SPEECH
SVERIGES RIKSBANK
DATE: 7 December 2016 (Correction 12 Dec 2016, Figure 8 has been corrected in this version)
SE-103 37 Stockholm
(Brunkebergstorg 11)
SPEAKER: Deputy Governor Per Jansson
VENUE: Swedbank, Stockholm
Tel. +46 8 787 00 00
Fax +46 8 21 05 31
registratorn@riks bank.se
www.riksbank.s e
Time to scrap the inflation target?*
To avoid keeping you on tenterhooks, I shall begin by answering the question in the
title of my speech. No, it is not time to scrap the inflation target, in case any of you
thought I wanted to. The question is of course rhetorical. The reason I ask the
question is that I think it has been the focal point of the recent debate in Sweden,
although it is not usually expressed so directly. Following the financial crisis the
foundations of monetary policy certainly have been discussed and questioned around
the world. But my feeling is that the debate has been driven further in Sweden than in
most other countries.
Monetary policy in Sweden has often attracted interest from other countries. One
reason is that we have often been among the first to implement changes in the
monetary policy framework and thus become an interesting object of study. As is
well-known, Sweden was one of the very first countries to introduce inflation
targeting in the early 1990s, and we have in many respects remained at the front edge
since then. For instance, the Riksbank is one of few central banks to publish its own
forecast for the policy rate and possibly the only central bank where the minutes state
1
which Board member has said what during the monetary policy meetings.
Inflation has been low for longer in Sweden than in many other countries
In recent years, international interest in Sweden as an object of study has been more
due to economic developments here, and to the measures the Riksbank has taken,
rather than the changes in the monetary policy framework.
Despite the Swedish economy developing relatively well since the global financial
crisis 2008-2009 (see Figure 1), inflation began to fall earlier in Sweden than in the
rest of the world. This has meant that inflation has undershot the target and been
lower than in many other countries for a long time (see Figure 2). This has in turn
contributed to the Riksbank considering it necessary to cut its policy rate below zero,
which only a few other central banks have done so far.2 The long period of low
inflation has also started a debate regarding the grounds for the Riksbank's monetary
policy and the inflation target, which as far as I can tell is more intense than in most
other countries. In this sense, too, one can therefore in some ways say that we are
pioneers.
What I intend to do today is first to say a few words about this debate. Most often,
the criticism merely states that the "monetary policy of the Riksbank is wrong". The
reasons for this vary: because a negative policy rate is not healthy, because housing
prices are rising, because the krona is too weak or because the economy is already
developing well. There is usually no detailed reasoning as to what the consequences
would be if the policy was shifted in another direction. In particular, what is often
missing, but I argue is crucial, is a discussion on why the advantages of the inflation
target should no longer apply and what the consequences would be if the Riksbank
abandoned it.
After discussing the debate on monetary policy, I intend to conclude by looking ahead
and examining the problems and possibilities for monetary policy in the future. Here, I
focus in particular on a scenario where monetary policy is not made more
expansionary despite a delay in reaching the inflation target.
In Sweden, the policy rate has been negative since February 2015. This has not been
an uncontroversial policy. The criticism can be divided into two types. These are often
expressed simultaneously and are difficult to distinguish from one another, but I think
there is a point in trying to keep the arguments separate. One sort of criticism is that a
negative policy rate in itself is something unnatural and unhealthy. The other is that a
negative policy rate is the wrong policy in the current economic situation. Let me
discuss these arguments one at a time.
Negative policy rate unnatural and unhealthy in itself?
One can dispute whether a negative policy rate is unnatural and unhealthy, but it is
certainly very unusual. This applies not only to policy rates but also to nominal
interest rates in general. Prior to 2015 we had never had a negative nominal interest
rate in Sweden. On the other hand, negative real interest rates, that is, nominal
interest rates adjusted for inflation, have occurred now and then. The short-term real
interest rate has been more or less constantly negative since 2009. If we look further
back in time, negative real interest rates have not been so unusual either (see Figure
3).
Of course one might think it rather unnatural to need to pay to lend money to
someone, and to be paid for borrowing. But as it is usually our purchasing power that
we are concerned with, it is not really clear, when one thinks about it, why it should
be more unnatural to have a negative nominal interest rate than a negative real
interest rate. If one lends money, one will in both cases be able to consume less when
one regains what one has lent, including interest. In the case of a negative real
interest rate, this is because inflation is higher than the interest payment, and one is
therefore unable to buy as much for the sum one receives from the borrower. If
instead the nominal interest rate is negative, then the negative return is written into
the contract from the start, so to say, and perhaps this is what many feel goes against
normal social and economic conventions. But regarded solely in terms of purchasing
power, a negative nominal interest rate is not anything very special, in any case no
more special than a negative real interest rate.
General interest rates low but not negative
Moreover, the fact that the repo rate is negative does not mean that general interest
rates in Sweden are negative. The repo rate is a very special short-term rate that only
the Riksbank's monetary policy counterparties encounter, including the major
Swedish banks. When the repo rate is negative, the banks pay interest to the
Riksbank, as the banking system as a whole has a liquidity surplus that must be
deposited in the Riksbank. The short-term interbank rates, that is interest on loans
between the banks, and some government rates have followed the repo rate down
below zero. However, the banks have not introduced negative deposit rates for
households and most companies. Only a few economic agents, primarily other
financial institutions, large companies and some municipalities, have experienced a
negative deposit rate, and these can in some cases also borrow at a negative interest
rate. Companies have been forced to expend a certain amount of resources on
avoiding negative return on their funds, but they appear to have succeeded relatively
well in this. Cutting the repo rate below zero has thus in total contributed to pushing
down interest rates, but has not meant that interest rates have become negative for
the general public.
Good profitability among the banks and few signs of a decline in demand
Another fear has been that negative interest rates reduce the banks' profitability,
which could lead to higher lending rates and a lower supply of credit. The reason for
this is said to be that the banks' deposit margin, that is, the difference between the
interest on deposits and lending, would decline because it is difficult to cut the
deposit rate below zero. However, Swedish banks' profitability has been good in
recent years, especially in relation to banks in the euro area (see Figure 4). The
negative repo rate has contributed to making their extensive market funding less
expensive, at the same time as lending volumes have increased. In low interest rate
environments there is also a tendency for income from fees and commission to rise,
as the demand for the banks' asset management increases as more people want to
invest in for example funds. Nor does it appear to have been too difficult or expensive
to adapt IT systems to manage negative interest rates. The Riksbank's overall
assessment is that the negative interest rates have had little or perhaps even a
positive effect on the banks' profitability.3
As negative nominal interest rates are a new phenomenon, it is nevertheless natural
that they are met with scepticism and give rise to various psychological reactions. One
fear along these lines has been that the negative policy rate would be perceived as a
crisis signal that would increase uncertainty among economic agents. I believe that
reactions of this kind should be taken seriously. That there are such reactions is one
reason why I am taking up this question here today. However, there are so far few
signs of declining demand resulting from concern among households and companies.
On the contrary, domestic demand has been the most important driving force behind
the improved economic activity in Sweden. In addition, sentiment in the household
and corporate sectors is good, according to various confidence indicators (see Figure
5).
It is also worth noting in this context that there is a fairly intensive international
discussion on whether negative policy rates should be included in the central banks'
normal arsenal going forward, as a weapon that could be used if special needs arise.
4
One advocate of this is Ben Bernanke, former chairman of the Federal Reserve. He
argues that negative policy rates have many advantages in relation to raising the
inflation target, which is also discussed as a means of creating greater room for
manoeuvre in future recessions. It is worth noting that this international discussion
exists, as a contrast to the picture often painted in the Swedish debate - that negative
policy rates are an isolated and strange invention of the Riksbank and a few other
central banks.
Negative policy rate wrong policy in current economic situation?
The second form of criticism, as I mentioned earlier, is that a negative interest rate is
the wrong policy in the current economic situation. One reflection one can make here
is that the criticism really concerns the repo rate being too low, not specifically that it
is negative.
Low global interest rates are not due to monetary policy
There are reasons to begin reflecting on why interest rates are so low. One important
observation is that there has been a downward trend in real interest rates around the
world for a couple of decades now (see Figure 6). It is not entirely clear why this has
happened and why global real interest rates are currently so low, but in general terms
it is due to the willingness to save long being greater than the willingness to invest.
Another significant factor is that trend growth has deteriorated in many countries
following the financial crisis. It is important to realise that global interest rates today
are low because of factors that are unrelated to monetary policy. And global real
interest rates are an important determinant for long-term real interest rates in
individual countries. Monetary policy has to continuously relate to this long-term real
interest rate. To put it simply, if monetary policy gives rise to interest rates below the
long-term real interest rate, then the policy is expansionary. Correspondingly,
monetary policy is tight if interest rates exceed the long-term real interest rate.
However, monetary policy can neither influence nor deviate in the long run from the
long-term real interest rate.5
These aspects are important, for instance with regard to the discussions about various
possible negative side-effects of the very expansionary monetary policy. One
argument is that the low interest rate constitutes a danger to pensions as the return
on pension savings becomes so low. But with regard to pensions, it is the long-term
return that is important. This means it is the long-term real interest rate that is the
most relevant variable. The solution to the problem is thus not that central banks
should raise their policy rates, much less that the Riksbank should do so
singlehandedly. To make interest rates persistently higher, one needs to implement
structural measures that push up the long-term real interest rate. This is
unfortunately not so easy to do.
With reasonable estimates of the long-term real interest rate, the Riksbank's
monetary policy has in recent years been clearly expansionary. The reasons why the
Riksbank has conducted this policy are that inflation has undershot the target for a
long time and that long-term inflation expectations have fallen to worryingly low
levels. Around the turn of the year 2014-15 the situation was particularly serious.
Expectations of inflation five years ahead had fallen some way below the target and
there was a tendency towards acceleration in the decline (see Figure 7). The Riksbank
therefore assessed it was necessary to conduct a very expansionary policy to
safeguard confidence in the inflation target.
Good reasons to preserve confidence in the inflation target
There are good reasons for safeguarding this confidence. When economic agents have
a collective picture of how prices will develop in the future, it becomes easier to plan
for the long term. The inflation target contributes to coordinating expectations in the
economy and thereby lays the foundations for smoothly-functioning price-setting and
wage formation. As I see it, the good wage formation system that we have today is
perhaps the greatest achievement of inflation targeting. During the 1970s and 1980s,
wage formation was a constant source of disruption in the Swedish economy. It
caused considerable uncertainty for many companies. One was forced to manage the
cost problem and poorer competitiveness through recurring devaluations of the
krona. The situation was generally untenable and eventually led to an extensive
economic crisis at the beginning of the 1990s.
An important insight here is that a credible inflation target can give rise to a beneficial
self-reinforcing cycle. If expectations are in line with the inflation target, and if
pricesetting and wage formation adapt to these expectations, actual price developments
will then also become consistent with the inflation target. On the other hand, if
expectations were to become stuck at a level that is too low, one instead has a
negative self-reinforcing effect, which means that the central bank has to struggle
much harder to attain the inflation target. This underlines the significance of taking
resolute action particularly when more long-term inflation expectations begin to
deviate fairly substantially from the target level.
There are also good reasons why the target is 2 per cent and not lower. Perhaps the
most important is that there should be sufficient scope to cut the policy rate in the
future if inflation becomes low or economic activity wanes. A lower inflation target
would mean reaching the policy rate's lower bound more often and for longer. This is
why there is currently an international discussion on whether the central banks'
inflation targets should be raised.6 A somewhat paradoxical observation here is that
many of those in the Swedish debate who are critical of negative policy rates are also
critical of higher inflation targets, and often even advocate lower inflation targets. But
with an unchanged or lower inflation target, it becomes even more important that the
policy rate can be cut below zero.
A further reason that I believe should not be underestimated is that wage formation
can deteriorate when average inflation is too low. The reason is that in practice it has
proved difficult to lower nominal wages. If inflation is low and nominal wages cannot
be lowered, it becomes difficult to adjust real wages between individuals at a
company and between different sectors. This can ultimately bring about both higher
unemployment and poorer productivity growth in the economy. These problems can
be mitigated if there is a certain underlying inflation rate in the economy.
Underestimating the significance of monetary policy and exchange rate
developments
One problem when criticizing monetary policy with reference to the current economic
situation is that one does not take into account the fact that the current strong
Swedish economy is of course to a large degree due to the monetary policy that has
been conducted. It is a little like taking medicine in connection with an illness and
when cured drawing the conclusion that it was unnecessary to take the medicine.
On this point I feel that the events of spring 2015 are a good illustration. The ECB had
announced in January that it intended to buy securities over slightly more than a year
to come for the equivalent of SEK 10,000 billion (around 2.5 times the size of Swedish
GDP). This is indeed a very substantial monetary policy intervention. Within the
course of just a few weeks the krona exchange rate appreciated significantly against
the euro, from almost 9.65 krona per euro to just over 9.10. This was in itself a large
appreciation of almost 6 per cent, but the real danger lay in the fact that it could have
been much worse. During 2014 and up to spring 2015 the US dollar and the British
pound sterling had appreciated by between 15 and 25 per cent against the euro.
There was agreement on the market that differences in monetary policy were decisive
for the different development paths of these currencies and the Swedish krona
against the euro. If the Swedish krona had in this situation so to speak appreciated
level with the dollar and sterling, the total appreciation would have been around 30
per cent. This would have meant a very serious deterioration in the competitiveness
of the Swedish export industry and would have entirely changed the playing field for
the Swedish economy (see Figure 8). Under such circumstances there would certainly
not have been any growth in the vicinity of 4 per cent in 2015.
My own impression is that the risk the Swedish economy was exposed to at this stage
is severely underestimated by many commentators. They appear to assume that the
strong performance in 2015 would have happened more or less regardless of
monetary policy and the krona exchange rate. The fact that the Riksbank in February
reacted by introducing a negative repo rate and beginning to buy government bonds
is not considered to have played any major role. Although it is possible that the
outcome would not have been quite as bad as I have outlined above, I think that it is
extremely misguided to assume that monetary policy was more or less insignificant.
There is also good reason for a reminder of a circumstance that tends to be forgotten.
The current debate sometimes gives the impression that the Swedish economy has
for some time been in a situation of almost overheating. But the fact is that we fairly
recently, according to most empirical estimates, once again attained a level of
resource utilisation that can be described as normal. Thus, although such estimates
are uncertain, the Swedish economy appears to have been producing below, rather
than above, its long-term capacity for several years following the financial crisis.
Confidence in the inflation target unimportant or possible to maintain
with a different policy?
One thing that is rarely done, but I think is of utmost importance, is to spell out the
practical consequences of this criticism. It is of course easy to agree that if the
Riksbank had not needed to defend confidence in the inflation target, then monetary
policy would not have needed to be so expansionary and the repo rate would perhaps
not have needed to be negative. One may therefore draw the conclusion that those
who say that monetary policy is wrong are arguing one of the following: Either that
confidence in the inflation target is not so important, or at least less important than
other things, or that the Riksbank should have been able to conduct a less
expansionary policy while still being able to safeguard confidence in the inflation
target.
The criticism is rarely clear with regard to which of the statements it is based on, but
my interpretation is that most of it is based on the first claim - that it is not so
important to maintain confidence in the inflation target. Unfortunately, this rarely
develops into any more detailed reasoning. Typically, the criticism tends to stop at
monetary policy having been inappropriate, while reflections on the merits of a
credible inflation target - and in particular on why the advantages of the current
target should no longer apply - are almost always lacking.
Essentially the criticism concerns whether or not to have an inflation
target
When thinking about it, this criticism is in fact quite remarkable. What it actually says
is that even if confidence in the inflation target is beginning to fail quite clearly, the
Riksbank should not do what it can to maintain it. In this sense, one can argue that the
discussion is essentially about whether or not to have an inflation target, and perhaps
even about whether or not to pursue an inflation-targeting policy at all, although it is
rarely expressed in this way.
I can only think of one earlier parallel. It was as long ago as the second half of 1994,
after the Riksbank had decided to introduce an inflation target, but before it came
into force in 1995. The reason for the delay between the decision in January 1993 and
the target coming into force was to give the inflationary impulse that arose when the
krona was allowed to float in November 1992 time to wane.
During summer 1994, inflation and inflation expectations began to rise.7 Most
analysts' forecasts pointed to inflation overshooting the target by a broad margin, and
various indicators showed that the long-term expected inflation rate, which had never
been close to 2 per cent, was now above 4 per cent. The inflation-targeting policy was
thus faced with its first real challenge and the Riksbank began to raise the repo rate.
Despite this being an entirely logical measure in the prevailing situation, it was met
with strong criticism from some parts of society. A number of members of the largely
politically-appointed General Council of the Riksbank, which was then the body that
made the monetary policy decisions, entered reservations against the decision. Some
even considered that this interest-rate and monetary policy was leading Sweden into
"economic suicide".8 The most important measure, they said, should be to achieve a
lower real interest rate. The criticism lived on for quite a long time, but it was
probably quite essential to demonstrate at that time that the inflation target was
taken seriously.
This was until now the only time I can remember that the Riksbank was urged not to
do its best to maintain confidence in the inflation target. The criticism then was
largely due to the inflation-targeting policy being so new - as I said, the inflation
target had not yet even come into force. It is less easy today, after twenty years of
positive economic developments, in which the inflation target has been a
cornerstone, to see why the Riksbank is being urged to lower its ambitions. Perhaps it
is because developments have been so positive for so long that one feels the
existence of a credible nominal anchor is no longer as important. If so, I am convinced
that this is a mistake.
Difficult to see reasonable alternatives to the policy conducted
But what about developments in household debt and housing prices? Don't they give
a reason for changing monetary policy? The Riksbank has previously used the repo
rate to try to subdue the upturn in debt and housing prices. But this was on a fairly
modest scale and - above all - during a period when confidence in the inflation target
appeared firmly rooted.9 In recent years, on the other hand, there have been signs
that this confidence has begun to be undermined, which has changed conditions
rather drastically. It has no longer been possible to do both; the Riksbank has been
forced to choose.
I think it has been an absolute necessity in this case to prioritise confidence in the
inflation target. It is not just because this is the Riksbank's main task. In my opinion, it
is rather obvious that the problems on the housing market are deeper than the
currently low interest rate. Housing prices and household debt have risen in parallel
and almost constantly for twenty years, and during this time the interest rate has
been both relatively high and very low (see Figure 9). Another observation that
underlines the claim that the interest rate does not play the leading role is that
developments in housing prices in Germany have been quite different from those in
Sweden, despite a rather similar monetary policy (see Figure 10).
As I see it, it is not reasonable given this to advocate that the Riksbank shall sacrifice
its main task - to maintain confidence in the inflation target - to perhaps attain some
easing with regard to housing prices and debt, which would in any case only be
temporary unless other measures were taken. If we are to attain a long-term
sustainable development in the Swedish economy there is no way around managing
the risks in the housing and credit markets with targeted measures in housing policy,
taxation policy and macroprudential policy. Anything else would be a very strange and
ultimately untenable allocation of roles in economic policy.
Could confidence in the inflation target have been maintained with a less
expansionary policy?
As I noted, some analysts would probably argue that it is important to defend the
inflation target, but that this could have been done with a less expansionary policy,
where the repo rate would not have needed to be cut below zero.
This is a view that I have greater understanding for. However, there are many
arguments against it. The expansionary policy conducted by the Riksbank has indeed
led to inflation turning upwards and to long-term inflation expectations being once
again at or very close to 2 per cent (see Figure 11). But the upturn in inflation has
been bumpy and fragile and there are some signs that it has slowed down in recent
months. Moreover, the upturn has to a fairly large degree been based on the krona
being relatively weak and its sustainability rests on the assumption that the krona will
not appreciate too rapidly going forward. It is very probable that developments would
have looked quite different with a higher repo rate. And in this context the
significance of a repo rate that is only half a percentage point higher should not be
underestimated. It is not particularly difficult to imagine a scenario where the krona in
such a case would have strengthened, possibly quite significantly, economic activity
would have slowed down and inflation and inflation expectations would have turned
downwards.
This relates to a different type of criticism that argues that the negative interest rate
has not had any effect or even been counter-productive. The grounds for this criticism
appear to be that inflation has not attained the target despite the repo rate being
negative. This is of course true, but the question one should ask is how things would
have looked if the Riksbank had not cut the rate as much as it did. Of course we can
never know for certain, but it is difficult to see any convincing reasons why inflation
would have been the same as it is now, or even higher, if the repo rate had stayed at
zero. And in this context the risks of a very strong krona appreciation that needed to
be dealt with during the spring of 2015 should be recalled.
Unclear arguments regarding exchange rate and welfare
Before I continue, I would like to say something about one type of criticism that has
been common recently. It appears to be based on the idea that the exchange rate can
be regarded as a measure of welfare and argues that "Swedes have become poorer"
when the krona is weak, and vice versa. As the Riksbank's expansionary monetary
policy is assumed to be an important explanation for the weak krona, the Riksbank is
thus considered to contribute to this increased poverty. This is then taken as
justification for saying that monetary policy is wrong.
I have some difficulty in understanding this linking of the exchange rate to welfare. A
weak krona does tend to increase the prices of goods we import. But imported goods
are included in the representative consumption basket that inflation is measured by.
And the problem today is not that inflation is high, rather the reverse. It is thus not
the case that the weak krona significantly erodes our daily consumption.
For the man on the street a weak krona is most noticeable because it becomes more
expensive to travel abroad. This is of course unfortunate, but it nevertheless seems
fairly far-fetched to compare this with reduced welfare or increased poverty. The
other side of the coin is of course that Swedish companies find it easier to export and
are able to increase their employment. A more established measure of welfare is GDP
or GDP per capita, or consumption or consumption per capita.
Negative policy rates no panacea
Before I go on, let me note in conclusion that the negative repo rate has on the whole
had the expected effects. It has most probably contributed to inflation being higher
than it would have been otherwise and the fears of what might happen when the
repo rate passed the zero mark have so far not been realised.
Having said this, I would like to point out that I do not see negative policy rates as a
panacea for the problems monetary policy has faced in recent years, in an
environment where the global real interest rate is very low. There is an international
discussion, mostly on an academic level, about monetary policy becoming more
effective if the central banks' policy rates were to be made very negative - that is, if
the lower bound could in principle be eliminated entirely.10 But personally I do not
regard this as a practically implementable solution. Negative policy rates are already
regarded with scepticism and it is easy to imagine how opinion would be if they were
cut so far that the general public's deposit rates also passed beyond the zero mark -
or, even worse, if one with various electronic money solutions were to force people to
"pay to save".11
I definitely believe that there is scope to cut the repo rate somewhat further if
necessary. But one cannot ignore the fact that this scope is limited. It is of course also
possible to make further purchases of securities, but even there it is reasonable to
assume that the positive effects will wane sooner or later and the complications will
gradually increase.
I would like to emphasise, to avoid any misunderstanding, that I still count on inflation
developing in line with the Riksbank's forecast and attaining 2 per cent safely within
the current forecast period. But it is nevertheless important and necessary to
seriously consider and evaluate alternative scenarios.
It may take longer to attain the target...
The idea behind the recent policy has been to avoid the exchange rate appreciating
too rapidly and in this way to hold inflation up until economic activity takes over as
the driving force. Thus, the plan has not been to try to permanently battle against
fundamentals.12 This has so far worked relatively well, but we are now beginning to
approach the critical stage where economic activity is supposed to take over the
baton. One cannot escape the fact that inflation outcomes have been somewhat
worrying recently. It is now mostly the CPI that is showing a clear upturn. The more
underlying rate of inflation measured by the CPIF excluding energy prices has over the
year developed more or less sideways, or even shown a tendency to decline slightly.
The inflation outcomes in coming months will be very important.
The conditions for economic activity to soon take over as the main driving force
behind inflation nevertheless look good, given the positive development we are
seeing in the real economy. But there are also reasons to consider the possibility that
the baton changeover might not go as smoothly as we hope and believe. One reason
for this could be that economic activity in Sweden as such does not continue
developing as favourably as we are presently assuming it will. Another reason could
be that the forces currently holding back inflation in Sweden and other countries are
stronger and more persistent than expected - that the inflation propensity has fallen,
at least temporarily.
The first step will then probably be to make moneta