Mr Bäckström covers monetary policy in Sweden from 1996 to 1998
Opening remarks by Mr Urban Bäckström, Governor of Sveriges Riksbank, the Swedish
central bank, before the Standing Committee on Finance in Stockholm on 18 May 1999.
Introduction
In the period 1996-98 the annual rates of inflation, measured with the CPI, were 0.8, 0.9 and
0.4 per cent, respectively. This means that in each of these years the change in the CPI not
only deviated from monetary policy's 2 per cent target for price stability but was also outside
the lower tolerance limit of 1 per cent inflation.
The Riksbank has indeed made assessments that subsequently proved to be a bit off the mark.
As a result we have also made decisions that, looking back when the outcome was known,
could have been somewhat different. But on the whole, the result of monetary policy in this
period seems to be acceptable. In my opening remarks I intend to give this appraisal more
substance.
One major reason why CPI inflation has been low in the past three years is that the price trend
has been affected by some specific price movements that monetary policy neither can nor
should aim to counter fully. If the Riksbank attempts to counter such price movements, the
result might be unnecessarily costly for the economy, that is, exaggerated fluctuations in
economic activity as well as in the financial markets. It was against this background that the
new Executive Board of the Riksbank clarified the inflation target earlier this spring. To a
large extent, the clarification tallies with how monetary period has actually been conducted in
the period that the Standing Committee is now appraising.
I therefore conclude that when inflation is measured with the CPI, deviations from the
inflation target, upwards as well as downwards, in certain periods are something to which we
unfortunately will have to grow accustomed. As a target variable, however, the CPI has many
advantages, including being familiar and covering a large assortment of goods and services.
Deviations from the target may sometimes even be desirable and actually benefit real factors,
such as production and employment, as well as financial market stability. This conclusion
does of course presuppose that people in general expect that in the medium term inflation will
be in line with the target.
Inflation in 1996, 1997 and 1998
I now want to look in more detail at the path of inflation in the three years 1996, 1997 and
1998. In the period as a whole, the annual rate of price increases, measured with the CPI,
averaged 0.7 per cent. As I just mentioned, however, in each of these years CPI inflation was
markedly affected by shocks that are fairly easy to identify and only have transitory direct
effects on inflation.
Lower interest rates
In the course of these years the Riksbank lowered the repo rate from 8.91 to 3.4 per cent, or by
more than 5.5 percentage points. The five-year T-bond rate moved down from about 8 per
cent to just over 3.8 per cent, or by 4.2 percentage points. Falling interest rates can stimulate
economic activity and thereby lead in time to higher inflation as the level of resource
utilisation rises. In the short run, however, the effect on inflation, measured with the CPI, is
downwards as a result of lower house mortgage interest payments. So although inflation may
ultimately rise as a consequence of lower interest rates, the initial effect is the opposite. In
these years, moreover, the effect on interest expenditure was substantial in that inflation
expectations dropped from high levels as the low inflation regime gradually gained credibility.
The downward effect of the lower interest rates on the CPI actually averaged as much as 0.7
percentage points a year.
Altered indirect taxes and subsidies
In this period there were also fairly large changes in indirect taxes. In the longer run this can
influence inflationary pressure via fiscal policy's impact on demand but there are also more
direct effects. In 1996 changes in indirect taxes had a downward effect on CPI inflation of 0.6
percentage points, followed in 1997 by an average upward effect of 0.5 percentage points. In
1998 as a whole the impact of altered indirect taxes was marginal; after the summer, however,
various measures, including the reduction of tobacco tax, lowered the rate of CPI inflation by
0.5 percentage points.
Falling commodity prices
The development of commodity prices has likewise affected the rate of inflation in the past
three calendar years. The international economic slowdown meant that in the course of 1998
international commodity prices began to fall relatively sharply. It can be mentioned, for
example, that towards the end of 1998 just the lower prices for coffee, petrol and domestic
heating oil had a downward effect on Swedish CPI inflation of 0.4 percentage points. As in
the case of changes in taxes and interest rates, there are distinct direct effects that may deviate
from the more long-term impact on demand.
1. CPI and underlying inflation
1996-98
Annual average, per cent
C P I U N D 1X U N D IN H X
4
3
2 .1
1 .5
2
0 .7
1
0
199 6-199 8
UND1X = CPI excluding interest expenditure, taxes and subsidies
2. CPI and underlying inflation 1996
Annual average, per cent
C P I U N D 1X U N D IN H X
4
2 .8
3
2 .2
2
0 .8
1
0
1 996
UND1X = CPI excluding interest expenditure, taxes and subsidies
= UND1X excluding goods that are mainly imported
UNDINHX
3. CPI and underlying inflation 1997
Annual average, per cent
CP I U N D 1X U N D IN H X
4
3
1 .7
2 1 .4
0 .9
1
0
1 997
UND1X = CPI excluding interest expenditure, taxes and subsidies
4. CPI and underlying inflation 1998
Annual average, per cent
C P I U N D 1X U N D IN H X
4
3
1 .8
2
1 .0
0 .4
1
0
1 998
UND1X = CPI excluding interest expenditure, taxes and subsidies
UNDINHX = UND1X excluding goods that are mainly imported
5. CPI and underlying inflation
4
3
UNDINHX
2
UND1X
1
0
CPI
-1
1 9 9 5 1 9 9 6 1 9 9 7 1 9 9 8 1 9 9 9
1996 1997 1998
Average impact
•Interest rate fall -0,6p.p.
•Interest rate fall -0,6p.p. •Interest rate fall -0,9 p.p.
on CPI
•Tax changes +0,2p.p.
•Tax changes -0,6p.p. •Tax changes +0,6 pe
•Coffee, petrol -0,1 p.p.
0,9 / 1,4 / 1,7 0,4 / 1,0 / 1,8
Annual rate for
0,8 / 2,2 / 2,9
CPI/ UND1X/ UNDINHX
One approach to a more detailed separation of trend or core inflation from these types of
transitory price effects involves looking at the various indicators of underlying inflation that
have been developed at the Riksbank. Whereas annual CPI inflation in the period 1996-98
averaged 0.7 per cent, inflation as measured by UND1X, which excludes interest expenditure,
taxes and subsidies, averaged 1.5 per cent. As measured by UNDINHX, which also excludes
goods that are mainly imported, inflation amounted instead to 2.1 per cent. However, the latter
indicator disregards a large proportion of the factors that contribute to a weaker price trend for
goods in the longer run.
6. Conclusions about inflation 1996-98
I
Inflation - measured with the CPI - was below the target and the lower
tolerance limit during 1996-1998
I
CPI-inflation has been markedly affected in all three years by
transitory effects that are easy to identify
I
Excluding more transitory price effects, inflation has been inside the
stipulated tolerance interval
This review shows that in all three years (1996-98) inflation has been below the target
expressed in terms of the CPI. However, excluding more transitory price effects that monetary
policy neither can nor should try to counter in full, inflation has been inside the stipulated
tolerance interval. I shall be returning to the reasons why price effects of this type should be
disregarded in an appraisal of the Riksbank's monetary policy.
Permanent and transitory inflation - a schematic account1
Let us now use some simplified examples to analyse how different transitory effects on
inflation may arise and what they may imply for monetary policy. Note that we are now
studying the direct effects on inflation and disregarding, at least in the second and third
examples, the indirect influences that act in the longer run.
7. Permanent and transitory inflation
A schematic account
Initial position
4
International slowdown. With
unchanged repo rate inflation
2 years ahead drops to 1%.
CPI and UND1X then
coincide.
3
Repo rate cut by 2 p.p.
UND1X
The economy picks up and
2
UND1X inflation returns to
CPI
2%.
However, the repo rate cut
means lower house mortgage
1
Forecast
expenditure; approximate
effects: -1.2 p.p. after one
year, -0.4 p.p. after two years
0
and some tenths in the
following year.
0 1 2 3
Example 1: an economic slowdown
Assume that international economic activity suddenly falters. This will affect the economic
situation in Sweden. In this example, given that the repo rate is left unchanged, it is assumed
to lead to the inflation rate two years ahead being 1 per cent instead of 2 per cent.
In this example we assume that the repo rate is reduced by 2 percentage points (in practice the
Riksbank might prefer to proceed in steps because of uncertainties in the forecast but here a
large cut is made immediately). The interest rate reduction counters the economic slowdown
and UND1X inflation returns to the target two years ahead.
A repo rate cut, however, lowers house mortgage interest expenditure and this has an
immediate and opposite effect on the CPI. The effect is larger and shows up earlier than the
impact on inflation from the economic slowdown. In the short run, the effect via interest
expenditure accordingly smothers the effect from economic activity and there is therefore a
sharp initial fall in CPI inflation. In this example, the falling interest rates are assumed to
lower the rate of CPI inflation by 1.2 percentage points in the first year and 0.4 percentage
points in the second.2 It is only after that, in up to three years time, that both CPI and UND1X
inflation are back on target.
The example shows that in retrospect, the Riksbank will turn out to be below the target for
CPI inflation. This is a consequence of the Riksbank's ambition to counter the shock from the
international economic slowdown and thereby prevent inflation from falling further ahead. In
such a situation it is therefore reasonable to base policy on an inflation forecast that excludes
the direct effects on interest expenditure.
8. Permanent and transitory inflation
A schematic account
Initial position
4
Economic development
stable, underlying inflation
UND1X - in line with the
3
target.
UND1X
2
Government and
CPI
Parliament lower indirect
taxes
1
CPI-inflation is lowered for a
period of twelve months but
underlying inflation,
measured with UND1X,
0
remains stable.
0 1 2 3
Year
Example 2: altered indirect taxes
In this example economic activity is stable and inflation in line with the target. Suddenly a cut
in indirect taxes, for instance the tobacco tax or the property tax on private houses, is
announced and approved. The cut is assumed to have a downward effect on CPI inflation of
0.7 percentage points in the current year. This, however, constitutes a one-off shift in the price
level, not an effect that alters inflation's trend. All else equal, 12 months later the rate of
inflation will shift back up to the earlier level. Note, however, that inflation measured with
UND1X is not affected; the rate remains stable around 2 per cent throughout the period.
Neither are any monetary policy measures taken in this example, as long as inflation
expectations do not change. The reason is that by the time a repo rate cut would elicit effects,
the tax changes would no longer be affecting the inflation rate. This is evident from the
absence of any effect on underlying inflation. Initially, moreover, the interest expenditure item
in the CPI would move in the 'wrong' direction and lower CPI inflation even more.
If medium-term inflation expectations were to be influenced, on the other hand, monetary
policy action might be called for. An adjustment of expectations in the light of the tax change
has consequences for underlying inflation, so that inflation may be below the target somewhat
further ahead.
9. Permanent and transitory inflation
A schematic account
Initial position 4
Economic development
stable, underlying inflation
UNDINHX - in line with the
3
target.
UNDINHX
Good coffee harvest and
2
increased supply of oil.
These commodities' prices
CPI och UND1X
fall sharply in July year 0 and
are then stable at the new,
1
lower level.
•CPI-inflation is lowered for a
period of twelve months and
0
so is UND1X.
0 1 2 3
•But underlying inflation
measured with UNDINHX
Year
remains stable.
Example 3: falling commodity prices
From the earlier examples it might be supposed that UND1X is an index of underlying
inflation that would be preferable to the CPI as a basis for the formulation of monetary policy,
so that policy ought to be appraised strictly in relation to this indicator. However, even
UND1X may be affected by transitory shocks.
Let us assume that the price of oil suddenly falls and then remains stable at the lower level.
Underlying inflation measured with UND1X will then fall as much as the CPI. UNDINHX, on
the other hand, remains stable around the 2 per cent target. After 12 months, however, the first
two measures of inflation return to 2 per cent. This follows from the assumption of a one-off
shift in the price of oil.
In this example, too, no monetary policy measures are taken as long as inflation expectations
are not adjusted. The reason is the same as in the previous example.
Could the CPI inflation target have been fulfilled?
Would it have been possible, then, for monetary policy to keep the inflation rate at 2 per cent
during these three years? The answer is both yes and no.
Briefly, the problem with adhering to the 2 per cent inflation target, measured with the CPI,
from 1996 to 1998 is as follows:
In the short run, the downward and direct impact on CPI inflation from lower interest rates -
the interest expenditure effect - is appreciably larger than the upward tendency associated
with stronger economic activity: the macroeconomic effect.
A situation in which forecast inflation one to two years ahead points to the rate being below
the target poses evident difficulties for monetary policy. In order to bring inflation back into
line with the target further ahead, the Riksbank responds by reducing the repo rate, which has
the effect of lowering inflation still more in the shorter run. The interest expenditure effect
disappears after a couple of years and the macroeconomic effect gains the upper hand. The
opposite applies if the repo rate is raised.
This accordingly indicates that an appraisal of monetary policy must be based on a thorough
analysis of the factors behind the path of inflation, for example by comparing CPI inflation
with other inflation indicators that exclude transitory price effects.
There was, in fact, a theoretical possibility of preventing CPI inflation from being so low in
1996, 1997 and 1998. The Riksbank never even considered it, for obvious reasons. Still, I can
illustrate how the inflation target could have been fulfilled mechanically by avoiding the direct
interest expenditure effect.
If the Riksbank had left the repo rate at 8.91 per cent - its level before the cuts were initiated
early in 1996 - then the direct interest expenditure effect could have been avoided.
Economic activity would have gradually weakened, however, and this would have pushed
down the CPI excluding the interest expenditure effect. But that would have taken time and to
begin with the macroeconomic effect would have been rather small.
Sooner or later, however, the macroeconomic effect would have begun to surpass the interest
effect on the CPI. In theory, that could have been prevented by raising the interest rate and
thereby increasing the interest expenditure effect.
Such a strategy could have been implemented for a time but in the end the economy would
have become so sluggish that the macroeconomic effect would still have gained the upper
hand. The situation would probably have caused the exchange rate to collapse. The marked
depreciation would have led to rising import prices and perhaps CPI inflation would then have
moved back up to the targeted rate.
That is what could have happened, though I want to stress that the scenario is theoretical and
hypothetical. The Riksbank would have fulfilled the CPI target but at the cost of marked
instability in interest rates and the exchange rate as well as in the real economy. I find it hard
to believe that such a strategy would have been supported for any length of time by either the
political system or people in general.
In the event of a deviation from the inflation target, the Riksbank has to decide how soon
monetary policy should bring inflation back to the targeted rate. If this is done too quickly, it
will exact a cost in the form of instability in the real economy and in financial markets. If it
takes too long, on the other hand, inflation will fluctuate markedly, with the risk of a rising
trend or even genuine deflation.
Against this background, early this year the Executive Board elaborated on the inflation target
and stated that, under certain specific circumstances, the Riksbank has reason to be more
flexible in its interpretation.3 When I presented this to the Standing Committee in more detail
last March, I noted that it amounted essentially to a codification of monetary policy practice in
recent years. That is also what I have described today.
There is another matter I want to take up concerning monetary policy and its result. It has to
do with the outturn for 1998, when the annual change in the CPI was 0.4 per cent, while
UND1X rose only 1 per cent and in some months was also outside the lower band limit.
Could not an alternative interest rate policy have succeeded in preventing such a low outcome
for underlying inflation?
Monetary policy could obviously have been given a more expansionary turn than was the case
at the end of 1996 and during 1997, in which case UND1X inflation might have been higher
and more in line with the 2 per cent target, quite apart from the interest expenditure effect on
the CPI.
In this context one can, of course, discuss the Riksbank's basic forecasts of inflation
excluding the transitory effects from interest expenditure and taxes. The Riksbank made a
forecasting error in failing to foresee the economic slowdown inherent in the Asian crisis and
the ensuing fall in commodity prices. Unfortunately, you might say, we shared this error with
a clear majority of observers. With the long time lag that applies to monetary policy, measures
should really have been taken before the end of 1996 or early 1997, which was before the
crisis had even arisen. If the commodity price fall does not leave any traces in inflation
expectations, it should not affect policy either.
CPI and underlying inflation in a longer perspective4
10. CPI and underlying inflation
The estimated indicator of underlying inflation broadly
corresponds to UNDINHX (see Inflation Report 1999:1)
Determinants of inflation:
Underlying
1. Expected inflation trend 2
inflation
2. Economic situation
3. Supply shocks, e.g. changes in
0
Transitory
indirect taxes, oil prices or interest
factors
rates
OPEC 2 -2
13
1996 1997 1998
OPEC 1
Tax reform
8
3
Sharp oil price fall, interest
rate cuts
Marked interest rate cuts, oil price fall
-2
1974 1978 1982 1986 1990 1994 1998
Underlying inflation CPI
4
Inflation Report
For a more thorough discussion, see 1999:1, box on pp 35-37, Transitory factors and
other supply shocks: a model approach.
BIS Review 61/1999
There have been periods in the last three decades when CPI inflation has deviated from the
indexes of underlying inflation. This happened, for example, in connection with the oil crises
in the 1970s, the fall in oil prices and interest rates in the mid-1980s, the tax reform in the late
1980s and the downward shifts in interest rates in the 1990s.
There is nothing new about this phenomenon, which can thus recur. It has to do with inflation
being determined mainly by factors of three types:
• long-term inflation expectations
• the economic situation
• transitory factors and supply shocks such as changes in indirect taxes and subsidies,
interest expenditure and commodity prices
For monetary policy it seems reasonable to assert that factors of the first two types are most
relevant because it is mainly through them that monetary policy is capable of influencing
inflation. Factors such as indirect taxes have effects on consumer prices that are transitory;
they normally disappear after a time unless long-term inflation expectations have been
affected.
Conclusion
The CPI is the target variable for monetary policy. Measured with the CPI, inflation is to be 2
per cent in a longer, annual perspective. There are grounds, however, for sometimes departing
from this target. Short-run deviations from the target should not be attributed automatically to
a faulty formulation of monetary policy. This presupposes, however, that clearly identifiable,
transitory price movements are involved that monetary policy neither can nor should aim to
counter. It is therefore important to look at the factors behind the CPI figures when appraising
monetary policy.