Stefan Ingves: Monetary policy and financial stability - some future
challenges
Speech by Mr Stefan Ingves, Governor of the Sveriges Riksbank, to the Swedish Economics
Association, Stockholm, 17 May 2010.
* * *
Every once in a while, developments take a course that turns old truths on their heads and
forces new solutions. This is what happened in Sweden in conjunction with the economic
crisis at the start of the 1990s, when the policy of a fixed exchange rate reached the end of
the road. At that point, we were lucky enough to be able to change track and become one of
the very first countries to start to apply an innovation in the field of monetary policy - inflation
targeting.
In much the same way, the financial crisis, not yet a completely closed chapter, has come to
function as a catalyst for reassessment and renewal - not just at home this time, but also on
an international level. The spotlight has primarily been focused on the work of maintaining
financial stability - but the crisis has also raised the issue of whether there may be lessons to
be learned for monetary policy too.
Today, I plan to discuss some of the challenges that I believe central banks will face in the
future. These challenges exist both in the work on financial stability and in the field of
monetary policy - and in the borderland between the two. Indeed, developments in recent
years have demonstrated that monetary policy and financial stability, in many ways, are more
intimately connected than we may previously have imagined. One of the challenges I intend
to address today deals with the difficulty of assessing the effects on potential output and
growth of the financial crisis and the regulations following in its wake. Another challenge
concerns the impact of these regulations on monetary policy's transmission mechanism.
Finally, I will also discuss the possibility of preventing a credit-driven property boom.
One highly current and significant challenge is that of preventing the central government
finance problems primarily facing Greece, but also a number of other countries, from leading
to new problems on the financial markets. The solution to this must primarily be sought on
the international political level. This is a matter both of implementing measures to maintain
confidence and of solving the most acute problems. The comprehensive support package for
countries with serious budget problems, recently presented by the EU countries and
International Monetary Fund, should be considered one such measure. Of course, a more
lasting solution will also require the problem to be tackled at its root - for the regulatory
framework for central government finances to be reviewed so that similar situations can be
avoided in the future. Discussions on how best to do this have also been initiated. Hopefully,
this will be enough to restore calm and for the process of recovery and normalisation
following the financial crisis to continue. I do not intend to say much more about the unfolding
situation other than that we are naturally following developments very carefully and, as
always, are prepared to act to safeguard financial stability, should such action be necessary.
Allow me, therefore, to return to the more general discussion I had originally intended to hold.
However, before proceeding further, I would like to point out that the thoughts I present here
are my own. My colleagues on the Executive Board do not necessarily analyse matters in
completely the same manner as I do. I would also like to emphasise that my ambition is to
illustrate different ideas in an intuitive manner, without attempting to propose any
cut-anddried solutions.
Monetary policy has developed
Let me start by looking back on how monetary policy has developed in Sweden and other
countries over the last fifteen to twenty years. As I have already mentioned, we were one of
the first central banks to introduce inflation targeting. When we started in 1993, our only
forerunners were the central banks of New Zealand, Canada and the United Kingdom.
Today, inflation targeting is applied in approximately twenty-five countries.1 Furthermore,
many other central banks have adopted essential elements of inflation targeting, such as
setting price stability as the overriding goal, basing the policy on forward assessments and
publishing regular reports to provide relatively comprehensive explanations of the reasoning
used.
Also within the framework of inflation targeting, the manner in which monetary policy has
been conducted has seen some development over the years as experience and knowledge
have increased. For quite a long period of time, monetary policy in Sweden took guidance
from a rule reading approximately as follows:
"If the forecast for inflation two years ahead exceeds the inflation target - raise the repo rate.
If the forecast falls below the target - decrease the repo rate." (Figure 1).
Figure 1
A simple rule of action
Inflation Inflation Repo Repo rate rate
2 2
r r
2 2 yrs yrs
This simple rule had a number of advantages, above all in the communication of monetary
policy decisions. For example, it clearly indicated that inflation was the overriding goal and
that monetary policy had to be forward-looking. These were important points to make when
the inflation-targeting regime was new. However, in many ways, this presented an
excessively simplified view of monetary policy. One weakness was that the forecasts for
inflation and the other variables were based on the assumption that the repo rate would be
held unchanged for the entire forecast period. This assumption was often quite unrealistic,
for example during a strong economic upturn with rising inflation, when an increase in the
repo rate was widely expected. Consequently, it could be difficult to reconcile this
assumption of an unchanged repo rate with credible and consistent forecasts.2
Today, our reasoning is somewhat different. We attempt to determine a forecast path for the
future repo rate that entails that monetary policy is, as we often put it, well-balanced. A
wellbalanced monetary policy is normally a matter of finding an appropriate balance between
stabilising inflation around the inflation target and stabilising the real economy, that is to say,
production and employment. One way of illustrating this balance is to say that the deviations
arising during the forecast period between, on one hand, inflation and the inflation target,
and, on the other, the real economy and a trend, may not become altogether too great
(Figure 2). As a measure of deviations in the real economy, the output gap is often used -
that is to say, the difference between actual production and the economy's long-term
production capacity or potential output.
Figure 2
Well-balanced monetary policy
Repo Repo rate rate Inflation Inflation Output gap
That the Riksbank does not only care about inflation, but also about the real economy, is
nothing new. We have done so more or less right from the very start, even if, when the
inflation-targeting regime was new, there was particular reason to emphasise that low and
stable inflation should be prioritised. However, in the present framework, the considerations
that we actually make as regards both inflation and the real economy have become more
apparent.
However, a number of problems still remain. For example, it is not obvious which measure of
the real economy monetary policy is to stabilise nor how best to calculate the trend to be
stabilised around. Quite different estimates can be made, not only in terms of the present
and the future, but also of past events (Figure 3). However, it remains clear that intellectual
progress has been made and that developments have moved forwards.
So far, relatively few central banks have gone so far as to publish forecasts of their policy
rates, as the Riksbank does. But it is clear that the manner in which monetary policy is
conducted has developed in most parts of the world and is presently more open and clear
than was the case fifteen to twenty years ago.
Different measures of resource utilisation
Per cent
6 6
4 4
2 2
0 0
-2 -2
-4 -4
The Riksbank, April -10
NIER, March -10
-6 -6
European Commission, May -09
OECD, November -09
-8 -8
IMF, April -10
Ministry of Finance, April -10
-10 -10
00 02 04 06 08 10 12 14
Monetary policy has contributed to increased macroeconomic stability
The trend towards inflation targeting, or policies resembling inflation targeting, and increased
openness and clarity has had positive results. In Sweden and other countries affected by
high and fluctuating inflation during the 1970s and 1980s, inflation has become lower and
more stable. Similarly, inflation expectations have been significantly better anchored than
before (Figure 4). In these cases, I believe that countries with explicit, quantified inflation
targets have had a particular advantage. These days, actual inflation can differ quite
considerably from the inflation target, for example due to temporary increases in energy
prices, without households and companies finding it particularly alarming. They rely on the
Riksbank to return inflation to target within a couple of years.
Inflation and inflation expectations
Annual percentage change
16 16
CPI
14 14
Historical mean
12 12
10 10
1993-2010
8 8
Mean 1,5
Std dev 1,4
6 6
4 4
1971-1992
Mean 8,3
Std dev 3,0
2 2
0 0
-2 -2
71 74 77 80 83 86 89 92 95 98 01 04 07 10
5 5
CPI
Inflation expectations
4 4
3 3
2 2
1 1
0 0
-1 -1
-2 -2
94 96 98 00 02 04 06 08 10 12 14
Note. Inflation expectations refer to money market participants.
Sources: TNS SIFO Prospera, Statistics Sweden and the Riksbank
More or less at the same time as inflation decreased and started fluctuating less, growth also
became more stable. This increased macroeconomic stability was a more or less worldwide
phenomenon, being generally known as "The Great Moderation". There exist various
hypotheses on what may lie behind this increased stability. One of them is that monetary
policy had started to be conducted in an improved manner, in which an emphasis on low and
stable inflation allowed inflation expectations to be better anchored. If actual and expected
inflation vary less, this will entail fewer variations in real interest rates and real exchange
rates. This may, in turn, allow for the more stable development of demand and, thereby, the
real economy. Well-anchored inflation expectations also make it easier for monetary policy to
stabilise the economy. Unless households and companies immediately adjust their inflation
expectations upwards, a minor increase in the interest rate will be enough to prevent an
inflationary impulse from becoming entrenched. And when substantial interest rate changes
become less necessary, fluctuations in the real economy become less extensive than when
inflation expectations are poorly anchored. One way of putting it is that well-anchored
inflation expectations make it easier for central banks to take consideration of the real
economy.
For Sweden's part, one important explanation for the increased macroeconomic stability is
probably also that inflation targeting - together with a more long-term focus for fiscal policy -
spelled the end of the uneven "stop-go" policy entailed by the many devaluations of the
1970s and 1980s. Quite simply, the stabilisation policy has shown more orderliness.
To sum up, the manner in which monetary policy is conducted across the world has thus
changed quite extensively in the last fifteen to twenty years. Within both the central bank
world and among academic researchers, a great deal of effort has been expended upon
attempting to find a solution for how monetary policy best should be formulated. These
efforts have also borne fruit. In most areas, inflation has fallen significantly and has been
more stable than previously. The real economy also seemed to be developing with more
stability, which was probably partly due to the fact that the policy was being conducted in a
better reasoned manner than previously. There may be those who believed that most
problems had been solved, and that the improved stability of the macroeconomy was here to
stay. But the Great Moderation would turn out to be a deceptive calm.
But an improved monetary policy was not enough
The recent period has seen frequent discussion of the financial crisis and its causes, to put it
mildly. Consequently, I do not intend to go into any detailed description of the development of
the crisis, but will remain on a relatively intuitive level. The origin of the financial crisis lay in a
number of interacting macroeconomic and microeconomic factors. However, the core of the
crisis was that the banks and other participants took on too much debt in relation to the risks
they were taking. Shortcomings in the regulatory framework, combined with a lack of
understanding of new complex financial instruments, contributed towards the altogether too
low pricing of risk by the market. Regulatory frameworks and supervision also failed to
ensure that the banks had enough high-quality capital to maintain confidence when the
economy took a downward turn and inflated asset values fell. Neither did the banks have a
sufficient liquidity buffer to manage their short-term funding in an environment in which
confidence in banks in general was being questioned and previously liquid assets were
suddenly becoming illiquid. The banks, quite simply, lacked sufficient resilience. When
Lehman Brothers filed for bankruptcy in the autumn of 2008, an acute crisis of confidence
arose in the financial system. Only massive efforts from central banks and authorities across
the world could prevent a collapse.
Paradoxically enough, the fairly long period of macroeconomic stability preceding the
financial crisis may partially have contributed towards making the crisis as deep as it
became. When things have gone well for a long period of time it is probably human nature to
relax and become slightly less cautious. Without oversimplifying matters, I think it could be
said that this was something that characterised not only investors and financial institutions
but also supervisory authorities and political decision-makers during this period.
Even if the financial crisis has triggered a new wave of thinking regarding the central banks
and their activities, I would like to point out that in no way do I consider that the development
of monetary policy over the last fifteen to twenty years has been misguided or a waste of
time. On the contrary, I am convinced that the policy that gradually developed will continue to
contribute towards more stable development in the future. Even so, it is clear that the
financial crisis functioned as a wake-up call in many ways. It showed that there existed areas
in which we needed to think further or maybe even revitalise old knowledge. Not least, it
made it apparent that, while central banks had become more adept at handling normal
shocks to demand and supply, there remained a great deal to be learned regarding the
manner in which imbalances on the financial markets ought to be handled.
So what consequences can we expect the crisis to have for central banks' method of working
in the future? Is there reason to supplement current monetary policy reasoning - and, if so,
how? A large part of what I will address here today consists of matters that are currently the
subject of intensive international discussion. The final result of these discussions remains to
be seen. Nonetheless, let me think aloud on the manner in which central banks' work may be
affected and on the challenges we will face.
Effects on potential output and growth?
One challenge concerns attempting to assess the manner in which the crisis will affect the
economy's long-term production capacity or potential output. This is significant for several
reasons. Firstly, the deviation between actual and potential output, the output gap, is a
measure of the stability of the real economy. Secondly, the output gap can affect the manner
in which inflation develops. If the production of an economy exceeds its long-term production
capacity (that is to say, if the output gap is positive), this tends to exert upwards pressure on
inflation. The opposite applies if the output gap is negative. For a central bank with a price
stability target, it is thus useful to have a good idea of the long-term production capacity. If,
for example, it is believed to be higher than is actually the case, an excessively loose policy
may be being conducted, in the belief that there are spare resources in the economy. This
may cause inflation to rise. One hypothesis about why inflation in the United States
increased so much during the 1970s is indeed that the Federal Reserve believed that the
economy's long-term production capacity was higher than was actually the case.3
To a certain extent, this is a "traditional" challenge in the sense that, after each deep
recession, it must be asked whether potential output may have fallen and, if so, by how
much. Potential output may fall as a consequence of permanent loss of real capital when
companies are forced into liquidation or when dismissed personnel have difficulty in finding
new work when economic activity turns upwards again. Following the crisis at the start of the
1990s, assessments of this nature were a central feature of forecasting work. Of course,
estimating the extent of the output gap is no easy task. As I have already mentioned, it is
possible to arrive at fairly disparate estimates even under normal circumstances when there
is no reason to suspect a fall in potential output.
Looking forward, another aspect also exists that may be more specific to this crisis in
particular. One consequence of the financial crisis is that, in the future, we will see more
regulation of banks and the financial sector in general. The fundamental aim of these
regulations is, of course, to reduce the likelihood and effects of crises of the type we have
just experienced. These increased requirements will probably lead to increased prices for
financial services, slightly higher lending rates to households and companies, and a slightly
lower credit supply. One way of putting it could be that these costs are a kind of insurance
premium that society is willing to pay to avoid financial crises or to considerably reduce the
risk of them.
However, at the same time, it should be borne in mind that these regulations could impact
the economy's potential output and growth. If the regulations are too far-reaching, they may
have a negative impact on the efficiency and growth potential of the financial sector. It is true
that the significance for growth of the financial sector is not entirely clear, but the possibility
that an "over-regulated" financial sector could contribute to lower potential growth in the
economy as a whole can hardly be ruled out.
For central banks and other economic forecasters, the challenge will be to attempt to make
the best assessment possible of the manner in which potential output and growth may be
impacted by both the crisis and the regulations resulting from it. For the authorities that are to
design the regulations, the challenge will lie in finding an appropriate balance: on one hand,
the regulations will need to be sufficient to reduce the risk of financial crises - which can
cause potential output to fall. However, on the other hand, they should not be so
comprehensive as to impede the financial sector unnecessarily, thus risking dampening
potential growth. In other words, it is a matter of finding just the right level of regulation.
Figure 5
Potential output with and without crises
Potential output
Without regulations, with crises
With regulations, without crises
Time
Somewhat simplified, it could be said that this is a matter of making a choice between two
development paths for potential output (Figure 5). In one, development is interrupted now
and again by crises, during which potential output falls, but between these, growth is
relatively strong. In the other, development is even, but growth may be slightly lower than is
the case between crises in the first development path. It is not obvious which development
provides the best welfare effects over the long term, but it is clear that general opinion at
present is that we should attempt to reduce the risk of crises and abrupt halts. I am quite
certain that most observers deem that this would also provide better growth over the long
term.
How will regulation affect monetary policy's transmission mechanism?
Another consequence of the regulation agenda is that what is usually known as monetary
policy's transmission mechanism may look slightly different in the future. More specifically,
the connection between the central banks' policy rates and the interest rates affecting
households and companies may change.
A stable transmission mechanism is usually an underlying assumption in economic models.
This is probably a fairly good approximation under normal circumstances, but, during the
crisis, it became necessary to reassess this assumption. The impact of monetary policy was
affected by a decline in willingness to take risks and the impaired functioning of the interbank
markets (Figure 6).
Figure 6
Difference between interbank rates and government bond rates (TED spread)
Basis points
500 500
Sweden
450 450
Euro area
USA
400 400
United Kingdom
350 350
300 300
250 250
200 200
150 150
100 100
50 50
0 0
Jan07 Apr07 Jul07 Oct07 Jan08 Apr08 Jul08 Oct08 Jan09 Apr09 Jul09 Oct09 Jan10 Apr10
Note. The difference is calculated as the difference between three-month interbank rate
and the rate on a three-month treasury bill.
Sources: Reuters EcoWin and the Riksbank
A simplified illustration of this can be provided by describing the banks' lending rate as a
function of the central bank's policy rate plus an interest rate margin or spread:
 
i i .
tlending t t
The interest rate margin ( ) is a function of the compensation taken by the banks for
t
administrative costs and capital costs, risk premiums, the banks' profit margins, and
loan-tovalue and amortisation requirements. Loan-to-value and amortisation requirements are not
directly visible in the interest rate applied to the customer, but, in order to illustrate their
effects on an aggregated level, these can be recalculated in terms of interest relatively
simply.
When risk propensity fell during the financial crisis, the interest rate margin increased as a
consequence of both higher risk premiums and lower loan-to-value ratios. This counteracted
the cut in the policy rate. When central banks and governments subsequently adopted
various measures to increase confidence on the markets, risk premiums fell in a similar way.
The lending rate thus fell without a change in the policy rate being required.
Now, it is not only during a crisis that there exists reason to consider the financial sector's
significance for the transmission mechanism. As I have just discussed, one of the
consequences of a crisis is that the regulations of banks and other institutions will become
more stringent. The intention of this is to reduce the socioeconomic costs that can result from
banking. However, there is also reason to consider how the regulations introduced could
affect the impact of monetary policy.
These regulations usually entail an increased cost for the banks which, to a certain extent, is
passed along to customers in the form of an increased interest rate margin. This could be
seen as a sort of "regulation premium". This premium can also be seen as the price to be
paid by households and companies for more stable real economic development as
represented by the broken curve in Figure 5. This concept can be illustrated with the
equation for the lending rate by adding a variable ( z ) designating regulations affecting the
interest rate margin:
 
i i (z) .
tlending t t
I would like to emphasise that this equation is, of course, a simplification. However, as my
focus today is on the correlation of interest rates and regulations, this description will be
facilitated by viewing regulations as a kind of "shadow interest rate", even if they can also be
analysed in terms of the supply of credit. If regulations become more stringent, the interest
rate margin and thus the lending rate both increase.
New regulations will not be introduced until we have emerged completely from the crisis, and
they will be introduced successively. The end result will probably be a higher interest rate
margin than was the case prior to the introduction of the regulations. In principle, this can be
seen as a "one-off shift" upwards in the interest rate margin. Adjustment to this higher level
may be more or less protracted, depending on the rate at which the regulations are
implemented and the degree towards which they are expected by the market. During this
period of adjustment, the transmission mechanism will be affected.
One criticism of the regulatory framework and supervision of the financial area was that, prior
to the crisis, these focused excessively upon individual institutions. The assumption was that
the system would remain stable as long as the individual institutions were stable.
Consequently, processes creating risks on the system level were ignored - processes such
as a general underpricing of risk, the increased element of short-term market funding and the
increasingly intimate connections between various market participants. One of the
components in macroprudential policy, the package of more explicit systemic crisis
preventative regulations being discussed internationally, is the more active application of
regulations to dampen risk-building tendencies and build buffers when times are good. One
specific proposal is to allow the capital requirement for the banks to vary over time. This
would entail a division of the total capital requirement into two components. The first of these
would be a constant minimum requirement to establish the amount of capital a bank is
always to hold. To this can be added a further capital requirement that varies over time by
being linked to a suitable indicator of, for example, credit growth or cyclical position of the
economy (Figure 7).
Figure 7
A time-varying capital requirement
Tier Tier 1 1
Countercyclical Countercyclical capital capital
Capital Capital
requirements requirements
Minimum Minimum
requirements requirements
time time
Upturn Upturn Downturn Downturn
When economic activity is strong, the capital requirement is high, and vice versa. This
timevarying capital requirement has two functions. The first is to build up the bank's capital buffer
when times are good and then let this buffer decrease during less favourable periods. The
second function is to dampen credit growth when times are good by increasing the capital
requirement and thereby the bank's lending costs. This increase in the bank's lending costs
in turn implies an increase in the interest rate margin - and thus the lending rate.
In light of the discussion of "just the right level of regulation", a time-varying capital
requirement and other regulations varying across time may have certain advantages. Their
more apparent connection with risk build-up may make them less costly than the alternative
of introducing a constant higher "minimum requirement".
One objective of varying regulations across time is to affect credit growth through the interest
rate margin. This creates an additional source of variation in the interest rate margin, which
can be illustrated in the lending rate equation by adding an additional time index for the
regulations:
i  i  z .
tlending t t( t)
An interest rate margin with time-varying regulations also implies another dynamic for the
transmission mechanism and is more complicated than a one-off shift. Of course, this will
have implications for monetary policy decision-making, which will become more complex.
The application of time-varying regulations may also give rise to a more indirect effect on the
interest rate margin. Just as uncertainty about the future policy rate gives rise to a risk
premium, so can uncertainty about the manner in which regulation will develop give rise to an
additional "regulation risk premium". It is already possible to see that the uncertainty
prevailing around the proposed tightening of the capital and liquidity regulations - which are
not intended to vary over time - is affecting both interest rate margins and the supply of
credit.
One way of increasing predictability would be to adjust the regulations automatically,
according to a specific rule, as, for example, is the case with the dynamic provisioning used
in Spain.4 However, I do not consider it practically feasible to rely entirely upon automatic
decision-making rules. Uncertainty surrounding the manner in which regulations may change
over time will thus always remain. However, it may be possible to learn lessons from the
experiences of monetary policy in order to reduce this regulation risk premium. Even if
monetary policy is essentially conducted in a discretionary manner, economic agents
frequently have a fairly good idea of the way in which the interest rate will change. Naturally,
I would like to believe that this is due to the present openness and clarity of monetary policy.
Hopefully, it will be possible to achieve an equivalent level of openness and clarity in the
matter of time-varying regulations. One possibility could be to develop some kind of rule of
action based on assessments regarding, for example, credit growth. Such a rule would thus
provide information on whether the "regulatory controls" needed to be shifted upwards or
downwards.
Inspired by the Taylor rule that is well-known within monetary policy, the arguments in the
regulation could be formed of the non-time varying regulations ( z ), a measure of actual
credit volume in relation to a level deemed sustainable over the long l l , and the
term t t
output gap:
z  zzl ,  l , y  y .
 ,...
t t t t t
I would like to emphasise that this is intended as an illustration of a so-far quite loose
conception, rather than a concrete proposal. However, it is a useful illustration, not least
because it indicates the comprehensive development work that will be required before
anything practically applicable can result. Nonetheless, I believe there are good conditions
for development work within this area to result in equally healthy returns as the efforts
expended upon developing monetary policy over the last fifteen to twenty years.
The application of time-varying regulations also raises the issue of what would be an
appropriate form of institutional organisation. Different countries have chosen different
solutions as regards the allocation of responsibility. One common feature is for the central
bank frequently to have a certain responsibility for financial stability via its role as lender of
last resort. In certain countries, the central bank also has responsibility for supervision and
the application of regulations. Meanwhile, in other countries, such as Sweden, responsibility
for regulatory and supervisory matters is placed with a separate supervisory authority. This
means that, in Sweden, it is the Riksbank that controls the policy rate and the Swedish
Financial Supervisory Authority, Finansinspektionen, that controls regulations.
For some time, a discussion has taken place on the international level regarding the role
central banks should play in matters of supervision and the application of rules. Ideas
regarding the application of more time-varying regulations are adding fresh fuel to this
debate. Utilising the expression for the rule of action above in the equation for the lending
rate allows different institutional arrangements to be illustrated. In the previous equation for
the lending rate, the regulations were described as a time-varying variable. However, with a
rule of action, the application of regulations itself becomes a function of a number of
variables that vary over time:
i  i  ((,, zzly ,...)) .
tlending t t t t
Various institutional arrangements can be imagined, based on the distribution of
responsibility for assessing the variables in the function, determining rules of action or
functional form and, finally, for translating the function into actual regulations. The latter
would probably require an element of discretionary decision-making. One possibility would
be for the central bank to determine the policy rate ( ) and for the supervisory authority to
ti
determine regulations, that is to say both z and z (...) , as is the case in Sweden. Another
possibility would be for the central bank not only to determine the policy rate, but also to
determine the time-varying regula