Mr Heikensten talks about the interaction between monetary and fiscal policy and labour
market developments
Speech by Lars Heikensten, First Deputy Governor of the Sveriges Riksbank, the Swedish central
bank, to the Landskrona Municipality in Landskrona, Sweden on 16 June 1999.
For more than six years now, monetary policy in Sweden has been conducted with an inflation target.
Sweden was one of the first countries, together with Canada, New Zealand and the United Kingdom,
for example, to adopt an inflation targeting strategy. Other countries have recently displayed an
interest in targeting inflation directly as the guideline for monetary policy. Examples are countries
with strong economic growth in Asia, South America and Eastern Europe.
In many respects, Sweden's period with an inflation target has been one of good economic results.
Inflation and interest rates have come down to levels that are historically low and growth since the
crisis in the early 1990s has been relatively high and stable. Part of the explanation is, of course, that
the recession left us with plenty of unutilised resources. But new production capacity has also been
created at a rapid rate. Moreover, inflation expectations have been lowered, which gives a new and
better environment for price and wage formation. International inflation has also been low. The
picture of unemployment is more disappointing, though here too the recent trend points in the right
direction.
Growth and inflation in OECD and
Sweden
1999 and 2000 forecast
6 Percentage annual change 6
Growth
5 5
4 4
OECD
3 3
2 2
1 1
0 0
- 1 - 1
Sweden
- 2 - 2
- 3 - 3
8 0 8 2 8 4 8 6 8 8 9 0 9 2 9 4 9 6 9 8 0 0
1 5 1 5
Inflation
1 2 1 2
9 9
Sweden
6 6
3 3
OECD*
0 0
8 0 8 2 8 4 8 6 8 8 9 0 9 2 9 4 9 6 9 8
* excluding hihginflation countries Source: OECD
Monetary policy, however, is just one of the factors that are important for economic development.
Two crucial matters for economic development in general and thereby for the conditions underlying
monetary policy are the situation in the labour market and fiscal policy. In recent years it is not least
the construction of fiscal policy that has contributed to the good economic performance.
The interaction of fiscal and monetary policy has been debated a good deal of late. Income tax cuts
have been discussed, for instance. Now that Sweden's economy seems to be moving into a stronger
phase, in large measure as a result of higher domestic activity, it is of the utmost importance that we
do not land in a situation with wage drift and overheating as a consequence of an unduly expansionary
fiscal stance. Against this background, I shall be talking today about the conditions for monetary
policy and its interaction with fiscal policy and labour market developments.
Interaction with fiscal policy
Fiscal policy affects the chances of success in monetary policy in various ways: via its impact on
general confidence in monetary policy, via short-run effects on demand and by modifying the
longterm conditions for economic growth and low inflation.
Let me begin with credibility. If the direction of fiscal policy is perceived as being unsustainable in
the longer run, economic policy's overall focus on low inflation and stable growth is liable to be
questioned. Few industrialised countries have experienced this as recently and tangibly as Sweden.
The massive budget deficits in the early 1990s, with rapidly accumulating government debt, made
Sweden's economic future uncertain and pushed interest rates up. With the consolidation of
government finances, however, and the long-term ambitions for fiscal policy that the Government,
supported by the Riksdag (Sweden's Parliament), has presented, confidence has improved.
The new budget process - with a moving budget ceiling and a budget surplus of 2 per cent of GDP
as a medium-term target - means that the Government and the Riksdag have set up a clear set of
rules to show that Sweden has no intention of relapsing into earlier habits. There is nothing fortuitous
about these rules. But the purpose of the budget ceiling and the budget target as confidence-enhancing
instruments does presuppose that they are observed consistently and continuously over the business
cycle.
Changes in fiscal policy also affect monetary policy through their direct impact on demand. The
debate in recent weeks has focused not least on these effects. An adjustment of income tax or of
transfers to households alters disposable income and thereby private consumption. Similarly, a change
in corporate tax or transfers to firms affects company profits and thereby investment and other
economic decisions. Activity in the economy may also be affected if the government decides to spend
more on public sector consumption or investment.
This makes fiscal policy a factor of importance when assessing economic activity and future
inflationary pressure. At the same time, the changes that are generated do not lend themselves to
mechanical calculations. Part of the reason is that the path of inflation is determined by other factors
besides fiscal policy.
A third important aspect of fiscal policy's interaction with inflation has to do with fiscal effects on
potential output. Lower tax on productive capital or companies may lead to more companies being
established and thereby raise potential output. Similarly, lower tax on labour or increased educational
inputs may generate an increased supply of labour and also influence wage formation. These are
examples of the numerous ways in which changes in tax and expenditure systems are likely to modify
economic opportunities and promote conditions for good growth without the attendant capacity
shortages that generate price pressure.
Current fiscal policy
The trade-off between monetary and fiscal policy - the policy mix, as we economists like to say -
has improved considerably in the present decade.
The rapid accumulation of government debt has ceased and the stock is now being reduced. While the
consolidation of government finances has made the fiscal stance restrictive, it has been possible to
lower interest rates and this in turn has stimulated investment, economic activity and employment
lately. This is accordingly a considerable improvement compared with the early 1990s, for example,
when factors such as very weak government finances led the Riksbank to keep interest rates up at a
time when government debt was rising markedly.
Government debt and budget balance
Per cent of GDP. 1999 and 2000 forecast
10 80
Government debt
75
70
5
65
60
0
55
50
45
-5
40
35
-10
Budget balance
30
25
-15 20
90 91 92 93 94 95 96 97 98 99 00
Source: National Institute of Economic Reasearch
In the June Inflation Report we noted that as a result of measures proposed in the Budget Bill, during
1999 and possibly also in 2000 fiscal policy would probably be more restrictive than the Riksbank
had assumed earlier but would still become successively more expansionary. The restrictive economic
effect of fiscal policy was accordingly judged to be less marked than in the period 1994 - 97.
Our scenario assumed, however, that there would be no further tax cuts next year. We foresee a
government financial surplus somewhat above 2 per cent of GDP but have thus assumed that it will be
used to repay government debt. In 2001, on the other hand, we assume that any surplus in excess of 2
per cent of GDP will be transferred to households.
The Swedish debate about tax cuts and increased spending has become more intense as the
government budget moved out of the red and is expected to show continued and growing surpluses in
the years ahead. That is hardly surprising. We had exactly the same debate in the 1980s as soon as the
budget deficits had been eliminated. Some comments are therefore called for.
One comment concerns the formulation of the budget target. A medium-term average implies that in
good years the surplus should be above 2 per cent and by most standards the coming years must be
regarded as good. While the economy does admittedly still appear to have some unutilised resources,
they will gradually be utilised. Maintaining a surplus above 2 per cent when activity is high means
that a smaller surplus can be tolerated when activity is lower. In this way, room is created for the
budget to act as an automatic stabiliser. If, instead, the surplus is held mechanically at exactly 2 per
cent from year to year, fiscal policy will tend to accentuate cyclical fluctuations and exert a
destabilising effect.
Another comment concerns the demand effects of an easier fiscal stance in the present situation. The
tax changes being discussed seem largely to be unfinanced income tax reductions for low and medium
income groups. Judging from what has been indicated to date, a corresponding adjustment of public
spending is not envisaged. In that case, the tax cuts would enlarge household income and raise the
level of economic activity via increased consumption. That could result in increased inflationary
pressure that monetary policy might need to counter.
That said, I want to underscore that tax cuts may well be motivated. There are many indications that
the Swedish economy would work better if taxes were lower. Moreover, with the growing
international exchange in almost every economic domain, maintaining taxes in Sweden at a higher
level than in the rest of the world will become increasingly difficult. But there is reason to deliberate
the type of tax cuts that would benefit the Swedish economy most in connection with good growth.
Tax reductions with positive supply-side effects - instead of the cuts being discussed, which mainly
stimulate demand - would increase the possibilities of combining the good growth with persistently
low inflation.
Tax and expenditure ratios in
1998
Per cent of GDP
70 70
Tax ratio
Expenditure ratio
60 60
50 50
40 40
30 30
20 20
10 10
0 0
Sweden Euro-10*
* Euro-11 excluding Luxembourg Källor: Europakommissionen och KI
Interaction with labour market trends
Let me now leave monetary policy's interaction with fiscal policy and consider its relationship with
the situation in the labour market. What forms does this interaction take?
Monetary policy's chief contribution to employment lies in the creation of economic stability and
clear rules for wage formation. A monetary policy that is predictable and operates with a clear
inflation target provides good guidance for wage negotiations. The lack of a properly functioning
stabilisation policy was presumably one reason why wage formation did not work in the 1970s and
1980s. The rules of the game were unclear to the labour market organisations. That is hardly the case
today, as the Trade Union Confederation, for example, has acknowledged. Their wage negotiations in
1997 started, in fact, from the 2 per cent inflation target.
In the assessment of future inflationary pressure, monetary policy in turn must take the labour market
situation into account. Wages are of major economic importance: in that the wage bill accounts for
almost 70 per cent of value added, the development of wages has a large impact on costs and thus on
price formation. Moreover, wage settlements are liable to influence inflation expectations.
Wage tendencies are therefore one of the principal variables in any assessment of inflation. However,
the difficulties in forecasting wage trends are considerable. The Riksbank does, of course, follow data
on wages and unit labour costs; other important indicators include labour shortages in particular
industries, wage drift, registered and total unemployment in relation to job vacancies.
A central concept in this context is equilibrium unemployment, often referred to by the English
acronym NAIRU-the level of unemployment that can be combined with stable inflation. Attempts to
push unemployment down below the NAIRU with monetary stimuli are liable to have the sole effect
of boosting inflation. In other words, the NAIRU is not responsive to an expansionary stabilisation
policy. It depends instead on the workings of the labour market, together with demographic changes
and technology. Thus, lastingly higher employment cannot be generated by continuously
implementing an expansionary monetary policy. This is a basic tenet of economics, yet to judge from
the public debate it still seems to be misunderstood.
Various attempts have been made to estimate the NAIRU for Sweden. If this could be done with some
certainty, it would obviously be of interest. Insights into when a reduction of unemployment risks
boosting inflation would be a useful guide for monetary policy. The matter is unfortunately not that
simple, mainly because equilibrium unemployment is something that cannot be observed directly.
Registered and structural
unemployment
Per cent
10 10
Registered unemployment
9 9
8 8
7 7
6 6
Structural unemployment
5 5
4 4
3 3
2 2
1 1
0 0
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999
Source: The Riksbank
Assessing the level of the NAIRU for Sweden is presumably particularly difficult at present. We still
do not know all that much about the long-term consequences of all that has happened in the past
decade. After fluctuating around a low level for decades, possibly with a slight upward trend, with the
crisis in the early 1990s, unemployment shot up in just a few years. Moreover, policy has been
realigned and focused successfully on low inflation. This is likely to influence wage formation and
hence the NAIRU.
It is notable that problems have also been encountered recently in estimating the level of the NAIRU
for the United States. Yet the adjustment to low inflation occurred there back around the turn of the
1970s. For some time now, US unemployment has been below the rate that an earlier rule of thumb
identified as the equilibrium level but inflation has not accelerated. Some explain this mainly in terms
of favourable transitory effects, while others attribute it to more far-reaching changes of a structural
nature. In any event, the US example shows that drawing conclusions about the NAIRU can be
difficult even in economies where unemployment has remained close to a level that is comparatively
constant.
In the Riksbank's work, estimates of the NAIRU are accompanied by, for example, calculations of the
output gap, which aim to provide a picture of total capacity utilisation. The output gap is the
difference between current production and the economy's long-term production capacity or potential
GDP. Like the NAIRU, the latter equilibrium level is not directly observable and therefore has to be
estimated with statistical methods. The equilibrium level of output and the NAIRU evidently have
points in common. The situation in the labour market must be a central aspect of any assessment of
total capacity utilisation.
Unemployment and output gaps
Per cent
6 6
Unemployment gap
4 4
2 2
0 0
-2 -2
-4 -4
Output gap
-6 -6
-8 -8
1980 1982 1984 1986 1988 1990 1992 1994 1996 1998
Source: The Riksbank
While good forecasts of inflation can be made without knowing the exact levels of potential GDP and
the NAIRU, for those of us who conduct monetary policy it is naturally a problem that it is difficult to
tell just how much employment can rise without entailing a risk of a renewed acceleration of wages
and inflation. But that is no reason for believing that the functioning of the labour market and wage
formation will not be of central importance for future inflation. This brings me to the current situation
in the labour market.
The current situation in the labour market
The Riksbank's view of the Swedish economy in the coming years is comparatively optimistic. With
the low interest rates and some recovery in international economic activity, GDP growth is judged to
be 2.5 per cent this year and 3 per cent in both 2000 and 2001. As I mentioned earlier, this will
presumably involve the gradual utilisation of the resources that are unutilised at present.
Forecast underlying inflation
(UND1X)
Percentage 12-month change
4 4
3 3
2 2
1 1
0 0
-1 -1
-2 -2
95 96 97 98 99 00 01
Sources: Statistics Sweden and the Riksbank
Increased employment is also foreseen and in the June Inflation Report we counted on a reduction of
unemployment to below 5 per cent in two years time. Against this background, in the period 1999-
2001 the average annual rate of wage increases is judged to be 3.5-4 per cent. That seems to be
consistent with a forecast annual rate of productivity growth of 1.5-2 percent and the same order of
inflation expectations among the labour market organisations.
I should perhaps underscore that this is a forecast, not a desired rate of wage increases. A lower
nominal wage rise would create better conditions for a quicker increase in employment.
How wages actually develop and the consequences of this for inflation and monetary policy will
depend in large measure on how the labour market turns out to function in the coming upward phase.
The Riksbank will be keeping a watchful eye on the available indicators. The estimates of the NAIRU
and the output gap suggest that inflationary pressure is rising and that in our forecast period the
economy will approach or even reach full capacity utilisation. But, as I emphasised earlier, it is not
only these indicators that we will be considering. All incoming statistics that contribute to the picture
of future inflationary pressure will be followed closely.
It should also be underscored that the outcome is not inevitable. An influence can be exerted with
economic policy. I spoke earlier of how budget measures in the form of taxes as well as expenditures
can modify the workings of the labour market and the economy in general. As regards the labour
market and wage formation, there are many other things to do, for instance in labour market policy,
the rules and implementation of unemployment support, the rules that influence wage formation and
so on.
Concluding remarks
In many respects, economic policy has produced good results in recent years. This applies not least to
the interaction of fiscal and monetary policy. Government debt has been reduced, interest rates have
fallen and economic growth has been good, and all this has been combined with low inflation.
Employment has been a problem; there are now clear signs of an improvement here, too.
One important explanation for the successful combination of high growth and low inflation in recent
years is that the crisis in the early 1990s brought capacity utilisation down to a low level. If economic
activity strengthens as expected, the situation may gradually change. Capacity utilisation is rising.
This presents policy with new challenges, with an increased risk of higher inflation.
It is desirable that the interaction of fiscal and monetary policy continues to function well. There are
strong reasons for adhering to the rules that have been established. An increase of 1 percentage point
in the level of interest rates weakens the budget balance by about SEK 10 billion. A continued
amortisation of the sizeable government debt will create much-needed room to manoeuvre in
economic policy. There will be more scope for stimulating increased demand in future slowdowns.
At the same time, tax cuts would clearly benefit the Swedish economy in the somewhat longer run.
But the cuts must then be concentrated to just those taxes that play a major part in the workings of the
economy, where changes can help to raise potential output. Together with other measures that
improve wage formation and the functioning of the labour market, such tax adjustments could lead to
the creation of new jobs without an acceleration of inflation. The more steps that can be taken in this
direction, the better will be the conditions for a continuation of a good economic development in
Sweden.
This BIS Review is available on the BIS website at www.bis.org.