Stefan Ingves: Monetary policy in an uncertain economic policy
landscape
Speech by Mr Stefan Ingves, Governor of the Sveriges Riksbank and Chairman of the Basel
Committee on Banking Supervision, at the West Sweden Chamber of Commerce, Göteborg,
14 October 2014.
* * *
Accompanying slides can be found on the Sveriges Riksbank's website:
http://www.riksbank.se/en/Press-andpublished/Speeches/2014/Ingves-Monetary-policy-in-an-uncertain-economic-policy-landscape.
Continued low repo rate so growth and inflation can rise
At the beginning of September, we members of the Executive Board of the Riksbank decided
to allow the repo rate to remain at 0.25 per cent so that the currently low inflation will rise
towards our target of 2 per cent. The low inflation we have today reflects the weak
developments in economic activity both in Sweden and abroad. In this weak economic
situation, companies have found it difficult to pass on their increased costs to higher
consumer prices. However, as economic activity strengthens and demand rises, companies
will have greater opportunity to raise their prices, which will contribute to higher inflation.
We are expecting this to happen as economic activity abroad strengthens in the coming
years. However, the world is somewhat out of step. While the signals from the United States
are strong, developments in the euro area are surrounded by storm clouds, which can be
seen in confidence indicators such as the purchasing managers' index for the manufacturing
industry.
The subdued confidence in the euro area is probably because uncertainty over what
direction events will take is unusually great. This is partly because of the conflict in Ukraine
and the remaining questions regarding European banks' balance sheets. The public finance
situation is not entirely clear in all of the countries either. But once this uncertainty has
calmed, developments in the euro area may also pick up, as we are expecting that monetary
policy will remain very expansionary, fiscal policy will ease and credit granting will function
better.
The currently weak development in the euro area is of course also leaving its mark on the
Swedish economy. The development of exports is weak, which is in turn holding back
investment. Exports will not pick up again until economic activity abroad strengthens and it
may take a year or so before export growth returns to a normal rate. But then investment is
also likely to pick up as interest rates are low and the funding opportunities are good.
Demand from our most important trading partners is currently fairly weak, therefore, and this
has contributed to dampening growth in Sweden. On the other hand, demand from Swedish
households has developed positively. In recent years, household incomes have increased at
a good pace and consumption and housing investment have shown strong development.
Since our previous forecast at the beginning of September, new revised GDP statistics for
the second quarter showed a somewhat higher GDP and a somewhat stronger development
in consumption and investment than we had reason to expect, given the preliminary
statistics.
Employment has also risen somewhat since the start of the year, and if economic activity
strengthens as we are expecting, the demand for labour will rise. Then unemployment will fall
and the employment rate, that is, employed as a percentage of the population, will attain
roughly the same level as before the financial crisis. When the labour market situation
improves, we will also see gradually higher wage increases.
Even if the situation is currently uncertain, we thus see signs that economic activity will
gradually strengthen, both in Sweden and abroad, and thus companies will have greater
scope to raise their prices.
However, we believe that one condition for growth, employment and inflation to rise in
accordance with the forecasts is that we continue to hold the repo rate at a very low level.
This forecast for the repo rate - what we call the repo-rate path - is, however, a highly
uncertain forecast, at least with regard to the end of the forecast period. This relates to
something as self-evident as the fact that we live in a world full of uncertainty, not least with
regard to the preconditions for monetary policy - for example, developments abroad,
inflationary pressures, the level of unutilised resources in the economy and coming
measures in the field of economic policy.
Here there are many factors contributing to making our forecasts uncertain and our repo-rate
decisions difficult, and I shall touch on some of these problems.
Unclear international developments - unclear conditions for monetary policy
There is greater geopolitical uncertainty in our immediate area than there has been for a long
time. The ongoing conflict in Ukraine could escalate, trigger more far-reaching sanctions, put
further downward pressure on demand in parts of Europe and push energy prices up or
down. We are monitoring developments closely, taking note of other analysts' assessments
and working with different scenarios, but it is of course difficult to assess the probability of an
escalating conflict and to quantify what potential effects it might have.
Another uncertainty factor concerns the situation in the euro-area banking sector. The
European Central Bank's review of banks' assets (Asset Quality Review) and accompanying
stress tests, which will be published soon, can strengthen confidence in the banks and
thereby hopefully give new vitality to the banking sector, which has so far hampered a
muchneeded recovery through restrained credit granting and high interest rates on bank loans. But
the problems in the Portuguese, Bulgarian and Austrian banks that have surfaced over the
summer imply that some problems remain and there is a risk that the review will either point
to extensive problems or be perceived as insufficient.
Another extremely important condition for monetary policy in Sweden is the shape that
monetary policy abroad will take and what effects it will have on growth, inflation and
exchange rates. In many parts of the world, and not least in the euro area, low inflation over
a long period of time has come as a surprise to central banks and others. The European
Central Bank (ECB) has expressed concern over falling inflation expectations and recently
cut its policy rate to 0.05 per cent, at the same time as declaring that this is the lowest
possible policy rate for them.
Moreover, they have announced several measures aimed at stimulating lending to
households and companies. But it is still uncertain exactly what the measures will be and
how extensive they will be. Moreover, there is little or no previous experience of these
interest rate levels and measures in the euro area. It is therefore difficult to assess what
effects the ECB's measures will have on GDP and inflation in the euro area and thus,
ultimately, what they will mean for inflationary pressures here in Sweden.
One complicating factor is that the central banks in the United Kingdom and the United
States appear to be taking a different direction with their monetary policy than the ECB. Their
monetary policies are diverging. One reason why we are interested in expectations of policy
rates and supplementary measures in other countries is that they influence interest in assets
denominated in Swedish krona and therefore ultimately the development of the krona
exchange rate.
Interpreting exchange rate fluctuations is often very difficult, but the changes in the
expectations of the European and US central banks probably contribute to explaining the
recent weakening of the krona in relation to the dollar and the strengthening against the euro.
It is difficult to foresee the net result for inflation in Sweden, as that is dependent on both how
much the various exchange rates alter and what effects this in turn has on import prices,
competitiveness and purchasing power.
Factors at home also lead to uncertain conditions for monetary policy
International events thus account for many of the sources of uncertainty monetary policy
needs to deal with. However, there are also developments at home contributing to the
uncertainty over the conditions for monetary policy.
One question that we have long been seeking an answer to is why inflation has been lower
than we and many other analysts have forecast. The answer is, of course, an important piece
of the jigsaw puzzle when putting together the picture of future inflationary pressures. At the
Riksbank we have therefore put a lot of energy into analysing the available statistics, and
also into interviewing companies about the development of their costs and pricing. The other
day we published an Economic Commentary on the subject of company pricing.1 The
responses from 895 companies in the retail trade, construction and various service industries
imply that companies have experienced difficulties in passing on their increased costs to
consumers. A natural explanation is that demand has been weak and uncertain. Our ordinary
Business Survey, which was published last week, confirmed the picture that many
companies currently perceive the situation as relatively uncertain and that they are so far
cautious in implementing price rises.2 Although there are some signs that price increases
have been held back by an increase in competition, it is nevertheless reasonable to expect
faster price increases and higher inflation when economic activity strengthens again and
demand increases.
In addition to inflationary pressures, developments in housing prices and household debt -
and not least the counter-measures needed and their consequences - comprise an
important, but difficult to assess, domestic condition for monetary policy.
One should bear in mind the fact that experiences from other countries point to a high and
growing indebtedness sooner or later having serious socio-economic consequences, but
there is no clear limit as to when the situation becomes unsustainable. If one looks at the
information available on indebtedness among the households taking on new mortgages,
which thus in many respects comprise the purchaser side of the housing market today, I
think there is reason for concern. On average, these households take mortgages equivalent
to more than 350 per cent of their disposable incomes. The interest rates they pay on these
mortgages are very low in an historical and an international perspective. This is partly due to
the fact that a very high percentage of new Swedish mortgages are taken at variable interest
rates. Many of the mortgages are also interest-only loans. This means that there is a risk that
housing prices and indebtedness will now be driven up to unsustainable levels.
For those of us making the monetary-policy decisions, the key issue is what measures will be
taken to slow down the build-up of debt and, not least, what effects these might have on
household consumption and ultimately on inflationary pressures in the Swedish economy
while our monetary policy is taking effect. This is an important source of the uncertainty we
have to deal with.
Unfortunately, there is so far little experience to learn from with regard to the effects of
socalled macroprudential policy measures. This makes it difficult for those making decisions
and for those of us assessing what the decisions will be and what effects they may have.
One trade-off concerns "dosage". What one wants to achieve is that the growth in debt and
housing prices slows down, but at the same time one wants to avoid a heavy fall in housing
prices. This is a delicate task.
Another question concerns the fact that macroprudential policy involves getting banks and
borrowers to behave in ways that they would not otherwise, for instance, amortising their
loans quicker than they do now. Before one has managed to gain experience of the effects of
a particular package of measures within the framework of the Swedish financial system, it is
difficult to assess to what extent it affects monetary policy.
Managing uncertainty in monetary-policy decision-making
My impression is that we are now in a situation where the conditions for monetary policy are
perhaps even more uncertain than usual. However, monetary policy decisions must
nevertheless be made, and I therefore want to discuss my views on how this uncertainty
should be managed and how it has affected by own stance recently.
An obvious measure that I have already mentioned is to try to acquire more knowledge of the
sources of uncertainty and in this way reduce the uncertainty we are facing. We of course
follow international developments closely and rely on both our own and other analysts'
assessments of what they may entail. With regard to inflationary pressures in Sweden, as I
mentioned earlier, we have put a good deal of energy into analysing the available statistics
and into gathering new information from companies regarding their pricing behaviour. On the
question of household indebtedness, we are currently calculating what effects an
amortisation requirement would have. At the same time, we are developing our analysis of
how monetary policy and indebtedness will affect the risks in the Swedish economy in the
coming period.
I think that when making the actual decision, one must be sensitive to the difficulty of
quantifying everything that needs to be taken into account. Models cannot capture
everything. One often sees forecasts as mean forecasts. This means in principle that the risk
that the economy will develop less well is as great as the chance that it will develop better. A
mean forecast for GDP growth abroad, for instance, balances everything that could give rise
to lower growth against everything that could give rise to higher growth. Another way of
expressing the same thing is that the forecast is a form of middle way of all the different
roads the economy could take in the coming period.
This way of working with forecasts means that one acts as though one has succeeded in
quantifying the possibilities and effects of all of the different potential courses of events. A
year or so ago there were frequent discussions of the risk of a split or disintegration of the
euro system - what was the probability that this would happen and what effects would it have
for Sweden? Today there may be reason to ask these questions with regard to an escalation
of the Ukraine conflict or to a substantial fall in housing prices in Sweden.
If one considers these difficulties in quantifying various possible sequences of events and
probabilities that they will occur, it may not be as simple a matter to make decisions on
monetary policy and make forecasts for future interest rates as it is sometimes made out to
be. It is not necessarily a case of assuming that one has succeeded in capturing all possible
sequences of events in a balanced manner and then choosing the repo-rate path that
provides the smallest deviations from the inflation target and a long-term sustainable
development of employment during the forecast period.
As my colleague Stephen Poloz at the Bank of Canada recently pointed out, the shaping of
monetary policy is more a question of risk management than a precise feat of engineering.3
If one takes the uncertainty seriously, and I think we have to do that, my assessment is that
one should put particular emphasis on the really serious negative scenarios that we have the
capacity to influence with monetary policy. One such risk that we have tried to take into
account is that in a situation where macroprudential policy measures cannot manage all of
the risks linked to household indebtedness, a low repo rate over a long period of time could
aggravate and increase the probability of a domestic crisis caused by household
indebtedness. Another risk that requires particular consideration is that a low inflation rate
over a long period of time could make inflation expectations lose their connection to the
inflation target.
When I entered a reservation against the monetary policy decision in July this year, all of us
Executive Board members agreed that the repo rate needed to be cut for inflation to rise. The
difference concerned how much it should be cut. My stance was based on the assessment
that we could have given a slightly smaller impulse to further indebtedness and at the same
time contributed to bringing inflation and inflation expectations back on target by limiting the
cut to 0.25 percentage points and at the same time signalling a willingness to wait before
increasing the rate again until 2016, even if this looked as though it might mean that inflation
would overshoot the target.
Economic activity in Sweden is now beginning to improve, supported by very low interest
rates charged to households and companies and by stronger developments abroad.
However, our forecasts are, as I have argued, quite uncertain, especially a couple of years
ahead. Anyone wanting to know more definitely what will happen needs a crystal ball that
can describe all the situations that will arise here in Sweden and abroad over the coming
years. However, there is no such crystal ball, so as always when making decisions in an
uncertain situation we will have to deal with what happens as it comes.
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