the new
Sveriges Riksbank Act that came into force in 1999 that it was natural that the Riksbank should
support the economic policy objectives of sustainable growth and high employment without neglecting
the long-term price stability objective. This was considered a natural consequence of the Riksbank
being an authority under the Riksdag (the Swedish parliament). It was therefore considered
unnecessary to specify any further objective than price stability in the law text. It would moreover be
difficult to combine such objectives with the EU regulations and also inappropriate given that monetary
policy cannot govern long-term developments in production and employment.
Monetary policy affects the economy with a certain time lag. This means that the Riksbank cannot
control inflation in the very short term and that monetary policy decisions must be based on forecasts
of future inflation. Monetary policy is normally aimed at achieving the inflation target within two years to
avoid the deviations from target from being too large and too protracted. The two-year horizon can be
regarded as a restriction the Riksbank has taken upon itself to give credibility to the inflation target. At
the same time, it provides an opportunity to show consideration for the real economy. If, for instance,
there is a shock that leads to inflation being pushed upwards despite weak demand, a very rapid
return to the inflation target could lead to a more severe slowdown in the already weak demand, than
would be the case if the recovery was allowed to occur at a slower pace. If inflation is instead held
back despite good growth in demand, attempts to quickly return it to target through very expansionary
monetary policy could lead to the economy overheating. Over time a policy that quickly subdues
inflationary impulses would probably result in more stable inflation, but there would be a risk of
substantial fluctuations in the real economy.
We have chosen a two-year horizon for monetary policy because this is considered to give sufficient
scope in most cases to ensure a good and stable development of the real economy. However, the rate
at which it is desirable to bring inflation back on target in an individual case depends on what shocks
the economy has suffered and how substantial they are. Sometimes the deviations from target can be
so large that there is reason to allow inflation to return to target beyond the normal two-year horizon. In
these cases, we shall explain this in connection with our decisions. Back when the new Sveriges
Riksbank Act came into force in 1999 and a new Executive Board entered office, the Riksbank
published a clarification of monetary policy, where it was pointed out that the horizon might need to be
longer when the economy was subjected to large shocks1. The new element is that we are clearer on
the point that the choice of time horizon concerns a desire to alleviate the consequences for the real
economy.
Another new element since last year is that we make forecasts under the assumption that the repo
rate will develop in line with market expectations, as these are reflected in implied forward rates.
Previously, forecasts were instead based on the assumption that the repo rate would remain
unchanged during the forecast period. What consequences does this change have? Monetary policy
could previously be described with a simple policy rule. If the forecast for inflation was below two per
cent, the repo rate would normally be cut, and 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.
Now we no longer use this simple policy rule. According to our new way of thinking, if the inflation
forecast is close to two per cent, the repo rate should normally develop in line with market
expectations. This could mean that the repo rate should be raised or lowered in a number of stages
over the coming two-year period.
The new way of thinking thus means that, unlike before, the monetary policy discussion is now based
on an interest rate path that stretches across the entire forecast period. This method of working
enables clearer communication regarding future policy. Although it cannot, of course, be regarded as a
commitment from the Riksbank that the repo rate actually will follow a particular path. Each time we
make a decision, we take a stance on the repo rate path, on the basis of the information available at
the time. Our considerations can and should be altered if the economy develops in a different direction
than we had expected.
Essentially, this is the same monetary policy strategy as before. The goal for monetary policy still
concerns inflation and the ambition remains the same; that is, a desire to ensure that inflation is low
and stable a few years ahead, while giving some consideration to the stability of the real economy.
This is characteristic of what is known as flexible inflation targeting, which as far as I know, is
conducted by all central banks that have inflation targets.
In this context I would like to take up a current issue that has recently featured in the monetary policy
debate. It has been claimed that the Riksbank places too much focus on asset prices and too little
focus on inflationary pressures from the labour market.
My response is that the basis for the monetary policy decisions includes analyses of demand and
production, as well as the labour market and inflation. It is necessary to analyse asset prices and
credit volumes as these affect and are affected by economic activity and inflation. Wage formation also
plays a central role in the development of inflation. Over the past ten to fifteen years, fiscal and
monetary policy has provided the foundation for good economic growth and wage formation has
adjusted to this and functioned well. The social partners have actively contributed to this development
and the results of the reforms have been good: Growth has been high and real wages have risen,
despite the moderate increases in nominal wages.
It is of course extremely important that this positive development can continue over the coming years.
Almost the entire economy is covered by a central wage agreement period that comes to an end in
mid-2007. The wage bargaining rounds in 2007 will be very widespread. The economic conditions
prior to the coming bargaining rounds are good and there is reason to believe that wage formation will
be able to function efficiently. However, we will of course follow the bargaining rounds very closely, as
we always do. I would like to emphasise that the social partners can sign agreements based on the
Riksbank's inflation target standing firm. Judging from the surveys we make of inflation expectations,
monetary policy in this respect has a very high level of credibility.
It is fairly clear that the labour market is facing many challenges and changes. This has been seen in
particular from the fact that developments in the labour market have long been weak, despite several
years of good growth and historically low interest rates. The poor growth in employment thus does not
appear to be primarily the result of weak demand. The explanation must instead be sought among
more long-term structural factors. This is reflected in particular in the fact that employment has not
recovered since the heavy fall in connection with the crisis at the beginning of the 1990s, despite
historically high economic growth.
Another sign that the unemployment problems have a structural nature is that there are large
differences between regions and between professions. Although monetary policy is common for the
Swedish economy as a whole, unemployment figures are twice as high in certain regions of the
country as in others, and certain professional groups have twice as many people collecting
unemployment benefit as others, and these differences appear to persist over a long period of time.
This indicates that the problems are partly related to a low level of mobility in the labour market. The
long-term solution to problems of this nature lies outside of the field of monetary policy.
Let me now explain in a little more detail why it is so important for us to also follow asset prices, such
as house price developments and household indebtedness. It is important both in view of the
Riksbank's task to promote financial stability and of the monetary policy objective to maintain price
stability.
Aspects of household indebtedness and house price developments
In addition to maintaining price stability, the Riksbank is responsible for promoting a safe and efficient
payment system. This requires, for instance, a safe and efficient banking system. The banks' activities
are closely interwoven with the rest of the financial sector. The responsibility of the central bank for the
payment system is therefore often expressed as a task to maintain financial stability.
The repo rate is not an efficient instrument for counteracting problems in the payment system. If such
problems threaten to arise, it is entirely different types of measures that need to be taken. The
monetary policy stance takes into consideration the outlook for inflation and the real economy, but
does not consider financial stability.
So if the repo rate is not a good tool for financial stability, how can we protect ourselves against
financial crises? In my experience, much can be achieved if the authorities and the financial
participants together draw up effective preventive measures and plans for good crisis management.
One clear and positive conclusion from the crises in the past twenty years is that good crisis
management can save large amounts of money and reduce disruptions to society. On the other hand,
it has been demonstrated that bad crisis management aggravates crises, partly by spreading
uncertainty among the general public and the financial market agents. This may sound abstract, but in
practice entails creating good laws, regulations and supervision.
Sometimes, acute banking problems may nevertheless arise and may mean it is necessary to close
down a bank. When a bank needs to be closed, a difficult balance arises, between the owners'
interests and the savers' interest, which are both safeguarded in law. One very current example of this
dilemma in Sweden is the case of Custodia. Both the county administrative court and
Finansinspektionen (the Swedish financial supervisory authority) have made their assessments on the
basis of what they should take into account, that is to say the company and owners' interests and the
customers' interests respectively. However, I feel that this episode indicates that it is very
unsatisfactory that we in Sweden do not have a clear legal framework that can manage this type of
situation and I assume that these difficulties will quickly be repaired.
Let me emphasise at the same time that we do not envisage any problems regarding financial stability
right now. The fact that we have highlighted developments in house prices and household
indebtedness has nothing to do with financial stability. It is because we are concerned about future
inflation and growth. Developments in asset prices can in certain situations be a sign of risks to
inflation and the real economy that need to be taken into account.
One problem is that it may be difficult in the forecasting and analysis work to know how to interpret
major fluctuations in house prices and prices of other assets. One reason for this is that the models
used to make forecasts do not have sufficiently sophisticated descriptions of the financial sector and
its interplay with the real economy. The problems are particularly great when house prices and credit
growth have over a long period developed in a manner that is not sustainable in the long term. Given
the analysis and forecasting tools we use today, it is difficult to say whether a sudden correction in
house prices will occur, or whether we can count on a calmer and more prolonged adjustment.
At the same time, the Riksbank must take into account the risks when conducting its monetary policy.
If house prices and household indebtedness increase rapidly over a long period of time, there is a risk
of imbalances building up. These imbalances may force an adjustment further ahead and in the worst
case may have severe consequences for the real economy and inflation. If house prices rebound, this
could lead to subdued demand further ahead through both a decline in household consumption and
reduced investment in construction. This type of development could in the longer term lead to both
inflation being below target and to weaker growth in the economy.
It is difficult to manage this type of risk. One possibility is to make changes in the interest rate slightly
sooner or later than would otherwise be justified on the sole basis of the forecasts for inflation and the
real economy. It is hoped that such a policy will contribute to a smoother adjustment process and help
to avoid a more abrupt correction. A two-year horizon is a good decision rule, but it cannot always
work in all situations.
There are now signs of some slowdown in the housing market. For the first time in two years the
median price for houses has fallen, according to Swedbank's Boindex. Moreover, the rate of increase
in household borrowing from mortgage institutions is now slightly lower than it was in the spring. Of
course, it is impossible to draw any far-reaching conclusions solely on the basis of these observations.
However, we will make a thorough assessment of the situation later in the autumn when we publish
our twice-yearly Financial Stability Report.
Summary and conclusion
Let me briefly summarise my message today.
•
We have raised the repo rate four times this year and my assessment is that it is reasonable
to assume that further increases will be necessary. This will ensure that inflation is close to
the target and that developments in the real economy are balanced.
•
Our focus is on the inflation target and the central aim is, as before, to anchor inflation
expectations in the economy around this target. When we formulate our monetary policy we
also give consideration to the way the rest of the economy is developing. You can read more
about this in our recently published strategy document "Monetary policy in Sweden", which
can be ordered from our Communications Secretariat. It can also be downloaded from our
website and is available in both Swedish and English.
•
The social partners can sign new agreements based on the assumption that the Riksbank's
inflation target stands firm. Judging from the surveys we make of inflation expectations,
monetary policy in this respect has a very high level of credibility.
•
The Riksbank also has the task of safeguarding financial stability. We see no problems with
regard to financial stability at present. The fact that we emphasise developments in house
prices and indebtedness does not concern financial stability. It is because we are concerned
over how future inflation and growth might be affected by a possible sudden correction in
house prices.
Finally, I would like to stress that the monetary policy framework has functioned well. This is indicated
in particular by the fact that inflation expectations are firmly anchored around two per cent. There are
no signs in the financial markets that monetary policy is regarded as unclear. However, this does not
mean we can rest on our laurels. We have one of the most open and transparent central banks in the
world and we wish this to continue. The Riksbank's forecasts assume, as I mentioned earlier, that the
repo rate will develop in line with market expectations. I have raised the question of possibly going one
stage further and instead reporting the Riksbank's own forecast of interest rate developments, as they
do in, for instance, Norway and New Zealand. Personally, I see it as quite natural that we should make
forecasts of repo rate developments in the same way that we forecast a number of other variables.
This type of methodology would require changes in the way the forecasts are produced as well as the
Executive Board's internal work. We are discussing this at present. The Riksbank is constantly
working on improving our analysis methods and our methods of communicating our decisions. It will
therefore be particularly exciting and interesting to see the assessment of monetary policy, which two
external experts have made and which will be ready soon. It will no doubt contribute to a serious
discussion of monetary policy and how the framework for the policy can be further developed in a
small open economy like Sweden. I look forward to these discussions.
Thank you!