Martin Flodén: The low inflation - should we be worried and can we do
anything about it?
Speech by Mr Martin Flodén, Deputy Governor of the Sveriges Riksbank, at SACO (the
Swedish Confederation of Professional Associations), Stockholm, 14 May 2014.
* * *
Thank you to Björn Andersson, Charlotta Edler, Gabriela Guibourg, Kerstin Hallsten, Marianne Sterner, Christina
Nyman, Stefan Palmqvist, Ulf Söderström and other employees at the Riksbank for valuable discussions and
views on earlier versions of the text, and to André Reslow for help with data production. The views expressed in
this speech are my own and are not necessarily shared by the other members of the Executive Board of the
Riksbank.
Those of you who follow the debate on monetary policy will probably not be surprised that
the theme of my speech today is the low rate of inflation. This is the most important question
for monetary policy right now. Over the past year, I have emphasised the importance of
ensuring that inflation does not get stuck far below the target of two per cent and said that
monetary policy therefore needs to focus on avoiding such a situation. Consequently, I
entered a reservation against holding the Riksbank's policy rate unchanged at the most
recent monetary policy meeting in early April. Instead, I was in favour of a repo rate cut of
0.25 percentage points.
Today I intend to focus on two issues. First, I wish to explain why I am worried by the low
inflation rate. The reasons I will take up concern wage formation, the credibility of monetary
policy, a too high real interest rate, and arbitrary reallocation from borrowers to lenders. I
consider these to be serious problems. But at the same time I find some of the recent
discussion on the problems with deflation - falling prices - to be exaggerated and focused on
the wrong risks.
Second, I wish to discuss the ability of monetary policy to prevent inflation from falling too
low. Sweden is a small open economy and is affected to a great extent by international
developments. This fact sometimes causes commentators to question rather resignedly
whether the Riksbank can actually influence inflation. I consider this attitude to be wrong.
Monetary policy determines how high average inflation will be. Having said this, I am not
claiming that we can control inflation with precision. Monetary policy can prevent inflation
from falling way below the target over a long period of time. It is, however, neither desirable
nor possible for monetary policy to continuously hold inflation stable very close to the inflation
target of 2 per cent.
But let me start by commenting on where we are coming from and the current situation.
Inflation has been on average 1 per cent in Sweden for the past three years, when measured
in terms of the CPIF.1 The Riksbank and other analysts have had forecasts that have shown
that inflation would be low over a relatively long period of time, but that it would gradually
rise. However, the timing of the rise has been repeatedly postponed in our forecasts and
inflation has instead fallen. I will provide some perspective on why this has happened and
discuss various factors that might explain this development.
Low inflation in Sweden early on, but now also a global phenomenon
Sweden is not the only country where inflation is currently low. Around half of all the OECD
countries have had an inflation rate that has on average been below 2 per cent during the
past two years. The trend also appears to be strengthening. During last year, inflation was
below 2 per cent for around two out of three OECD countries. Of course, not all of these
countries have an inflation target that is 2 per cent and in the countries which have an
inflation target, this may be formulated in different ways. It is nevertheless clear that many
central banks, in addition to the Riksbank, are currently undershooting their targets.
However, inflation fell several years earlier in Sweden than in other countries, and Sweden is
one of the OECD countries that has had the lowest inflation in recent years (see Figure 1).
This is despite the fact that growth has been higher and the employment rate has not fallen
as much as in many other countries. This applies regardless of whether one measures
Swedish inflation in terms of the CPI, the CPIF or the internationally harmonised HICP.2
Inflation in several of the crisis-torn countries in Europe has been pushed up by the
increases in indirect taxes implemented to improve public finances. And this explains some
of the difference with regard to inflation in Sweden. But even taking this into account, it is
clear that inflation has been more subdued in Sweden than in Europe in general since 2011
(see Figure 2).
The fall in inflation is broad
A closer examination of developments in Sweden shows that the fall in inflation is broad and
not caused by any individual component. We have already noted that inflation measured in
terms of the CPI, the CPIF and the HICP is low, compared with both the inflation target and
other countries. This also applies to measures of underlying inflation, that is, measures
where one tries by various means to take into account that some prices vary a lot and may
temporarily influence the CPI.3 Regardless of which measure one looks at, it is clear that
underlying inflation has shown a falling trend since 2012 or earlier.
Price developments for sub-groups behind the CPI measures show a similar picture (see
Figure 3).4,5 Over the past two years, goods prices have fallen somewhat faster than normal.
Prices of services have increased more slowly since the beginning of last year. This
3
See Figure A1 in the appendix. Trim85 is a measure that excludes the prices that have varied most and least.
UND24 is a measure that weighs together the prices included in the CPI in a different way - the prices that
have varied the most in historical terms are given the lowest weighting, and vice versa.
4
Please note that there has not been time to update the figures I show here with the inflation outcome for April
published by Statistics Sweden yesterday. CPI inflation then rose to 0 per cent, that is, prices in April were
unchanged in relation to April 2013.
5
Normally, one divides the CPI into prices of energy, foods, goods (excluding energy and foods), services and
interest expenditure. One reason for this particular division is that energy and food prices met by consumers
are to a large degree influenced by developments in commodity prices on the global market. It may thus be
interesting to study the sub-groups separately. The component in the CPI that measures interest expenditures
is also special, as it is affected by the Riksbank's changes in the repo rate. It is for this reason that, in addition
to the CPI, the Riksbank also looks at the CPIF measure, in which interest rates are fixed and not allowed to
vary. Figures A2 and A3 in the appendix show the developments in prices in recent years for goods, services,
energy and foods.
development has generated some attention, as the rate of increase in service prices was
relatively stable during the years prior to this. Energy prices are volatile but usually increase
faster than the inflation rate, but they have been unusually stable during the past two years.
Finally, we have interest expenditure, which has pushed down CPI inflation via lower
mortgage rates.
Why is inflation low?
Our examination of developments in prices for the sub-groups behind the CPI measures
shows that the fall in inflation is broad and not due to any individual component.
It is also difficult to point to any individual factor that has led to inflation in Sweden being low.
It has rather been a combination of factors. One important factor that can hardly be
disregarded is monetary policy. The repo rate has been held higher due to consideration of
risks linked to household indebtedness than it would have been if the aim was solely to
stabilise inflation around the target. It was after the Riksbank began to raise the repo rate in
summer 2010 that inflation in Sweden - unlike inflation in other countries - began to fall (see
Figures 2 and 4). The monetary policy strategy has most likely contributed to inflation being
lower than it would otherwise have been.
Another important explanation for the low inflation is the weak international economic
development. Sweden is a small open economy that is affected by international
developments. The prices of the goods Swedish companies import are affected partly by
global market prices of traded goods and services and partly by the exchange rate.6
Global market prices appear to follow international economic developments relatively well.
Like global GDP, prices of traded goods and services fell in connection with the financial
crisis in 2008. When the international recovery began in 2010, these prices also began to
rise. However, in recent years, global economic activity has slowed down again and at the
same time the rate of increase in global market prices of traded goods and services has
fallen. Over the past year, these prices have remained in principle unchanged.
The prices Swedish companies pay in SEK for imports are also affected by the krona
exchange rate. The krona weakened substantially against other currencies in connection with
the financial crisis, which meant that import prices for consumer goods in the producer
channel actually increased quite substantially when measured in Swedish krona, despite the
fall in international prices. Import prices have been falling since the middle of 2012. One
contributory factor was the rapid strengthening of the krona in the summer of 2012. During
2013, the krona fluctuated somewhat, but on average it was stronger than in 2012. This,
together with the fact that global export prices have in principle remained unchanged, has
continued to dampen import prices although these are no longer falling to any great extent.7
Sometimes the impact of developments in international economic activity and prices on
domestic inflation is regarded as unrelated to monetary policy in Sweden. I consider this to
be a mistaken point of view. But before I return to this question, I would like to explain why I
am worried about inflation being so low.
Why should we worry about low inflation?
We have thus noted that inflation has been below the two per cent target in recent years, and
also lower than the Riksbank and other analysts had expected. But is the low inflation really
something we need to worry about? My answer is yes. I shall explain why.
Surprisingly low inflation leads to arbitrary reallocation
Some of the problems with low inflation arise if inflation is surprisingly low. For example, this
leads to arbitrary reallocations from borrowers to lenders. The real cost of a loan, that is, the
interest cost adjusted for inflation, becomes higher if inflation is surprisingly low. Another way
of describing this so-called debt deflation is that surprisingly low inflation means that the real
value of debts rises. It then becomes more difficult for borrowers to pay off their debts, at
least unless their real incomes also rise.8
One can expect that the problems will be particularly extensive if inflation is surprisingly low
during an economic downturn that coincides with high private or public debt. This is because
those who try to reduce their debt do so by reducing their expenditure, which means that
demand in the economy declines.9 And this reinforces the economic downturn.
We are not seeing such a scenario in Sweden right now. Although household debt is high,
economic activity is beginning to pick up and household consumption has developed
relatively well in recent years.10 The risk that many see with the high household indebtedness
is rather that a future economic downturn would be reinforced by households rapidly
reducing their consumption. A relevant question - without an obvious answer - is whether
such concern should be countered with a tight monetary policy that dampens households'
propensity to increase their nominal debts or with an expansionary monetary policy that
ensures inflation does not become surprisingly low. The idea behind the latter strategy is to
limit growth in households' real debts.11
The low inflation could thus worsen the situation for households with a high level of
indebtedness. But even if we disregard the problems of debt deflation, it is a problem if
inflation fluctuates in an unexpected manner. A stable and predictable development in prices
gives a better functioning economy, where it is simpler to make well-founded long-term
economic decisions.
Wage formation deteriorates when inflation is too low
Another area where problems may arise if inflation is too low is wage formation. Surprisingly
low inflation means that real wages eventually prove to have become higher than was
planned when the nominal wage agreements were signed. This sort of wage development
would make companies less willing to employ and would ultimately contribute to higher
unemployment.12
8
The reasoning on debt deflation goes back to Fisher (1933).
9
Of course, every debt is someone else's asset, so one might perhaps think that the fall in demand should be
compensated by increased demand from the lenders who benefit from the increase in real debt values. But
assets can be held abroad or be concentrated to a few individuals whose demand is not particularly sensitive
to changes in wealth. See Eggertsson and Krugman (2012) for an analysis of these mechanisms.
10
In the crisis countries in the euro area, on the other hand, high debt is a central element in the economic
downturn. As Moghadam et al. (2014) note, there is a significant risk that low inflation in these countries may
lead to an increase in the debt burden and to a deeper economic downturn.
11
Lars E.O. Svensson has argued in favour of this point of view in several papers and commentaries (for
example Svensson 2013a).
12
It is difficult to quantify how much higher unemployment becomes when inflation is low. According to
Svensson (2013b), unemployment was on average 0.8 percentage points higher during 1997-2011 than it
But wage formation will probably deteriorate even if the low inflation is entirely anticipated.
This is because it is difficult to reduce nominal wages. If inflation is low, it will be more difficult
to adjust real wages between different sectors and between the individuals in a company.
This could also mean that average real wages increase faster than is justified by the growth
in productivity, particularly if the rate of inflation is very low or negative. Both problems in
adjusting relative wages and unjustifiably high real wages would lead to a rise in
unemployment.
Repo rate has a lower bound
A low inflation rate can also make it difficult for monetary policy to be sufficiently
expansionary. The economy's real interest rate is comprised of the nominal interest rate
minus the (expected) inflation rate. As the nominal interest rate has a natural floor
somewhere around zero per cent, a lower (expected) inflation rate will raise the lowest level
that can be attained for the real interest rate. After the financial crisis, many central banks
have long been limited by the lower bound for their policy rates.13 The problem has, however,
not been as acute in Sweden. Although the repo rate was cut to 0.25 per cent in 2009, it has
been higher than this since summer 2010. The problem is rather that it may be desirable in
the future to stimulate the economy further, for instance, if the economic recovery comes to a
halt. The scope for further cuts in the repo rate may then be limited.
The credibility of the inflation target could be impaired
Finally, it is a problem if monetary policy and the Riksbank start to lose credibility. The value
of money in modern economies is entirely based on expectations. Firmly-anchored inflation
expectations and confidence in the central bank's actions therefore comprise the basis for
monetary policy. The inflation-targeting policy has successfully built up this credibility by
communicating a clear overall target - a particular inflation rate. It has also become possible
to gradually give greater consideration to the stability of economic activity as credibility has
accumulated, although the primary target has become somewhat less clear as a result of this
flexible inflation-targeting policy.
However, monetary policy can hardly maintain its credibility if the inflation rate deviates from
the target for too long. One question that has been discussed frequently in the wake of the
recent financial crisis is whether central banks should use their policy rates to try to mitigate
the credit cycle.14 Monetary policy could possibly contribute to this type of stabilisation for a
would have been if inflation had averaged two per cent during this period. And according to Svensson (2013c),
60,000 more people are now unemployed than if the repo rate had not been raised since 2010.
It hardly needs to be pointed out that such calculations are very uncertain. I have previously criticised
Svensson (2013b) for focusing on a specific measure of inflation expectations. If one instead uses a different,
more accurate, measure of expectations, almost all of the unemployment effect Svensson has calculated
disappears (Flodén, 2012). And Söderström and Vredin (2013) point to problems with interpreting causal
relationships behind Svensson's estimated Phillips curve.
The claim that unemployment would have been lower if a more expansionary monetary policy had been
conducted since 2010 appears more plausible, however. But one can find objections to this conclusion. First,
the reasoning presumes that a more expansionary monetary policy would not have caused the crisis scenario
that a majority of Executive Board members have expressed as a risk that justifies a higher repo rate (see the
article in Monetary Policy Report February 2014). Second, higher unemployment now can be counterbalanced
by lower unemployment in the future, as monetary policy can become more expansionary in the future when
inflation and inflation expectations today are low. The question is thus whether the low inflation affects the
average level of unemployment or merely the volatility of unemployment over the business cycle.
13
Examples are the US Federal Reserve, the Bank of England and the European Central Bank (ECB). The two
first-named banks have supplemented low policy rates with quantitative easing to try to make monetary policy
more expansionary.
14
See Smets (2013) for a review of various points of view on this question.
short time before other macroprudential policy measures are in place. But studies show that
typical credit cycles are much more protracted than normal business cycles.15 The status of
the inflation target would probably be questioned if monetary policy "leans against the wind"
- that is, results in an inflation rate below the target - for many years to dampen an
expanding credit cycle.
This reasoning becomes increasingly important the lower the inflation and policy rates are. If
inflation expectations fall, increasingly expansionary monetary policy will be required to bring
inflation back up to the target.16 And as the policy rate has a lower bound, it may be difficult
to make monetary policy sufficiently expansionary once this bound has been reached. One
conclusion from these insights may be that monetary policy should react asymmetrically
when inflation is low. Monetary policy should then counteract falling inflation particularly
strongly if there is a risk that the policy rate will otherwise reach its lower bound.17
But the danger of deflation should not be exaggerated
The low inflation in Sweden and the euro area has recently led to much discussion on the
risks of deflation, that is, a general fall in price levels.18 Although I am worried that Swedish
inflation has been too low for several years, I believe that the debate on deflation is
sometimes too foreboding and that it often focuses on the wrong risks.
To begin with, I do not see a lengthy period with falling prices as a likely scenario for
Sweden. Growth is relatively strong, which should contribute to a rise in prices. Moreover, we
have the scope to counteract falling prices with more expansionary monetary policy. The
repo rate can be cut by at least 50 basis points before the lower bound is reached. If this
were not enough, we could draw up other monetary policy measures that would contribute to
a rise in inflation.
Moreover, nothing dramatic will happen merely because inflation falls below zero and is
weakly negative rather than weakly positive. The problems of low inflation that I have listed
above gradually increase when inflation is lower and this will of course continue to apply
when inflation is negative. But the problem with prices falling is often said to be that demand
will then collapse as households are postponing consumption while waiting for prices to fall
so they can buy more cheaply.19 This reasoning is not necessarily wrong, but is really only a
reformulation of the problem I mentioned above; that low inflation limits the scope for making
monetary policy more expansionary. There is a risk that households will postpone their
consumption - that is, that they will increase their saving - if the real interest rate becomes
unjustifiably high. Here it is necessary to put price developments in relation to developments
in wages and the return on saving. There is therefore scarcely reason to believe that
anything dramatic will begin to happen just as the general rate of inflation becomes negative.
One should also remember that substantial differences are hidden in the price trends for
different product groups that lie behind the general rate of inflation. One example is
developments in prices for technology-intensive goods such as TVs, computers and mobile
15
According to Drehmann et al. (2012), an average financial cycle, in which the credit cycle is a central element,
is 16 years long. The length of an average business cycle is much shorter, perhaps five years.
16
Inflation expectations have fallen in recent years in the surveys conducted by the National Institute of
Economic Research and Prospera. Short-term expectations are now just below one per cent, but long-term
expectations are still close to the two per cent inflation target.
17
See the reasoning on this in Williams (2009) and Bayoumi et al. (2014).
18
See for example Krugman (2014) and Pettersson (2014).
19
Bordo and Filardo (2005) note that episodes of deflation have been common throughout history and often
been unproblematic. But they also note that these unproblematic episodes often occurred under the gold
standard regime and that long-term inflation expectations were then firmly anchored. Mechanisms that are
based on expectations of lower prices in the future then do not arise so easily.
phones. The price level for these goods has fallen fairly quickly, as a result of the rapid
productivity growth, even during periods when the general inflation rate has been clearly
positive (see Figure 5). But despite the falling prices, demand for these goods has not
collapsed, but rather increased over time.
To summarise, I am thus worried about the low inflation in Sweden in recent years. I see it as
particularly problematic that the low rate of inflation risks impairing wage formation and
contributing to unnecessarily high unemployment. There is also a risk that the credibility and
efficiency of monetary policy will deteriorate and that there will be arbitrary reallocations
between lenders and borrowers.
But, at the same time, I believe that some concerns and problems have been exaggerated in
the debate. I see it as a small risk that Sweden would suffer a prolonged period with falling
prices. And if this were nevertheless to happen, the consequences would probably only be a
gradual strengthening of the problems I already see with the current low inflation.
The risk that we would face a prolonged period of deflation is partly linked to the view of what
monetary policy can achieve. I sometimes see an overly pessimistic attitude to the
Riksbank's ability to influence Swedish inflation rate. Let me discuss this question in
conclusion.
Monetary policy determines the inflation rate
Central banks often talk about the so-called transmission mechanism, that is, how a change
in the policy rate affects different aspects of the economy and ultimately the rate of inflation.
But how well does this transmission actually work? Does a small open economy like Sweden
need to adapt to monetary policy and price trends abroad? Has the transmission mechanism
been damaged or weakened by the financial crisis?
My perspective on these questions is perhaps rather split. It is clear - and has been so for a
long time - that we do not completely understand how the transmission mechanism works.
The description we give is simplified and partly based on theories and hypotheses that have
not been completely verified by data. But at the same time, empirical studies and practical
experience show that the policy rate is a useful tool for influencing economic activity and the
inflation rate.
It is of course true that a small open economy like Sweden is dependent on developments
abroad. Low demand abroad contributes to low demand in Sweden, too. And low price
increases abroad contribute to low import prices at a given exchange rate. However, this
does not mean that monetary policy lacks the ability to counteract these developments. I
usually think of this as a rowing boat in a strong current. If we do not row, the current (global
developments) will determine what direction the boat moves in. But if we row, we have a
better ability to get where we want to go, particularly if we try to keep away from the parts of
the water where the current is strongest.
The monetary transmission mechanism is usually divided up into different channels (see
Figure 6).20 The channel most often mentioned is probably the interest rate channel. A lower
interest rate makes it more attractive to consume and invest. This increases demand in the
economy. And in the long run, the higher demand means that prices and wages rise, that is,
inflation increases.
In an economy like Sweden's, which is so dependent on international developments, the
exchange rate channel probably has greater importance, at least for the development of
inflation. An (unexpected) repo rate cut means that the krona weakens. The weaker krona
leads to an increase in demand for Swedish goods at the cost of foreign goods. In addition,
there is a direct inflation effect that arises when imports become more expensive as a result
of the weaker exchange rate.
The importance of the direct inflation effect is confirmed by empirical studies using Swedish
data (Hopkins et al., 2009); inflation in Sweden is affected almost immediately when the repo
rate is changed, and most of the inflation effect arises through the exchange rate channel.21
I note that in line with this reasoning, the krona strengthened after the Riksbank began
raising the repo rate in summer 2010. And, as I pointed out earlier, it was after these
reporate increases that inflation in Sweden - unlike other parts of the world - began to fall.
Short-term inflation expectations are a component of the transmission mechanism that I feel
are paid too little attention as a possible explanation for the low inflation. When firms set their
prices, important factors are how they believe other companies will set their prices, and how
they believe their customers will react to price changes. The same applies when employers
and employees negotiate wages. If one believes that other companies will keep their prices
and wages unchanged, it is more difficult to raise one's own prices and wages. As inflation
expectations appear closely linked to the most recent inflation outcomes, there is thus a risk
that the low inflation becomes a self-fulfilling prophecy.
One consequence of this type of reasoning is that it is important that monetary policy reacts
early on when inflation begins to fall. The later one tries to deal with the problems, the more
expansionary monetary policy will need to be to bring inflation up to the target. Or to return to
the rowing boat metaphor; when one finds oneself in a very strong current, one needs to row
very hard to get back.
Note that the two transmission channels I have focused on, the exchange rate channel and
the expectations channel, do not necessarily have an effect through the real side of the
economy. It is therefore fully possible that monetary policy has a substantial ability to
influence the inflation rate even if real variables like unemployment and GDP growth are not
so tangibly affected.
Based on this reasoning, my view is that monetary policy in Sweden has good potential to
bring inflation back to the target of two per cent. But I often come across arguments disputing
this conclusion. Let me conclude by giving my interpretation of these arguments and
explaining why I am not convinced by them.
Misinterpreted: The impact of the repo rate on other interest rates has been weakened
After the financial crisis the repo rate was cut by nearly five percentage points. But the
interest rates households and companies could borrow at did not fall as much, as risk and
liquidity premiums increased at the same time. However, these observations do not mean
that the effects of changes in the repo rate have altered. A more reasonable interpretation is
that the cuts in the repo rate have been counteracted by, and perhaps sometimes drowned
in, other effects.22 If the repo rate had not been cut as aggressively, households and
companies would most probably have had to pay higher interest rates.
Misinterpreted: Monetary policy in small economies is determined internationally
A traditional textbook account would say that a country that has a floating exchange rate and
allows the free mobility of capital across national borders can formulate its monetary policy to
attain a domestic inflation target. But Rey (2013) claimed recently in a widely-read paper that
this conclusion is no longer valid. She argued that globalisation and the increasing
international flows of capital meant that monetary policy around the world must adapt to
monetary policy in the dominant economies, primarily the United States.
Rey's theory is that large amounts of capital will flow into a country that tries to conduct a
tighter monetary policy. The capital inflow will either lead to an undesired appreciation of the
country's currency or to asset prices in the country rising too quickly. This theory, which Rey
formulated with emerging markets in mind, could very well also be correct and relevant for
more developed economies, like Sweden. My interpretation of such arguments is that
monetary policy in Sweden then cannot deviate too far from monetary policy in the United
States and the euro area without giving rise to an unjustified appreciation of the krona.23
Misinterpreted: Inflation is also low in countries with more expansionary monetary
policy
Inflation is also falling now in countries and currency areas where the central banks have
conducted a more, sometimes much more, expansionary monetary policy than the Riksbank.
I have sometimes heard these observations put forward as arguments proving that a more
expansionary monetary policy would not have much impact. This is not a very convincing
conclusion.
To begin with, it is only a year or so ago that there was much international discussion as to
why inflation was so surprisingly high.24 The background to this discussion was that the weak
economic developments in many parts of the world did not appear to have any great effect
on inflation. Despite the low demand in the economy and high unemployment, inflation
25
remained at levels that did not appear compatible with historical patterns.
To some extent, one can probably say that monetary policy abroad was more successful in
stabilising inflation than economic activity, at least for a period of time. Without the powerful
monetary policy stimulus, inflation would probably have been much lower. And in the
countries which have perhaps conducted the most expansionary monetary policy, the United
22
In line with this interpretation, Karlsson and Fredriksson (2013) find that the repo rate has had the same
shortterm impact on mortgage rates before and after the financial crisis.
23
The conclusion that Rey emphasises is that monetary policy needs to be supplemented with other tools; either
macroprudential policy measures that can counteract undesired fluctuations in asset prices, or restrictions to
the international