Kristina Persson: Monetary policy in a low-inflation economy
Speech by Ms Kristina Persson, Deputy Governor of Sveriges Riksbank, at the Stockholm Strand
Rotary Club, Stockholm, 18 February 2005.
The references for the speech can be found on the Sveriges Riksbank's website.
* * *
Introduction
Thank you for the invitation to take part in this morning seminar. I intend to begin by giving my views
on the current prospects for the economy and inflation, including the risks associated with, among
other things, the unwinding of the present global imbalances. I will do so against the background of the
minutes from this year's first monetary policy meeting, which were published last week and which gave
an account of the Executive Board's discussion on 27 January. Then I will discuss the Riksbank's
remit, different ways to conduct monetary policy and the possible implications of the low inflation rate
for future monetary policy.
The current monetary policy situation
Since Christmas the news flow has been dominated by the huge tidal wave disaster that hit the
countries in the Indian Ocean. Despite the scale and extent of the disaster the consequences for the
world economy will probably be very small. That at least has been the conclusion from the different
international meetings that have taken place after Christmas.
International economic activity is thus expected to continue to strengthen and resource utilisation in
the world economy to become increasingly higher in the coming years. Inflation has risen slightly in
most countries, owing mainly to the increasing oil price. But excluding oil, inflation has not risen at the
same rate. There are plenty of spare resources in several of the biggest economies, and in recent
years competition has toughened in many industries. As a result, international inflation is forecast on
the whole to be relatively moderate in the coming years.
The economic situation in the US and the euro area
In the US the economic situation is continuing to improve. In the fourth quarter last year GDP in the
US rose by 0.8 per cent compared with the previous quarter, partly due to a sharp increase in
investment. This reflects a benign investment climate in the US with historically high profits and
optimism among firms. Indicators of growth prospects for the fourth quarter provide a positive picture
of the activity level in the US economy.
As resource utilisation has picked up the Federal Reserve has raised its key policy rate from 1 per
cent to 2.5 per cent. Many factors suggest that we can expect the tightening to continue in the spring.
Inflation is estimated to rise in the period ahead, partly because the weakening of the dollar in recent
months has made US imports more expensive. In the main scenario of the Riksbank's most recent
Inflation Report the US economy is expected to continue to perform strongly in 2005 and 2006.
One source of concern for both the United States and the world as a whole is the large deficits in the
US economy. In the third quarter last year the current account deficit totalled USD 165 billion, or
around 6 per cent of GDP. Data for November show that the deficit has continued to grow, reaching a
new record high of just over USD 60 billion. This may result in changes in interest rates and exchange
rates that could have considerable consequences for world trade.
A large share, or about 40 per cent, of Sweden's exports go to the euro area, and as a result
economic developments there are especially important for us. The recovery in the euro area economy
is going slowly. Growth in the third quarter was lower than expected. Available indicators for the fourth
quarter provide a mixed picture. Germany, which is an important market for Swedish products, is
showing some signs of an improvement. After several years of extensive cutbacks there should be a
pent-up need among firms to invest. At the same time exports are being dampened by the euro's rise
against mainly the dollar.
The economic situation in Sweden
As regards Sweden the Riksbank has been positive in the past year in its outlook on economic
developments. International demand has increased faster than anticipated, with above all exports of
services proving unexpectedly robust.
Economic policy is also contributing to the relatively bright growth prospects. Interest rates are at an
all-time low and the proposals in the Government's Budget Bill imply a looser fiscal stance. Household
consumption will continue to grow steadily in the period ahead, and business investment also appears
to be picking up again following a number of years' weakness. Taken together, this means that GDP
growth in 2004 is forecast to be around 3.7 per cent, after which it will be dampened somewhat,
standing at about 3 per cent in 2005 and 2006, which is a fairly high level in historical terms.
Despite the firm growth Swedish inflation is very low - in January it stood at 0.4 per cent, measured as
the annual change in UND1X. The weak inflation is primarily due to surprisingly low import prices.
Other causes are the strong productivity growth; the krona's appreciation in the past half year, above
all against the dollar but also against the euro; and low electricity prices. There are many indications
that we won't be seeing any significant inflationary pressures in the coming year either. That made it
natural for us to decide not to raise interest rates at the end of January. My personal view is that it will
probably be a while before a rate hike comes into question.
The risk outlook
Surrounding this rather bright picture are a large number of risks that our growth and inflation forecasts
will not be met in the coming two years. The key risk factor is how the US deficits will be corrected.
Will it come about through a sharp correction in the dollar and, if so, what will the consequences be for
the world economy?
The majority of forecasters agree that the large deficits in the US are not sustainable. It's true that the
weakened dollar is expected to be able to lead to a certain stabilisation of the current account, but
since the US imports around 1.5 times more than it exports there would have to be a sharp reduction
in imports or an even steeper rise in exports for the deficit to be able to narrow.
At the same time, demand in the US has to a great extent been the engine for the world economy in
recent years. Expansionary economic policy has contributed to this and also resulted in a very large
saving deficit. The inflow of capital to the US has stemmed, among other things, from Asian central
banks' purchases of US government securities. China has recently accounted for about one-third of
the US external borrowing requirement. In that way, both China and Japan have built up substantial
dollar reserves.
The logic behind this loss-making activity (if the dollar continues to fall in value) is that it enables
Japan and China to maintain low values for their own currencies, thus facilitating continued exports to
the US and other countries. For China the substantial exports translate into jobs and incomes in an
economy where a very high percentage of the population still live in the conditions of a developing
country. Fast growth means increasing prosperity, which in turn may result in a stable social and
political climate. However, in order for China to switch from export-led to domestic demand at a
quicker pace - which has to happen in the future - it will require institutional and other reforms that
take time to implement. The financial infrastructure in particular is in great need of change and
development.
Where will demand come from when the economy is tightened in the US? The weak growth in Europe
and the uncertainty surrounding developments in the Japanese economy means that there is no
obvious candidate to take the United States' place as growth engine. While China has recently
become the world's third biggest trading nation it can hardly assume the mantle on its own. Domestic
demand in Europe needs to pick up but the current upswing here is sluggish and is being restrained
by efforts to tackle public finance deficits in countries such as Germany, Italy and France.
So how likely is it that China will abandon its fixed rate with the dollar in the period ahead? Most
commentators believe that China will take a gradual, slow and cautious road towards a floating
exchange rate. Should the dollar continue to weaken, therefore, the euro will continue to bear a large
part of the adjustment in the future as well, thus having an adverse effect on European
competitiveness and growth.
Another important growth factor is how interest rates develop in the period ahead. There is little to
suggest that the US federal budget deficit will narrow to a sufficient extent. That is worrying, especially
given that the country in the long term will see sharply increasing costs for medical care, health care
and pensions. As a result there is a clear risk of rising market rates in the US that could trigger a fall in
house prices, which in turn could dampen private consumption. A reduction in public expenditures
would also have a tightening effect but in the long term would lead to a more balanced development
and thereby prevent an overly quick rise in rates.
Another risk factor is the oil price. As the US is more oil-dependent than the euro area countries, its
economy is more sensitive to changes in oil prices. Should the oil price remain at a high, fluctuating
level it may curtail growth in the US.
All in all, this picture of large global imbalances implies a clear risk that growth will be more subdued
over the coming two-year period. The question is how fast this slowdown may come about. If
controlled, the moderation would be softer, while rapid changes could entail a considerable weakening
of the world economy and thereby also check Sweden's economic performance in the period ahead.
In addition to the competition problems that an ever stronger euro means for Europe there is the issue
of how we are to meet the competition from low-wage countries, both the new member states of the
EU and the emerging economies in Asia. The differences in labour costs are very large. The
toughening competition places great demands on the ability of Swedish economic players to adjust.
What can Sweden do to attract and keep new investment that can create jobs and incomes here?
Swedish investment is among the lowest in Europe and must in all likelihood increase as a share of
GDP to ensure continued growth.
The global exchange rate adjustments may result in more subdued growth, which makes them a big
uncertainty factor in the period ahead. The rebalancing of demand between currency areas takes time,
and the relative price changes via the currencies creates, in the same way as inflation, an uncertainty
that may have an adverse impact on both investment and demand.
The Riksbank's remit and inflation targeting policy
The Swedish parliament has decided that the Riksbank's objective shall be to maintain price stability,
and the Bank has since defined this to mean an annual change in inflation, measured in terms of the
consumer price index (CPI), of two per cent, with a tolerance for deviations of plus/minus one
percentage point. In practice we often choose to look at a measure (UND1X) that excludes the effect
of changes in indirect taxes and subsidies as well as mortgage interest expenditure - i.e. what we can
call political or administrative decisions.
Our interest rate decisions are based on forecasts of price developments one to two years ahead. If
our forecasts are higher than the inflation target the Bank normally raises interest rates, and vice
versa. In other words the policy rate is normally adjusted so that inflation 1-2 years ahead, taking into
account the balance of risks, is in line with the target.
The Riksbank introduced the current regime of a floating exchange rate and inflation target in 1993,
after a number of decades with a fixed exchange rate. The new regime has meant a new way of
working whereby we attempt, with the aid of monetary policy, to adjust economic growth to what the
inflation target allows. A common analogy is that the economy is like a car with certain characteristics
that enable it to drive at certain speeds but not at others. In that case we in the Executive Board are
the driver, using the policy rate to accelerate or slow down. If the car is going too fast, its tyres will start
to overheat and we risk driving off the road, i.e. prices will rise and we have to raise the policy rate to
slow down. Conversely, when the car is going too slowly we accelerate by lowering the policy rate.
In reality the analogy with a car is somewhat misleading. First, it is difficult to know exactly the speed
at which the economy is actually growing. The statistics that we use when forecasting economic
growth contain errors, do not provide a comprehensive picture of the economic situation and
furthermore are produced with a lag. Another problem is the difficulty in knowing exactly how long it
takes before a rate adjustment has the desired effect. Since it takes time - we allow for a time horizon
of one to two years before the transmission mechanism has worked through the economic system -
we have to form an opinion of the state of the economy in the long run.
Predicting the future is difficult for many reasons, not just due to statistical shortcomings but also
because the economy is changing all the time. The economy can be hit by different kinds of shocks,
e.g. the increased electricity prices when there was a shortage of water in Sweden's reservoirs, and
the price of meat and other food when cows in Europe were affected by a number of diseases. It is
difficult to determine early on what changes in the economy are temporary and what are permanent.
Another factor complicating the picture is that inflation expectations in society greatly influence price
and wage formation, and thereby inflation. In other words the car - to continue with the analogy - has
a fogged windscreen, a speedometer that is very difficult to read and pedals that sometimes are
sluggish and sometimes easy to push down.
How can we make the economy go at an appropriate speed?
In somewhat simplified terms there are two different ways to describe monetary policy based on
inflation targeting: The first is to employ a simple monetary policy rule whereby the policy rate is set as
a function of the current inflation rate and the output gap, which is a measure of the difference
between actual and potential output and reflects resource utilisation in the economy.1 When the output
gap is negative, actual output is lower than potential output, which means that there are plenty of
spare resources in the economy. In such a scenario price and wage increases are small and inflation
is generally below target.
When the output gap is positive the situation is the reverse: resources are overstretched and the
excessive demand generates inflationary pressures in the economy. So according to the rule the
policy rate should be raised if growth is above its potential rate and inflation is higher than the inflation
target, and vice versa in the reverse situation. When actual and potential output are the same the
economy is in balance and inflation is normally in line with the target, provided that policy is credible.
A common argument in favour of conducting monetary policy in this way is that the central bank's
knowledge of how the economy functions is too limited for a forecast-based monetary policy to be
formulated in a good enough way. Incorrect forecasts can also burden the central bank with credibility
problems, which is one reason to prefer a simple rule.
The other method, applied by the majority of central banks including the Riksbank, is to forecast how
the economy will evolve over the next couple of years and adjust monetary policy accordingly. One
complication here is that something unexpected can always happen, causing the economy to move in
a different direction than that expected. For this reason the central bank must take account of different
risks when setting the policy rate. The forecasts are produced by experts through the use of various
statistical methods and models. The results are often presented in the shape of a main scenario and
one or more alternative scenarios.
A monetary policy that is based on forecasts requires more information about the economy than a
rule-based policy, and according to its critics there is a risk that forecasters will overestimate their
ability, perhaps leading to poorer results than would have been the case with a less complicated
approach. Advocates of the method, on the other hand, say that we should make full use of the
knowledge that we nevertheless have.
Since a forecast-based monetary policy requires the analysis of many more variables than is the case
for a simple rule, it is more difficult for external players to predict how the central bank is going to act.
For this reason a forecast-based policy places high demands on the bank's openness and
transparency in relation to external parties, as well as on its ability to communicate.
There are also other advantages associated with a forecast-based monetary policy. Since it is
forwardlooking the central bank can at least try to foresee future problems or structural changes and meet
them through a rate adjustment. The ability to act quickly is essential, as monetary policy acts with
some lag and the economic cost of increasing inflation becomes lower if it is checked at an early
stage. Another benefit is that the central bank does not become as tied as with a rule, but instead can
take account of alternative scenarios and risks. Moreover, these assessments can be regularly
updated in the light of new information about economic developments.2
Flaws in the data underlying decisions and the difficulty of predicting what will actually happen in the
future mean that the ability to evaluate and weigh up a large amount of complex information is what
most distinguishes an accurate monetary policy from a less accurate one. Judgement is therefore
highly significant for how good the final result is. This favours the use of a forecast-based monetary
policy, which allows greater scope for judgements than a simple rule.
Openness and communication
The choice of monetary policy strategy is of key importance for a central bank's external
communication. Good communication with external players is extra important for central banks that
conduct a forecast-based monetary policy. It is therefore important that the Riksbank is open about
how we view economic developments and the inflation outlook and about how we have reasoned in
our conduct of monetary policy. The aim is to create an understanding of what governs the Bank's
interest rate decisions and to generate support among the Swedish public for the inflation target.
This is also a reason why we in the Executive Board often give public speeches. Openness and
transparency from our side can help stabilise expectations regarding inflation and interest rate
developments and lower the risk of unease in the financial markets. So inflation expectations play a
key role for monetary policy and for that reason we keep a close eye on how they are developing.3
Perhaps the most important task of monetary policy is to influence inflation expectations since it is via
market rates, and not the repo rate itself, that demand in the economy is affected. That is why
communication and credibility are so significant. If we can get our message across we increase the
chances of a successful monetary policy.
Monetary policy in a low-inflation economy
The Riksbank's rule of action, which says that the policy rate should be adjusted when inflation is
above or below target one to two years ahead, is not at all as mechanical as is sometimes perceived.
The Executive Board's clarification in 1999 made it clear that the practical formulation of monetary
policy takes account of developments in the real economy.
According to the clarification there may be reason for the Riksbank to deviate from the target if inflation
is being affected by a temporary shock that will not fully dissipate during the coming two-year period
but that is nonetheless not deemed to have any lasting influence on inflation developments. Another
reason is when a bigger shock makes a return to the target one to two years ahead associated with
excessive undesirable effects on the real economy.
There are many examples in recent years of when we have taken such factors into account. At the
turn of the year 2002-2003, for example, rising energy prices were pushing up inflation quickly. But
since the high energy prices were expected to gradually fall back entirely we saw them as temporary
and decided to leave the repo rate unchanged.
When the current regime of inflation targeting was established in the early 1990s it had been preceded
by a long period of high, fluctuating inflation in both Sweden and other countries. Many countries
around the world experienced a similar shift in regime around this time. Partly as a result of this,
international inflation fell sharply during the 1990s, from about 30 per cent to below 4 per cent a year
on average.4
The inflation targeting regime and its practical application has been underpinned by the conviction that
high, variable inflation is bad for the economy. Now we are living in a world with very weak price
increases, particularly for manufactured goods. Is there anything in the current circumstances that
could motivate a change in the Riksbank's thinking? The integration of China's and India's large,
fastgrowing economies into the world economy will most likely affect world growth and inflation for a long
time. Globalisation has been given a powerful push forward. Even though setbacks are possible, it is
reasonable to believe that the supply shock produced by Asia's low-price exports will continue to
depress prices in the world for many years ahead. China's government has set a target of quadrupling
its GDP during 2000-2020, as happened over the last twenty-year period. In rural parts of China there
are hundreds of millions of people who dream of a better life in the cities and of working in a modern
company.
In Sweden we can see how inflation in recent months has turned out lower than we expected,
because price increases for imported goods have been weaker than anticipated. The productivity
gains that we have witnessed, and that have also contributed to such a low inflation rate, may also be
due to the increased global competition. Another dampening effect can be expected from the abolition
of the import quotas for textiles.
At the same time there is as usual reason to believe that world market prices will increase as
economic activity improves. The rapid growth in the new industrial countries is also pushing up the
prices of commodities, not least oil. It is therefore uncertain how long import price pressures will
remain very low. In any event this is a very important issue for monetary policy in the coming year, and
at the Riksbank we are keeping a close eye on import price developments.
Allow me to round off with some thoughts regarding the stance of monetary policy. Given that inflation
is anticipated to be below target for a large part of the coming two-year period, I think one can argue
that there has been scope to lower the repo rate somewhat more than we have done recently. But I
have, like my colleagues, decided against this. There are several reasons for that - interest rates do
not always have to be changed when inflation prospects differ from the target.
The reasons are that growth is currently firm. We believe that the problems in the labour market are
chiefly due to structural factors; it is therefore likely that they would only be marginally affected by
lower interest rates. Moreover, the demand for labour is expected to begin to rise during 2005-2006,
Swedish monetary policy is already loose, real interest rates are low, household borrowing is
increasing quickly and house prices are rising - and have been for a long time. Even lower rates could
further fuel the willingness to borrow, entailing risks in the long term in the shape of a growing property
bubble.
In addition, if monetary policy is to try to fully offset the low import prices by driving up domestic prices,
for example in the service sector, this could lead to a domestic inflation rate that would be difficult to
stop if economic activity were to continue to develop strongly for a longer period and resource
utilisation thereby to rise.
The clarification of monetary policy that was published in 1999 can thus be applied to today's situation:
Out of consideration for developments in the real economy, i.e. growth and employment, in the
somewhat longer term, we can refrain from lowering the repo rate now, even though a mechanical
application of our rule of action could justify such a move.
But should economic activity weaken, for example due to the risk scenario that the adjustment of the
US deficits could trigger, the situation will be different. Then I can see reason to lower the policy rate
further, especially if the weakening is coupled with a stronger krona. In such a situation I believe it
would be an advantage that the repo rate is not even lower than it is today.