Barbro Wickman-Parak: "Translating" forecasts into repo-rate decisions
- no easy task
Speech by Ms Barbro Wickman-Parak, Deputy Governor of the Sveriges Riksbank, at a
meeting with Nordea Markets, Stockholm, 24 May 2011.
* * *
I would like to thank Hans Dillén for his help with this speech and Lina Majtorp for her help with the illustrations.
My speech here today is about making forecasts. In order to be able to conduct a
wellbalanced monetary policy we need to make good forecasts, which in turn requires good
models. Models cannot of course capture everything, so the forecasts that the Riksbank
presents are the result of a structured interaction between models and assessments. Further
assessments are then made when the time comes to make a repo-rate decision. Not even
the best forecasts can simply be "translated" into a repo-rate decision. This is always a
difficult process, but it becomes even more difficult when the economy is subject to major
disruptions such as the financial crisis that hit in the autumn of 2008.
The Riksbank, and most other analysts, made significant forecasting errors at that time. The
basic problem was that our models do not capture a number of the financial links that played
a role during the crisis, and the risks associated with these links were therefore
underestimated. I think that we all agree that we need to increase our understanding of the
various financial links that affect the Swedish economy.
The step from forecast to repo-rate decision is also affected by other considerations. One
issue is whether our assessments should stop short at the end of the forecast horizon.
Another issue is that positive and negative deviations from our inflation target may entail
different costs and affect the balance of monetary policy. Finally, I would like to underline my
view that flexibility is crucial in monetary policy. The fact that we quickly changed the course
of monetary policy during the crisis is a clear sign of flexibility. But even in more normal times
it is important to remember that our knowledge of the future is incomplete and uncertain I am
therefore in favour of repo-rate changes being made gradually in normal circumstances. This
makes it possible to continuously analyse developments and to determine whether to
continue to follow the chosen path, to call a halt or to change direction. Sudden and dramatic
changes in monetary policy can then be avoided.
We cannot do without forecasts
I worked with macroeconomic forecasts long before I became a member of the Executive
Board of the Riksbank. At that time I was involved in the nitty gritty of forecasting, now I am
part of a process in which the spadework is done by others. My role in this process is to
contribute assessments.
A question I have often been asked is why economists bother producing economic forecasts
- everyone knows that they often prove to be wrong. The answer is that many activities
cannot do without forecasts as a basis for their planning. The spring budget bill that was
presented recently is, for example, based on a macroeconomic forecast of the levels of
central government income and expenditure in the years ahead and the potential scope for
reforms that will therefore be available. Forecasts of different kinds also play a practical role
for the planning of companies, even though they may not call their underlying assessments
forecasts. Financial investors, who are better able than others to forecast macroeconomic
developments, have an advantage in the search for yield as financial prices such as interest
rates, exchange rates and share prices are strongly affected by business cycle
developments. A final but important example concerns households who, when planning to
buy a home, largely base their decision on what they believe about the development of
interest rates in the future.
Although forecasts are seldom entirely correct, I would still say that they are often correct
enough to provide a reasonable basis for planning. It is mainly in connection with turning
points in economic activity and with different types of crisis that forecasts prove to be wrong.
On the other hand, we should be aware that forecasts are predictions of what will happen in
the future and are therefore shrouded in uncertainty. We must always be prepared to change
our course of action if events move in a different direction.
Monetary policy is based on forecasts
The Riksbank also uses forecasts to "plan" monetary policy. This planning is reflected in our
repo-rate path and if developments take a different turn than forecast then we have to adjust
the repo-rate path. It may seem that the Riksbank uses forecasts in roughly the same way as
other players whose operations are also affected by the development of economic activity.
There is, however, an important difference. The Riksbank can, in contrast to most other
forecasters, affect the forecasts. This is the whole point of monetary policy. Put simply, we
can say that a well-balanced monetary policy is characterised by the forecast for inflation
being close to the inflation target and the forecast for resource utilisation being close to its
normal level.1
There is nothing to say that we have to publish our forecasts. Life would in some respects be
easier if we did not publish them. We would avoid the criticism we are subjected to when our
forecasts prove to be wrong and we would be able to write in more general terms about
economic developments without needing to present a detailed and cohesive forecast. For a
long time, central banks were rather closed and secretive bodies and when, for example, the
Riksbank began publishing its inflation forecasts in 1997 there were many people, not least
in the world of central banking, who had misgivings; wouldn't confidence be eroded if the
forecasts turned out to be wrong? This proved not to be the case and these days we present
the entire cohesive forecast for the inflation target, wages, GDP and its components, the
repo rate and so on. I believe that by doing this we have increased the public's
understanding of monetary policy and reduced the drama surrounding the entire monetary
policy process. Assessing economic activity entails reviewing material that is in a constant
state of flux, and when we change our monetary policy these changes can be concretely
related to changes in real-economic conditions. I would also like to add that the quantified
forecasts are of course interesting, but the associated analyses of the driving forces behind
different courses of development are at least as interesting.
How do we make our forecasts?
Developments abroad play an important role
For a small open economy like the Swedish economy, the international outlook is the point of
departure for the forecast. We cannot influence events abroad, but what happens there has a
major impact on developments here at home. Here I would like to highlight some of the
special aspects relating to the forecast of developments abroad.
The world is a big place...
To start with, the rest of the world is a big place and we do not have the resources to
produce detailed forecasts for individual countries in the same way as we do for Sweden.
Instead we have to limit the number of forecast variables and focus on those parts of the
world that are most significant to the Swedish economy. For other regions we have to rely to
a great extent on the assessments of other forecasters, although this of course does not
mean that we copy their forecasts directly.
Another important aspect is that the forecasts for the different regions of the world must hang
together in a consistent way. If, for example, we change the forecast for the United States
then this also affects the forecast for the euro area (and other regions) and vice versa. This
mutual interdependence is not always easy to manage but the preconditions have improved
recently following the introduction of a new model for the international outlook. It is called the
Global Projection Model (GPM) and its main aim is to produce cohesive and consistent
forecasts for different regions of the world.2 The GPM also plays an important role when we
want to produce different risk scenarios.
...and changeable
So, what regions of the world are most important to Sweden? The region on our doorstep is
of course very important. This primarily includes the euro area, but also the UK, Denmark,
Norway and a couple of other countries in central and eastern Europe. Most of our trade
takes place with this region. A region that has increased in economic importance over time is
Asia. The emerging economies in Asia, led by China, have been the driving force behind the
recovery of the global economy following the financial crisis. The importance of these
countries for Sweden's foreign trade has also shown an increasing trend since the early
1990s. This of course means that it is now more important to monitor these countries than
previously.
The United States affects Sweden through financial links
Finally, developments in the United States are always important even though in
tradeweighted terms the United States only accounts for about 10 per cent. The reason for this is
that the US economy often sets the tone for the development of stock markets and bond
rates around the world. It is true that our knowledge and understanding of these financial
links is limited3 but it appears to be the case that they play a particularly important role during
slowdowns. The global financial crisis that originated in the US housing market is perhaps an
all too clear example of this. The IT crash that took place just over 10 years ago is a more
normal example of how events in the United States affect the global economy via financial
prices.
Assessing the current situation - the essential starting point for the forecast for
Sweden
Assessing the current situation entails producing a forecast for the current quarter, and
perhaps the next quarter. At such a short forecasting horizon, not so much importance is
attached to large macro models; the assessment is instead based on many different
economic indicators. An assessment of the current situation is a kind of mapping of the
disruptions and imbalances that are currently affecting the economy; in other words it
describes the situation at the starting point for the forecast. It goes without saying that it is
difficult to assess where you are going if you do not know where you are today. Assessing
the current situation thus lies at the very core of all forecasting.
Such an assessment does not simply entail producing forecasts for outcome data like GDP
and the CPI, it also involves having to assess demand and supply factors in the economy. In
this context the assessment of resource utilisation plays a prominent role. If resource
utilisation is low then the economy can grow rather rapidly without prices and wages
increasing in an alarming way. If it is strained then high growth may lead to overheating
tendencies that could be reflected in excessively high inflation. So, even if the Riksbank
produces fair forecasts of economic growth monetary policy may be less well-balanced if we
misjudge resource utilisation. A complicating circumstance in this context is that resource
utilisation, unlike GDP growth, cannot be observed directly. This underlines the fact that the
assessment of the current situation is fundamentally an assessment of the state of the
economy that is very difficult to make.
Confidence indicators, which capture the mood of the economy, play an important role in the
assessment. High values in the confidence indicators normally entail relatively strong growth
in consumption, exports and investment, all else being equal. Important confidence indicators
include the purchasing managers' index, data from various business tendency surveys and
surveys on expectations relating to wages and prices, but there are many more. We also
conduct our own company interviews in which we get direct information on how various
submarkets are functioning in practice.
The indicators often provide a slightly diffuse picture of the state of the economy. Here we
find various indicator models useful in that, on the basis of an analysis of the historical
significance of different indicators, they help us to put our most important forecasts into
figures. Ultimately, we also have to weigh information that is not captured by our indicators
into our assessment of the current state of the economy.
Model forecasting is the next step
Once we have produced a forecast for the outlook abroad and performed an assessment of
the current situation we are ready, with the help of various large macro models, to produce
forecasts for longer time horizons. It could be said that the models give a description of how
prevailing impulses from abroad and the initial state of the Swedish economy will affect the
development of the economy. In the very long term, however, the effects of the prevailing
impulses will have faded and the economy will then follow a balanced path in the long run.
This balanced state, which in model terms is often called a steady state, is an important
characteristic of a model. We could perhaps say that an assessment of the current situation
tell us where we are while models tell where we are going in the very long term.
In the monetary policy analysis, however, the focus is often on what will happen in the period
in-between, or on developments two to three years ahead. It is generally accepted that it is at
this time horizon that monetary policy has its greatest effect. As I said earlier, monetary
policy aims to make monetary policy decisions that provide as good a target attainment as
possible and the models are important in this context because they make it possible for us to
evaluate different monetary policy alternatives in forecast terms. Models are on the whole
very useful when we want to evaluate alternative scenarios in which development takes a
different course than predicted in the main scenario. However, the analysis of alternative
scenarios must not be reduced to a purely model exercise and it is important that such
analyses are also complemented by assessments.4
Let me conclude the discussion of model forecasts by saying that they are sometimes
described as being in some way at odds with forecasts that are based on assessments. In
my opinion there is no such opposition between them. A forecast is always an assessment.
We develop models so that they can help us to make better assessments. A good and
wellfounded forecast is often produced in a structured interaction between models and
assessments by experts.
Forecasting, extreme scenarios and the financial crisis
In normal circumstances, a forecast path can be described as a probability-weighted average
of different reasonable scenarios. Note that I use the term reasonable scenarios, which
means in practice that in practical forecasting work we disregard certain kinds of scenario.
Examples of scenarios that we choose to disregard include a decision to abandon the
inflation target, the outbreak of war, major natural disasters or an epidemic that infects a
large part of the labour force. We ignore such scenarios partly because they are very unlikely
and partly because they would entail a radical change in the preconditions for monetary
policy. If such a scenario did nevertheless occur, we would have to decide what would be
required of monetary policy at the time.
The financial crisis can also be seen as a kind of extreme scenario, even though this was not
an event that could be regarded as being highly unlikely. Most analysts believed that there
was a clear risk that the problems that arose on the financial markets in 2007 could get
worse. The problem was that the crisis not only became unusually severe; it also took a
course that few of us could predict.
The crisis spread throughout the global economy through various international financial links
and fundamental functions in the financial system were seriously disrupted. This had
dramatic, negative effects on, for example, the possibilities of companies to get funding and
on world trade. This was a case of crisis mechanisms that we had very little experience of
and that were therefore not included in our forecast models. We were unable to take in the
complexity of the financial system and the contagion that this entailed.
Although it was extremely difficult to make forecasts, the Riksbank did not stop making them.
However, the forecasts were unusually uncertain and we were prepared to revise them
significantly, which is what subsequently happened. The forecast for GDP was revised so
much that we ended up far outside the uncertainty bands that surrounded the forecast before
the crisis (see Figure 1). At a later stage, we also underestimated the strength of the
recovery.
Figure 1
GDP and forecasts for GDP at different times
Annual percentage change, seasonally-adjusted data
8 8
6 6
4 4
2 2
0 0
90%
75%
-2 -2
50%
Outcome
-4 -4
September 2008
September 2009
September 2010
-6 -6
April 2011
-8 -8
06 07 08 09 10 11 12 13
Note: All forecasts entail a degree of uncertainty but to preserve the
graphic profile only uncertainty bands for the September 2008 forecast are
shown.
Sources: Statistics Sweden and the Riksbank.
The radically-changed economic conditions of course had a major impact on the repo-rate
forecast. It was revised so much that the repo-rate path also ended up far outside the
uncertainty bands that surrounded the forecast produced in September 2008. It could also be
said that the monetary policy actually conducted was closer to crisis management than to
forecasting. Let me illustrate this with an analogy.
Figure 2
The repo rate and forecasts for the repo rate at
different times, per cent
7 7
90%
75%
6 6
50%
Outcome
September 2008
5 5
September 2009
September 2010
April 2011
4 4
3 3
2 2
1 1
0 0
06 07 08 09 10 11 12 13
Note: All forecasts entail a degree of uncertainty but to preserve the
graphic profile only uncertainty bands for the September 2008 forecast
are shown.
Source: The Riksbank.
Monetary policy is sometimes compared to driving a car, in that it is a case of moving forward
safely along a road at a good speed. The forecast can be compared to looking ahead along
the road and then adjusting the speed of the car and the movements of the steering wheel to
keep the car on the road. The financial crisis can be compared to a collision that threatens to
throw the car off the road. In such a situation, it is a case of using all the means at your
disposal to ensure that you stay on the road and do not fall into the ditch. What the road
looks like 50 meters further ahead is highly uncertain and, in effect, less important. Once you
are back relatively safely on the road your speed will be very low and you will be able to look
ahead and try to return to more normal driving.
In the upturn: patterns had been broken, parallels with previous crises
Thanks to resolute action on the part of central banks and other authorities the crisis entered
a less acute phase. However, the financial markets were still not functioning effectively and
support measures were still needed. But, a total collapse had been avoided and it was
possible to see signs of a normalisation on some financial markets. Nevertheless, the
situation was highly uncertain. It was also difficult to assess the real economy. Did the major
falls in GDP in Sweden and abroad mean that potential GDP had declined? In many
countries the households had experienced substantial falls in house prices. To what extent
would the need of the households to strengthen their balance sheets mean that consumption
would decline and that the ability of monetary policy to stimulate the economy would be
weakened?5
It was clear that the economic patterns that prevailed before the financial crisis had largely
been broken. In such a situation it was natural to study the form of the economic recovery
following previous crises. The overriding conclusion that could then be drawn was that the
recovery would be slower than normal.6 However, it is also the case that every crisis is
unique in many respects and there were circumstances that pointed in the opposite direction.
Among other things, the emerging economies in Asia, led by China, recovered relatively
quickly and became something of a driving force for the recovery in the rest of the world.
Another positive factor was that growth was rather good around the world when the crisis
began.7 With hindsight, it can be noted that the recovery in many areas, and not least in
Sweden (see Figure 1 above), has been much more rapid than we could have expected. As
can be seen in Figure 2, the Riksbank began to increase the repo rate somewhat earlier than
predicted during the most severe phase of the crisis and the repo-rate path was given a
somewhat more "top heavy" profile.
It is natural to try to learn from previous crises, but at the same time we must be careful not
to draw too far-reaching historical parallels. In the midst of the crisis there was, for example,
sometimes a slightly careless tendency to refer to the Swedish crisis of the 1990s, despite
the fact that the circumstances at that time were entirely different. My point here is that if
somewhere at the back of your head you have a preconceived idea of how a crisis should
develop then it is easy to miss signals that may indicate that the course of the crisis is
moving in a different direction.
Some personal reflections on forecasting
The things I have said about forecasts so far are fairly general observations that I believe my
colleagues on the Executive Board would essentially agree with, even though they would
probably express themselves differently. In this concluding part of the speech I would
therefore like to take up some aspects of forecasting that are perhaps more personal.
The development of interest rates abroad and the krona exchange rate
Let me begin with the forecast for economic activity abroad, which I think in some respects
has been given too much significance in the discussion of our forecasts for, for example, the
krona exchange rate. As I see it, changes in interest rates abroad relative to Swedish interest
rates say more about the current exchange rate for the krona than about the future
development of the krona. The fact that interest rates increased more in Sweden than in the
euro area in the first half of 2010 is thus an explanation of why the krona strengthened
against the euro in the same period, but high Swedish interest rates relative to those in the
euro area will not necessarily lead to the krona strengthening in the period ahead.8 My belief
that too much importance has been attached to forecasts of policy rates abroad does not
mean that financial prices abroad are of no interest. On the contrary, developments in 2010
illustrate that long-term Swedish rates often appear to be strongly affected by developments
abroad, and especially in the United States, without these shifts being motivated by changes
in economic activity in Sweden. We need to improve our understanding of international
financial links of this kind.
Can assessments stop short at the end of the forecast horizon?
Another point that I usually make is that it can be difficult to draw monetary policy
conclusions from our forecasts as they only cover a limited forecast horizon of three years. A
certain repo-rate path may appear to provide better target attainment than other paths over
this limited forecast horizon but could well lead to poorer target attainment beyond it. It is
therefore desirable when making monetary policy decisions to take into account the possible
state of the economy beyond the forecast horizon, even though it is difficult to do this in
terms of quantified forecasts. One way to do this is to choose a repo-rate path that provides
good target attainment at the end of the forecasting period but does not entail serious
tendencies towards poorer target attainment beyond the forecast horizon. Even though we
have a limited forecast horizon, the monetary policy decisions must also to some extent look
ahead to what can happen afterwards.
The development of house prices and household indebtedness could, for example, entail
risks that materialise beyond the current forecast horizon, especially if monetary policy
remains far too expansionary for far too long. The question of whether risks of this type
should be considered in the monetary policy decisions has been widely debated. One view is
that such risks should already be taken into account in our standard quantified forecasts.
Although I hope that the analysis will eventually develop to the extent that it is possible in a
reasonably reliable way to take account of this type of risk in our forecasts we are not there
yet. My view is that it may sometimes be justified to consider this kind of unforecastable risk
in our monetary policy decision-making. Ignoring such risks completely is, in my view, the
same as saying that they do not exist, and that is a position that I would not want to defend.
Positive and negative risks can have different costs
There are also other cases where it may be a mistake to let monetary policy be guided by
forecasts alone. A forecast-based monetary policy is good if it is believed that the costs of
negative deviations from the target are the same as for positive deviations, but this is not
always the case. Greater importance should be attached to a scenario in which the collapse
of an asset bubble leads to a state of deflation that is difficult to escape from than to a
scenario with high inflation, assuming that the inflation target still has credibility. Experience
from Japan in the 1990s illustrates this. During the financial crisis, there were discussions in
the Executive Board9 about temporarily allowing inflation to be relatively high with the aim of
pushing up inflation expectations, which would lead to lower real interest rates and a
wellneeded stimulation of the economy. Stimulating the economy with lower nominal interest
rates was not possible as the Riksbank had already reduced the repo rate as far as was
considered possible. I was doubtful about experimenting with our monetary policy framework
in this way during an ongoing crisis. I admit, however, that there is a certain logic in the
argument that underlines the fact that it is sometimes more costly for inflation to become too
low than for it to become too high. However, if the credibility of the inflation target is
threatened by high inflation then the reverse may also be true.
We can learn from our mistakes
Let me now say something about forecasting errors. It is sometimes argued that monetary
policy was well balanced at a certain point in time given the information that was available at
that time. Such a stance seems to be based on the attitude that at the time of the decision
the decision-makers were guided by the best conceivable forecasting model and that any
forecasting errors were only due to entirely unforeseen events. It is normally not quite as
simple as this, however, and forecasting errors are usually a combination of unforeseen
events and shortcomings in the assessment of the economy.
Allow me to be a little self-critical and to go back the autumn of 2008 when the Riksbank
raised the repo rate in September but then changed direction and adopted a highly
expansionary monetary policy when the crisis got dramatically worse. Even later in the
autumn, when the financial risks were increasingly apparent, we underestimated the
seriousness of the situation. We, like most other analysts, simply lacked the ability to fully
assess the incredible impact that the crisis would have on the global economy and on the
Swedish economy. Even though I entered a reservation against the repo-rate increase in
September I can honestly admit that I also underestimated the risks on the international
financial markets. With hindsight, it is possible to identify several areas where the Riksbank
could have made a better analysis. The basic problem was that our models do not capture
the various financial links that played a major role during the financial crisis, and we therefore
underestimated the risks.
You might think that in such situations we should tone down the model analysis and instead
rely on assessments of various indicators, which in fact the Riksbank did, but we could have
performed better here too. We made substantial downward revisions in the figures for GDP,
but we did not expect the fall to be as great as it actually was. When assessing GDP during
the fourth quarter of 2008 we should, in my opinion, have attached more weight to the alarm
signals that came from our company interviews, especially as data from the business
tendency surveys, the statistics on redundancy notices and falling share prices all pointed in
the same direction. On the other hand, the underestimation of the fall in GDP did not affect
the conduct of monetary policy as the repo rate was still reduced substantially, by several
percentage points, over a short period of time.
Nor do I believe that the conduct of a less restrictive monetary policy earlier in 2008 would
have had much effect on the course of the crisis. That is not the point. The point is that the
misjudgements made by the Riksbank were partly due to shortcomings in the analysis. The
models that have been developed entail a tacit assumption that the financial markets will
continue to perform their central functions of mediating payments, converting saving to
funding and managing risks. We, and all the other macroeconomic analysts, were given a
rude reminder that the analysis models lacked important elements. This is an important
lesson that is reflected in the discussions and in the research work now underway. We need
to gain greater insight into, and more knowledge about, the branches of the global financial
system and the connection between real and financial variables.
Flexibility is the be all and end all in monetary policy
Even if the Riksbank, like many others, made a number of misjudgements, one positive
aspect of the situation is that we quickly changed the course of monetary policy and
implemented extraordinary measures in an attempt to mitigate the downturn in the economy
and support the financial system. There was no question of trying to stick to previous
forecasts and assessments. This is testimony to an essential flexibility. We must be able
react like this when reality turns out to be radically different to what we imagined it would be.
Even in more normal times we must always bear in mind that our knowledge of the future is
by no means complete. I have on several occasions expressed my view that gradual
changes in the repo rate are to be preferred in the normal case10. It is, I think, a wise strategy
to proceed cautiously and to continuously observe what is happening around you in order to
decide whether to continue following the chosen path, call a halt or change direction.
Strongly driving policy in a particular direction may be a success factor in other policy areas,
but for monetary policy it is a case of carefully monitoring the state of the real economy and
being constantly prepared to adapt policy so that our predetermined target, the inflation
target, is not put at risk. There are no absolutes in monetary policy. If we fail to realise this
there is a risk that monetary policy will be subject to sudden and radical changes of direction.