SPEECH
SVERIGES RIKSBANK
DATE:
04/12/2018
SE-103 37 Stockholm
SPEAKER: (Brunkebergstorg 11)
Deputy Governor Per Jansson
VENUE:
Insurance Sweden, Stockholm
Tel +46 8 787 00 00
Fax +46 8 21 05 31
registratorn@riksbank.se
www.riksbank.se
Monetary policy in less favourable
times - what are the options?∗
To say the past decade has been transformative for monetary policy is scarcely an
exaggeration. Many central banks have cut their policy rates to exceptionally low
levels and found other ways of conducting monetary policy than adjusting interest
rates. In some countries, including Sweden, the policy rate has also passed the
zero bound that was considered to be the absolute minimum level not very long
ago, and has entered negative territory. Despite this policy, the recovery has on
the whole been slow and, above all, inflation has been low for a long time. This
has led to the policy rate in many countries remaining at record low levels for
several years.
The need to keep policy rates so low is not only due to the financial crisis 2007-
2008 and the ensuing euro crisis requiring very expansionary monetary policy. An
equally important explanation is that real interest rate levels around the world
have trended down for several decades, largely independent of the financial crisis.
Real interest rates are currently at record low levels (see Figure 1).
The downturn in the real interest rate is a sign of the global, so-called "neutral",
rate of interest having fallen. The neutral interest rate normally refers to the real
rate of interest that has neither an expansionary nor a contractionary effect on
the economy.1 Central banks cannot influence the neutral interest rate but they
must consider it when they adjust their policy rates. It is the relationship to the
neutral interest rate that determines how expansionary or contractionary a
particular monetary policy is. By causing the short-term real interest rate to temporarily
deviate from the neutral interest rate, the central bank can affect resource
utilisation and inflation via different channels.
One important problem with the neutral interest rate currently being so low is
that monetary policy has less scope to stimulate the economy when necessary, as
it is difficult to cut the policy rate as much as would be required. Moreover,
estimates of the neutral interest rate and its driving forces usually indicate that it will
remain low for a fairly long time to come.2 This raises difficult questions both in
the shorter and slightly longer perspective.
In the slightly longer perspective, the question has arisen internationally, mainly
in research circles but also to some extent among central banks, whether the
current inflation-targeting policy could be reformed or replaced with another
monetary policy framework that makes it easier to counteract economic downturns and
recessions in the future.3 The aim is to find a framework that reduces the risk of
not being able to make monetary policy as expansionary as may sometimes be
necessary.
But reforming the monetary policy framework is not something that can or should
be done hastily. The experiences of inflation targeting in recent decades are very
favourable and it is never a good idea to "throw the baby out with the
bathwater". There is therefore reason to also consider a shorter perspective, where
one assumes that the monetary policy framework will not change for some time
yet. Within the scope of the current framework, and given the monetary policy
situation that arose after the crisis, there is every reason to begin examining what
opportunities exist to deal with the next economic downturn - whenever this may
occur.
So I intend to talk about these two subjects today - the conditions for dealing
with the next economic downturn if we do not reform the monetary policy
framework and the possible changes to the framework being discussed internationally
and how promising I assess these to be. Let me begin with the first subject.
The conditions for dealing with the next
economic downturn
The picture painted by Swedish analysts at present is that a regular economic
downturn is not imminent (see Figure 2). But there is nevertheless much that
suggest that it is wise to prepare for less favourable times arriving sooner than we
expect; the recent somewhat shaky signals regarding economic activity in Europe,
the uncertainty regarding the effects of trade conflicts and Brexit, tension in the
euro area and the large indebtedness and other imbalances in emerging market
economies. But despite these words of warning, the most reasonable starting
point is of course that developments in the coming years will be largely as the
leading forecasters believe.
The repo rate will be somewhat higher
Given this, we can expect the repo rate to have been raised at least somewhat
before the less favourable times arrive. Most Swedish forecasters, including the
Riksbank, are expecting the repo rate to be 0.5-0.75 per cent at the end of 2020. Until
then, almost all analysts believe that growth will slow down, but not to the extent
that the Swedish economy will enter a regular economic downturn before 2021.
There are of course no guarantees, but this is how things look at the moment.
Neither is it possible for anyone to say how soon after 2021 a downturn may
occur. It could come soon after, or some years later.4
Now 0.5-0.75 per cent is not a particularly high level for the repo rate, if one
looks at it from an historical point of view. But on the other hand, history may not
be as informative in this case as there has been a downward trend in global real
interest rates in recent decades, as I just pointed out. It is therefore difficult to
know what is currently a neutral, "normal" level for the repo rate. What one can
say with some certainty is that it is much lower than it was 10-15 years ago. But
even taking this into account, a repo rate of 0.5-0.75 per cent does not appear
particularly high if an economic downturn were to occur in early 2021.
How much is the interest rate usually cut in economic downturns? In Sweden, it is
not so easy to have a clear idea of this as we have had a floating exchange rate
and an inflation target for just over 25 years, and that is not long enough to have
experienced so many economic cycles. It is only when the exchange rate floats
that one can use the policy rate to counteract economic downturns - when the
exchange rate is fixed the policy rate is in principle locked on defending the
chosen exchange rate. A couple of the rate-cutting phases we have had during this
period have also been a little unusual. What happened in 1996 in particular, when
the repo rate was cut from almost 9 to just over 4 per cent, was largely a question
of confidence in the inflation target become established and enabling a
substantial cut in the policy rate. The substantial rate cut in connection with the global
financial crisis, from 4.75 to 0.25 per cent within the course of a year, was also
special, as crises of this kind are fortunately rare (see Figure 3).
In the United States, which has a longer history of a floating exchange rate, it is
usually estimated that the policy rate is cut by around 5 percentage points in
economic downturns.5
It is reasonable to assume that in Sweden, which is a small
open economy, a larger share of the adjustment in an economic downturn will
come through the exchange rate than is the case in the United States. Let us say,
without claiming any scientific exactness, that it would be desirable to cut the
repo rate by 2.5-3 percentage points in a normal economic downturn. If the
downturn were to occur at the beginning of 2021 and the policy rate were cut
from 0.75 to -0.5 per cent, the cut would be 1.25 percentage points, that is much
less than the estimated 2.5-3 percentage points.6
Raising the repo rate to have ammunition ready?
Here I should like to briefly touch on a particular question before I go on. If one is
concerned that the repo rate will not be sufficiently high when the next economic
downturn comes, can one not just raise it to a suitable level now, as a preventive
measure - so that there is ammunition available when needed? This is an
argument sometimes put forward in the general debate. But unfortunately there are a
number of problems with this argument.
Firstly, the economy will of course be affected by interest rate increases. Growth
would slow down and inflation would fall. If one raises the rate quickly and
substantially, one might even cause the economic downturn one was ultimately
aiming to prevent. But even if this was not the case then, secondly, a very probable
scenario would be that inflation nevertheless fell substantially, perhaps down to 1
per cent or lower, that is, to the level it was at some years ago. This could in turn
mean that the credibility of the inflation target was questioned once again and
economic agents would begin to expect that inflation on average would be 1 per
cent rather than 2 per cent. The effect would then be in practice the same as if
the target had been lowered to 1 per cent. With a lower expected rate of inflation
the nominal interest rates in the economy, including the repo rate, will on average
be lower. This means that in future economic downturns the distance between
the repo rate and the lower bound may be smaller than before.
If the repo rate hits its lower bound earlier, and remains there for longer periods,
it will be a less effective tool in counteracting economic downturns. It will be even
more difficult than it is now to bring down the real interest rate as low as one
might need. The essence of this is that "preventive" increases in the repo rate
would ultimately not result in more ammunition, but less. It is therefore important
that increases in the repo rate are not made in such a way that inflation will be
tangibly lower and confidence in the inflation target is put at risk.
Cut the repo rate further?
Another possible means of counteracting an economic slowdown is to cut the
interest rate more than to the -0.5 per cent level which has so far been the lowest
point. It may be possible to go even lower - for instance, the policy rate in
Switzerland is at -0.75 per cent. But personally I think the possibilities here are fairly
limited.
It may not be so much a question of purely economic aspects, but rather what is
feasible according to social conventions and possible to create understanding for.
During the period we have had a negative repo rate, individuals have not faced
negative interest rates and thus not needed to pay for having money in the bank.
But if the repo rate becomes sufficiently negative, this may happen. On a
theoretical level, one can argue that the policy would then be more powerful and have a
greater effect on the economy - that the so-called monetary policy transmission
mechanism would function better. But this also risks leading to various types of
problem. As I see it, the biggest problem is not the economic arguments usually
raised, such as the general public wanting to empty their bank accounts and hold
cash instead. Holding savings in cash is, when it comes down to it, troublesome
and costly and given that most people in Sweden are getting used to living
without cash it would not be a natural thing to do. The threshold would probably be
relatively high here.
The main problem, as I see it, is another one. A couple of years ago I held a speech
in which I explained why it is not necessarily more unnatural to have a negative
nominal interest rate than a negative real interest rate, that is, the interest rate
discounting inflation.7 Unlike a negative nominal interest rate, a negative real
interest rate has arisen every now and then. The reason why one might think there
is not such a big difference is that it is usually our purchasing power that concerns
us. If one lends money, one will be able to consume less than before, both in the
case of a negative real interest rate and a negative nominal interest rate. In the
case of a negative real interest rate, this is because inflation is higher than the
interest one receives, and one is therefore unable to buy as much for the sum of
money one receives from the borrower. When the nominal interest rate is
negative, one can say that the negative return is written into the contract from the
start. But seen in terms of purchasing power, a negative nominal interest rate is
not very different from a negative real interest rate.
Since I held that speech we have had a negative repo rate for a further two years.
My experience is that communication about the negative interest rate has not
become easier, which I thought would be the case. Although a negative nominal
interest rate is not more unnatural in economic terms than a negative real interest
rate, it is evident that the former, unlike the latter, is perceived as going against
social and economic conventions. I therefore strongly suspect that it would be
difficult to foster understanding for a policy that means that individuals have to "pay
to save". This is perhaps a limitation that one must simply accept. Ultimately, the
legitimacy of, and confidence in, an independent institution like the Riksbank is
based on the general public understanding the policy conducted, or at least not
considering it to be illogical and unjust.
This does not mean that I am saying we should refrain from using the scope that
there seems to be for holding the repo rate at a negative level in situations where
this is necessary to avoid major costs for the economy. But there are limits as to
how far the rate can be cut. And, as I said, my view is that it would be difficult to
cut the rate so low that people were forced to pay to have money in the bank.
Do expectations affect the future repo rate?
If one has cut the repo rate as far as one considers possible, one can also try to
affect expectations of the future repo rate among economic agents in a way that
stimulates demand. What I have in mind here is a strategy that is usually termed
"lower-for-longer" or "makeup strategy" and which has been advocated by the
previous chairman of the Federal Reserve (the US central bank) Janet Yellen.8
The idea is pretty straightforward. Let us assume that the central bank in a
recession has cut its policy rate as far as it considers to be possible. Exactly how low the
interest rate can be set is not obvious and the assessments vary from country to
country. The Federal Reserve usually regards zero as the lower bound and talks
about the "zero lower bound", while in Sweden and other countries, which have
cut their policy rates below zero, we talk about the "effective lower bound". For
the sake of simplicity I will from now on refer to this simply as the "lower bound"
for the policy rate.
Let us now assume that the central bank would actually have needed to cut the
policy rate lower than the lower bound for monetary policy to become sufficiently
expansionary. To compensate for not being able to do this, the central bank can
instead hold the policy rate at the lower bound for a longer period of time (see
Figure 4).9 Seen in a slightly longer perspective, for instance a ten-year period, this
should give roughly the same average policy rate as if one had been able to cut
the rate below the lower bound.
If the economic agents are aware that the central bank applies this strategy when
the interest rate is at its lower bound, and they regard it as credible, then long
interest rates should adapt in roughly the same way as if the lower bound did not
comprise any limit.10 If one uses the reasonable assumption that demand in the
economy is not solely dependent on the current level of the policy rate but also
depends on interest rates with longer maturities, this should give the central bank
the possibility to stimulate the economy even in times when the policy rate is at
the lower bound.
One advantage of the makeup strategy is that it can be applied within the
framework of the current inflation-targeting policy. However, a condition for it to work
is that it is a predictable element of the central bank's policy. If one wishes to
apply such a strategy, it would therefore be a good idea to formalise it in advance by
means of a strategy document describing how the central bank will act in a
situation where the interest rate is at its lower bound.11 In a moment I will discuss a
specific application of the makeup strategy.
Moderately strict Odyssean forward guidance?
When the central bank tries to give economic agents an idea of how the policy
rate will develop, this is known as "forward guidance". In Sweden the Riksbank
publishes quantitative forecasts for the repo rate. This is called in academic
literature Delphic forward guidance, with reference to the Oracle of Delphi, who was
thought to be able to see into the future. How well this strategy will function
depends on how successful the central bank is at predicting its future interest-rate
policy. If the forecasts for the policy rate are often correct, then it will be common
for economic agents to believe in the central bank's forward guidance. But if the
forecasts for the policy rate are not so accurate, then the forward guidance will be
taken less seriously. And unfortunately it seems to be quite difficult to forecast
policy rates. If the economy is hit by shocks, which is often the case, then the
forecasts will not be very accurate.
Our experiences in Sweden illustrate this problem clearly. Both the Riksbank and
the market have often made substantial overestimates of the repo rate in their
forecasts (see Figure 5).12 Although the market's forecasts were better than the
Riksbank's during the period 2011-2013, the pattern is essentially the same -
substantial overestimates and inaccurate forecasts.
A brief remark is in order here. Sometimes one gets the impression from the
debate that it is only the Riksbank that has produced inaccurate repo rate forecasts,
while most analysts, including the market, have been quite successful. Apparently,
this is not the case. One may perhaps object that the market may not produce
forecasts of its own, but merely assumes that the Riksbank will follow its
reporate path. But the experiences of the period 2011-2013 indicate that this is not
really the case. I think this is a useful picture to bear in mind.
If one wants to implement a makeup strategy in a situation where the repo rate is
at the lower bound, it is probably necessary to use a more convincing approach
than Delphic forward guidance. The alternative to Delphic forward guidance is
called Odyssean forward guidance. This name is also taken from Greek mythology
and refers to Odysseus, who had his men tie him to the mast so he would not be
tempted by the song of the Sirens and steer his ship towards the cliffs. In terms of
monetary policy, this strategy is less dependent on the accuracy of the forecasts;
instead it is a case of committing oneself to not deviating from the interest-rate
development one has indicated.
But Odyssean forward guidance also has its problems. Binding oneself to a
particular monetary policy no matter what may on the one hand indicate strong
determination and thereby have an effect on expectations. But on the other hand, such
a policy may appear obstinate and unrealistic. If events occur that cause the policy
to appear as inappropriate or directly harmful, it will be difficult to implement it.13
And once one has deviated from a strategy which one has firmly undertaken to
follow, one will hardly appear credible when trying to apply it the next time.
When applying a makeup strategy, a less strict Odyssean forward guidance might
mean that the central bank - in accordance with predetermined and clarified
principles - makes it clear that it will hold the policy rate at the lower bound until
inflation, or perhaps some measure of the development of the real economy, has
attained a particular level. In this case, one does not make an unconditional
commitment but makes one's behaviour depend on certain developments.14
Purchases of financial assets?
One possibility the Riksbank and other central banks have made use of to make
their monetary policy more expansionary when the policy rate is at or close to the
lower bound is to buy government bonds on the secondary market. This affects
market rates and other financial prices through various channels.15 What one
normally talks about are the signalling channel - which works through the purchases
signalling that monetary policy will be expansionary and the repo rate will remain
at the lower bound a long time, the portfolio balance channel - which means that
the purchases will have contagion effects on prices of other assets and the
premium channel - that works through purchases reducing the supply of bonds,
which pushes up bond prices so that interest rates fall.
As this is a new monetary policy tool, it has given rise to extensive academic
research that attempts to estimate its effects. The most common conclusion is that
the policy has functioned more or less as expected and complemented the policy
rate cuts in a useful way.16
One problem for Sweden is that it will become more difficult to use government
bond purchases as a tool in the next economic downturn as the Riksbank already
owns a large share of the outstanding stock of government bonds, just over 40
per cent. These are not then available for trading on the market, which
contributes to making the market less liquid and means it takes longer to make
transactions. The problems have been manageable so far, but the larger share the
Riksbank owns, the greater the problems are likely to be. It may also be the case that
the expansionary effect of each further purchase gradually declines.
Of course, the Riksbank will eventually taper its holdings, but probably at a slow
pace.17 The Riksbank will therefore most probably have a substantial holding of
government bonds for a long time to come. All in all, this means that there are
limits with regard to the opportunities to use purchases of government bonds as a
monetary policy tool going forward. My assessment is that it will probably be
possible to increase the purchases a little further but, as I said, there is a limit.
Buying government securities is not a completely unnatural step for a central
bank that normally tries to affect the economy by adjusting a short-term risk-free
interest rate, the monetary policy rate. Buying government bonds means that one
also tries to affect credit risk-free interest rates, via the premium channel,
although these are interest rates with both short and long maturities.18 Despite the
measure being termed "unconventional", one can say that this type of monetary
policy intervention followed a standard way of thinking in that one limits oneself
to trying to have an effect on risk-free interest rates, the "ground plate" for
interest rate setting in the economy. The idea is, as when adjusting the repo rate, that
the effects will spread to other, higher risk interest rates.
However, it is of course also possible, although the Riksbank has not yet done so,
to buy other financial assets than government bonds. The Federal Reserve, the
European Central Bank, the Bank of England and the Bank of Japan, for instance,
have also purchased different types of commercial securities, including mortgage
bonds and corporate bonds. Unlike purchases of government securities, this often
entails a direct intervention in higher-risk assets. The market where the
intervention takes place will then experience a "positive funding effect", both because the
interest rates on the market concerned become lower in relation to other
commercial markets and because the issuers on the market in question have found a
"safe" lender. This type of measure therefore requires a more detailed
consideration and moreover knowledge of how different commercial markets function and
are interlinked with other parts of the economy.
Therefore, it is not so surprising that purchases of commercial securities have
often been used just when there are serious problems on a particular market and
when there is a risk that these problems will have negative effects on the
economy as a whole. For example, the Federal Reserve purchased large amounts of
mortgage bonds when this market threatened to cease functioning, which could
have had serious consequences for credit supply to the household sector.
Purchases of commercial paper are thus in principle a different type of measure
than purchases of government paper. But they definitely comprise a possible tool
to be used if the need arises, even for the Riksbank.
Natural for fiscal policy to play a larger role
All in all, the Riksbank will thus not be without means to counteract the next
economic downturn. But it is hardly possible to claim that the opportunities are as
good as they were, say, 15-20 years ago, when the neutral interest rate was still
relatively high and there was plenty of scope to cut the repo rate. Depending on
when the next downturn occurs and how deep it is, there is thus a risk that
monetary policy will not suffice when it comes to counteracting it.
As I see it, this has implications for how to look upon the division of roles in
stabilisation policy. There has long been a tendency, both in Sweden and abroad, to
claim almost by default, that when you have a floating exchange rate it is the job
of monetary policy and not fiscal policy to stabilise economic activity. Perhaps it is
time, in the light of our experiences following the crisis, to qualify this picture
somewhat.
In a way, of course, fiscal policy always contributes to stabilising economic
activity. For instance, systems for taxes and expenditure are often designed so that
they automatically adapt to economic developments. Examples are progressive
income taxes and unemployment benefits.
On the other hand, there has long been scepticism against using so-called
discretionary fiscal policy - direct decisions on adjusting taxes and public expenditure -
with the aim of stabilising economic activity. One problem is that discretionary
fiscal policy measures are often implemented or have an effect too late because of
various delays, and they therefore aggravate economic fluctuations rather than
stabilise them. Another and perhaps even greater problem is that this type of
fiscal policy has historically tended to be used too generously and has therefore
caused problems with the sustainability of public finances.19
But there may be reasons to consider that the conditions today are somewhat
different than they were a couple of decades ago. As I pointed out, one new
circumstance is that central banks now have greater difficulty counteracting economic
downturns by cutting the policy rate, because of the lower bound. Another
change, especially in Sweden, is that public finances are now in much better
condition than they were before. The fiscal policy regulations introduced after the
crisis at the beginning of the 1990s have contributed, together with good growth, to
the Swedish gross public debt declining from between 70 and 80 per cent of GDP
in the mid-1990s to around 40 per cent today. Thus, the prospects for using fiscal
policy to counteract an economic downturn are much better nowadays.
However, it is not obvious what forms this would take. In the United Kingdom, it
has been proposed that the Bank of England's monetary policy committee should
indicate when it is prevented by the lower bound from stimulating the economy
as much as it considers appropriate.20 It is proposed that in these situations the
committee should state how much it would have wanted to cut the policy rate.
The United Kingdom's Treasury are then invited to implement a fiscal policy
measure of its choice as a replacement for the rate cut. The Treasury can take note of
this proposal, but can also ignore it, publishing a response. If the Treasury takes
the advice, then the Office for Budget Responsibility (equivalent to the Swedish
Fiscal Policy Council) will assess whether the measure is compatible with a
sustainable fiscal policy.
The idea is thus that discretionary fiscal policy measures shall replace the
monetary policy stimulation that is not brought about because of the lower bound.
Some argue that this would be a more effective and economically more reliable
mechanism than trying to achieve the same effect through, for instance, the
purchase of financial assets.21
It is an open question whether a similar solution might function in Sweden. One
condition that one should bear in mind, as the British proposal emphasises, is that
the use of discretionary fiscal policy always entails a balancing act. Sweden's
currently strong public finances provide protection against shocks. For some time
now we are no longer affected by financial premiums that resulted from
credibility problems in economic policy. This can be seen, for instance, in the fact that the
difference in ten-year government bond yields between Sweden and Germany is
much less than before (see Figure 6).
The fact that interest rates and exchange rates vary relatively little despite the
difficulties in forming a new government can also be regarded as an indication that
the Swedish economy enjoys a high level of confidence. The fiscal policy
framework introduced after the crisis in the 1990s is central to this stability and it is
important to safeguard it. Creating confidence takes a long time, but it can be lost
very quickly. Having said this, it does of course feel reassuring to have fiscal policy
room for manoeuvre, even if one would prefer not to use it.
The role that fiscal policy should play is therefore not an uncomplicated question.
But I think that it is nevertheless important that the question of how to stabilise
economic activity when the Riksbank's possibilities are not unlimited is brought up
on the economic policy agenda.22
Before I go on, it may be worth emphasising that yet another alternative for
stimulating the economy that is sometimes mentioned - what is known as "helicopter
money" - also requires interaction by monetary policy and financial stability. In
brief, helicopter money involves the government increasing public expenditure or
cutting taxes and this being funded by a permanent increase in the money stock.23
However, I have chosen to ignore this alternative as it involves considerable legal
complications.
International debate on changes to the
monetary policy framework
As I mentioned at the start, there are discussions in research circles and among
central banks about whether the current inflation-targeting policy should be
reformed, or replaced with some other monetary policy framework, so that the
conditions for counteracting economic downturns and recessions will be better in the
future.
This is a rather interesting discussion, not least because people who are
prominent in the ideological debate on monetary policy or have been influential
policymakers have somewhat varying views on which solution is most appropriate. I
have already mentioned that Janet Yellen argues that one might perhaps not need
to make that many changes to the current framework and that it might suffice
with a makeup strategy, where the central bank follows a formalised plan that
means that the interest rate is held at the lower bound for a long time.
Temporary price level target
Yellen's predecessor as chairman of the Federal Reserve, Ben Bernanke, has
proposed a solution that can be regarded as a special application of a makeup
strategy.24 This is based on the central bank under certain circumstances not having a
target for inflation, but instead for the development of the price level. The
difference may appear subtle, as inflation is the change in the price level, but it is
potentially quite important.
Let us assume that both the inflation target and the target increase for the price
level is 2 per cent. If, in an inflation-targeting regime, one has an inflation rate
that undershoots the 2 per cent target for a period of time, it is the central bank's
task to bring it back on target. The fact that inflation has deviated from the target
before is not important - "bygones are bygones". But if it is instead the
development of the price level that is the target and inflation deviates from 2 per cent,
then this must be "made up for". The principle is thus the same as Yellen's
makeup strategy, but here one has clarified in advance that the target refers to
the price level rather than inflation.
The differences between a price level target and an inflation target is illustrated in
Figure 7.25 If something unexpected occurs in an inflation-targeting regime that
causes inflation to be lower than the target, it is enough to brin