Per Jansson: My view on inflation targeting
Speech by Mr Per Jansson, Deputy Governor of the Sveriges Riksbank, at Karlstad
University, Karlstad, 11 October 2012.
* * *
Twenty years of a floating exchange rate
I would like to begin by taking you on a trip back in time, twenty years ago to 11 October
1992. Sweden and a number of other countries were then in the midst of a crisis that in many
ways is similar to the one many countries in Europe are now undergoing. The situation was
critical. Property and financial companies had gone bankrupt, the entire Swedish banking
system was rocked to its foundations, unemployment had begun to soar and public finances
were drained. The fixed exchange rate was put under severe pressure and many assumed
that Sweden would do what it had done so many times before - adjust the value of the krona
to get the wheels in motion once again.
Around one month earlier the Finnish central bank had been forced to give up its defence of
the exchange rate and let the markka float. One week later, on 16 September, the United
Kingdom and Italy decided to give up the fight for sterling and the lira. The Riksbank on the
same date had instead raised its repo rate to 500 per cent in an attempt to stop the currency
flows and the speculation against the krona. On 6 October, a statement of government policy
declared that there was almost total support for the hard currency policy and that the
prospects of success were good.
We all know what happened. Just over one month later, on 19 November, the Riksbank was
forced to give up the fight and the krona was allowed to float, or perhaps I should say sink.
As I have understood things with hindsight, there was no clear plan in place as to how
monetary policy would be conducted from then on.1 And this was perhaps not so strange -
with the exception of a couple of brief periods between the wars, Sweden had had a fixed
exchange rate for the past 120 years. So it was probably difficult to think along new lines.
The aim also seems to have been that Sweden would return to some form of fixed
exchangerate system as soon as possible, and so the idea was to find some way of conducting
monetary policy until then.
Inflation targeting has worked well, but has been criticised
Some countries, New Zealand, Canada and the United Kingdom, had begun to apply a new
type of monetary policy known as inflation targeting. This entailed setting a numerical target
for inflation, which the central bank then tried to attain by using the policy rate to affect
aggregate demand. Sweden also jumped onto this bandwagon and it proved to be a much
more enduring solution than most people expected at the time.
We have now lived with inflation targeting for almost twenty years. I am convinced that most
people today would say that it has worked well on the whole - that it has fulfilled its purpose,
and perhaps even exceeded expectations. But when one has got used to a particular system
over a long period of time, it is fairly natural to start looking for faults and begin to question
whether it might not be possible to make some modifications and improvements. And I do
have the impression that inflation targeting in Sweden has recently been criticised somewhat
harder and somewhat more often than usual.
Today I intend to discuss and respond to three types of criticism that have been put forward.
The first is the claim that the Riksbank has an inbuilt tendency to set the interest rate too high
and has thus caused unemployment to be unnecessarily high. The second criticism suggests
that the target for monetary policy should be revised, by raising the inflation target and giving
the Riksbank a numerical target not just for inflation, but also for employment or
unemployment. The third type of criticism is that monetary policy has recently been unclear
and difficult to understand.
Inflation targeting's most important contribution
But before I move on to the different types of criticism, I would like to dwell a little longer on
the situation twenty years ago. When analysing the inflation-targeting regime, I believe that it
is important to remind oneself of the situation when it was introduced. Why was there such
strong support for defending the krona, even though it meant high interest rates in the middle
of a recession? What were the problems policymakers were so anxious to resolve?
As I have already mentioned, the recession in the early 1990s can be regarded as a setback
following an excessive credit expansion, similar to the situation in many European countries
today. The regulation of the Swedish credit market was phased out in the mid-1980s.
Combined with a tax system that encouraged borrowing and an overly expansionary
stabilisation policy, this contributed to creating a property market bubble. When the bubble
burst in the early 1990s, it led to a banking crisis. As this coincided with an international
economic downswing, the recession in Sweden was particularly severe.
But there was also a deeper and more fundamental problem in the Swedish economy at that
time. Sweden had been caught up in what might be termed a devaluation cycle since the
early 1970s. Fixing the exchange rate is equal, at least in theory, to setting a target for
domestic inflation. The idea is that domestic inflation should not be able to exceed inflation in
the countries to which one's own currency is pegged, at least not for any longer periods of
time. But this requires that the commitment to holding a fixed exchange rate is backed up by
other policies to ensure its credibility, and this was not the case in Sweden. As there were
expectations that inflation would remain high and that the krona would be devalued, wage
inflation in Sweden was persistently higher than that abroad. As the exchange rate was fixed,
Swedish companies' competitiveness was undermined - a cost crisis arose. To resolve this,
it was necessary to devalue the krona, which meant that expectations were fulfilled. This in
turn meant that the inflation trend could continue, competitiveness was gradually undermined
once again, the exchange rate was devalued one more time, and so on. What is referred to
as "the nominal anchor" - the benchmark for inflation expectations and thereby for price
setting and wage formation - had come loose.
The widespread support for the defence of the krona should be seen against this backdrop.
There was considerable agreement that the devaluation cycle was harmful and must be
broken. The only way of doing this that policymakers considered possible was to convince
everyone that the commitment to hold onto the fixed exchange rate was irrevocable. Today
we may think they overestimated the chances of success and that the defence of the krona
thus went too far. But one has to remember that there was no obvious alternative. Inflation
targeting was new and untried and not many people were even aware of its existence.
Moreover, it was far from obvious that it would succeed where the fixed exchange-rate policy
had failed - in establishing an anchor for price setting and wage formation.
We now know that it did succeed and moreover that it did so fairly quickly. If I were to choose
what I think is the most important contribution of inflation targeting, and indeed its overall
main merit, it would be this - that is provides a nominal anchor for the economy.2 It is quite
clear from a Swedish point of view that inflation targeting has helped "to put the house in
order" by providing such an anchor, and it is probably an important explanation as to why the
Swedish economy has developed so well since the crisis in the 1990s.
Has the Riksbank systematically set the repo rate too high?
But, as I noted, inflation targeting has nevertheless been criticised, particularly in recent
years, so let me now move on to this criticism. One criticism is that the Riksbank has an
inbuilt tendency to set the repo rate too high. This is said to have caused inflation to
undershoot the target for most of the inflation-targeting period and to have led to
unemployment being unnecessarily high, sometimes quantified to tens of thousands of
people. I would like to respond to this criticism as I consider it to be misleading and based on
oversimplified analyses.
How much has the target been undershot?
The first question to ask is by how much the Riksbank has actually missed the target.3 The
answer to this question is not as obvious as one might think. The inflation target is formulated
in terms of the familiar measure CPI (consumer price index) and says that the CPI is to
increase by 2 per cent per year. But sometimes there is good reason to allow monetary
policy to be guided by other measures of inflation than the CPI. This is something the
Riksbank has long emphasized.4
One of the most obvious reasons for also looking at other measures of inflation is that when
the policy rate is adjusted, this has a direct impact on CPI "in the wrong direction" through
households' mortgage costs - when the repo rate is increased, interest costs increase and
this is reflected in higher CPI, and vice versa when the repo rate is cut. Seen over really long
periods of time this should not matter as the Riksbank's cuts and raises of the repo rate can
be expected to offset one another. However, during periods when the repo rate is adjusted
substantially and in the same direction, there is reason to consider these direct monetary
policy effects, as otherwise the Riksbank might be tempted to "chase its own tail" - a policy
rate increase leads to higher CPI, which in turn leads to further policy rate increases and
higher CPI, and so on.
The period with an inflation target has been special in the sense that the repo rate has fallen
more than it has risen. One important reason for this is that it has been possible to cut the
rate as confidence in the inflation target has increased and inflation has slowed down. For
example, in 1995 the repo rate was almost 9 per cent, while three years later it was around
3 per cent. Since then it has only exceeded 4 per cent for brief periods.
If one calculates the average inflation rate since 1995 - when the inflation target began to
apply5
- with a measure, the CPIF, that excludes the direct effects of monetary policy, it
amounts to 1.85 per cent. As CPI inflation during the same period was around 1.5 per cent,
one can say that 3-4 tenths of the deviation in the CPI from the inflation target is explained
by the Riksbank having cut the repo rate more than it had raised it during this period. Even
though the target is specified in terms of the CPI, this information is fairly important when
determining how successful monetary policy has been.
Favourable developments have held inflation back
Of course, it is also important to analyse why inflation has undershot the target, even after
these direct effects of interest rate changes have been excluded. My view is that growth in
the economy has often been surprisingly high during the periods when inflation has been
unexpectedly low. The combination of low inflation and high growth indicates that the
economy was affected by positive changes on the supply side. The Riksbank and other
forecasters have, for instance, often been surprised by the high productivity growth in the
Swedish economy. As I see it, it is thus largely unforeseen, but beneficial developments that
have kept inflation down. It is not, as one might sometimes get the impression in the current
debate, a result of the Riksbank systematically putting on the brakes, thus pushing down
demand and holding back price increases. If this had been the case, the low inflation would
have gone hand in hand with a much weaker growth in the economy.
So is this development in inflation a poor result for monetary policy? It is of course possible
to have different opinions on this. But from what I have said so far, it should be clear that I
believe there are good explanations as to why inflation has been slightly lower than the
target. The repo rate has been cut more than it has been raised during this period, and there
have been changes in the economy - which have been difficult to forecast and often
beneficial - that have dampened inflation.6
To gain further perspective, it may also be valuable to go back to where I started, twenty
years ago, just before the inflation target was introduced. As I observed earlier, the high
inflation trend at that time was a fundamental problem in the Swedish economy. During the
decades preceding the crisis of the 1990s, average inflation was almost in double figures and
varied substantially from year to year. Suppose one would have claimed at that time that
inflation from 1995 and seventeen years onwards would be on average just below 2 per cent
and much more stable, and that growth during this period would not be lower than before, but
on the contrary somewhat higher. I am pretty sure that one would have been met with
considerable scepticism. And very few would probably have characterised a monetary policy
that contributed to this as unsuccessful.
This is a rather different picture than the one on which the criticism of tens of thousands of
"lost jobs" is based. The latter instead appears to view the relatively limited undershooting of
the target as a major failure, without any real mitigating circumstances. It also appears to
assume that the Riksbank for some reason has intentionally and systematically aimed to
attain a lower inflation rate than the 2 per cent it has itself set as the target. It is difficult to
see the logic in such behaviour. And it is definitely not something that I recognise after
working at the Riksbank at various times over the past fifteen years.
Wages not necessarily based on incorrect expectations
There are also other objections to the criticism that monetary policy should have cost tens of
thousands of jobs. One reason claimed for the unnecessarily high unemployment is that real
wages, that is, wages adjusted for inflation, have been higher than they would otherwise
have been if inflation had been on target. In other words, the Riksbank is said to have
"tricked" the social partners into setting wages too high in relation to the inflation that was
later realised.
However, it is far from clear what inflation expectations are used as a base for wage setting.
In the long run, say five years, expectations are well anchored around the inflation target of
two per cent. But in the shorter run, expectations vary more and follow actual inflation more
closely. It may be that wage setting is based on the expectations in the somewhat shorter
run. Expectations can be measured in different ways that give slightly different results. The
measure of inflation expectations that appears to have the strongest link to actual wage
increases is firms' inflation expectations one year ahead from the National Institute of
Economic Research's business tendency survey.7 According to this measure, inflation
expectations have followed actual inflation fairly well. In other words, the agents have not
been "tricked", but have realised that inflation can deviate from the target in the short run. If
wage increases are based on this measure, then in other words real wages have not been
too high and unemployment has thus not been "unnecessarily high".
Before I move on to the next type of criticism, I would like to emphasise that what I have said
here should not be interpreted to mean that I wish to make light of inflation undershooting the
target. The Riksbank should of course do its best to attain the inflation target and I can
assure you that we do. However, it is not an easy task, and I believe that many people
understand this.
Proposal for higher inflation target and target for employment
Another type of criticism is aimed at the target formulated for monetary policy. It comes in
slightly different forms, but a common theme is that the inflation target should be raised, and
that it should be combined with an explicit target for employment or unemployment. One
concrete proposal that is put forward is that monetary policy should support a target for an
employment rate of 80 per cent.8
The level of central banks' inflation targets has begun to be discussed internationally as a
result of the recent crisis.9 One argument is that if the targets were set slightly higher, it
would make it easier to stimulate economies in deep recession, as it would reduce the risk of
the policy rate reaching the zero lower bound. This is a relevant argument. Moreover, it is
probably not the case that an inflation rate of, say, 3 per cent would be more problematic to
live with than an average inflation of 2 per cent. It is only at considerably higher figures that
inflation is harmful.
Difficult to change an established inflation target
However, it is one thing to set an inflation target for the first time, and a quite different thing to
raise an existing target. If we go back twenty years in time, to when the policy of inflation
targeting was introduced, the target could in principle have been set at 3 instead of 2 per
cent. It is possible that it would have been a little more difficult to make the target credible,
partly because it should have been higher than actual inflation at the time - which was fairly
exactly 2 per cent, and partly because the few central banks that had begun targeting
inflation at that time had chosen targets on or close to 2 per cent.
But the problems would most likely be much greater if one were to change an already
established inflation target. There is a risk that, for instance, an increase from 2 to 3 per cent
could be interpreted as an indication that the target will be raised a little every now and then,
when the situation is perceived as problematic. There is even a risk that the nominal anchor
in such a case could come loose. Sooner or later expectations would adjust to the new
target, but the adjustment period could prove costly. The central bank might feel forced to
conduct a very tight policy to convince the agents in the economy that this was indeed a
one-off increase of the target. So far, no government or central bank has made the
assessment that an increase in the inflation target would have sufficient advantages to
outweigh the potential drawbacks.
Monetary policy only affects employment indirectly in the long run
When setting a policy target, it is important that whoever is to meet the target can do so on a
lasting basis. A natural target for a central bank is to keep inflation at a particular level over
time. The central bank's ability to govern inflation ultimately depends, somewhat simplified,
on its ability to affect the amount of money in the economy. It cannot steer inflation with a
high amount of precision, but still well enough to ensure that it is on average close to the
target over time.10
But when it comes to targets for employment, monetary policy does not have the same
power. The best way for monetary policy to promote a good long-run development of
employment is to "keep the house in order". By this I mean keeping inflation low and stable
- supplying a nominal anchor - and in addition holding the economy in balance by
dampening fluctuations in economic activity. This creates a good macroeconomic
environment where companies dare to invest and hire. The possibility of monetary policy to
influence the long-run employment rate, the equilibrium level, is thus in all essentials indirect.
Employment target not meaningful and potentially counter-productive
The long-run employment rate is essentially determined by factors beyond the control of
monetary policy, such as demography and, above all, the functioning of the labour market. If
these factors together imply that what is possible to attain is a long-run employment rate of,
say, 75 per cent, it would be meaningless to give the central bank the task of promoting an
employment rate of 80 per cent. What monetary policy might be able to do in such a situation is
to make the employment rate temporarily reach 80 per cent by overheating the economy. But
nothing would be gained by this, as the employment rate would soon return to 75 per cent.
However, the overheating, in turn, could cause problems that might be difficult to deal with,
such as making inflation expectations rise and creating asset market bubbles. Thus, one
cannot give the central bank a numerical target for employment that it should strive to attain in
the same way as an inflation target.11
It is sometimes claimed that the Federal Reserve is an example of a central bank with an
employment target. Although the Federal Reserve Act states that the Federal Reserve shall
"promote effectively the goals of maximum employment, stable prices, and moderate
long-term interest rates", this does not mean that it in practice works with a numerical target
for employment.12
One can illustrate the fact that the long-run level of employment is determined by factors
other than monetary policy in different ways. Following the crisis in the 1990s, unemployment
and the employment rate have varied around an apparently unchanged long-run level,
despite the policy rate having been both relatively high and very low during this period.
Although there is a relationship between monetary policy and the labour market in the short
run, monetary policy does not seem to have influenced the labour market on average.
Despite periods of very strong growth and economic activity, unemployment has never been
lower than just under 6 per cent, with an average rate of around 7 per cent since 2000. An
overwhelming proportion of unemployment is thus structural rather than cyclical. This picture
is also supported by unemployment varying substantially between groups. For instance, it is
very high among people who do not have upper-secondary school approved grades, as well
as among immigrants and young people. These groups comprise a relatively large share of
job-seekers. Structural measures to enable these groups to gain a foothold in the labour
market are a better recipe than expansionary monetary policy for bringing down
unemployment. A further indication that long-run labour market developments are governed
by factors other than monetary policy is that unemployment has varied substantially between
the countries in the euro area, despite their common monetary policy.
Trying to place the responsibility for employment with monetary policy and the central bank is
thus, in my opinion, not very meaningful. It could even be counter-productive as the focus is
moved from the places where the problems really can be dealt with - the labour market and
the political sphere - to a place where they cannot. Sometimes one almost gets the
impression that the actual purpose of trying to transfer responsibility for employment to the
central bank is to avoid having to take the fairly unpleasant decisions that might be needed to
create good conditions for employment. Of course, it would be much easier if the
employment problem merely concerned cutting the policy rate to a low level and keeping it
there. But it is not that simple.13
Has monetary policy been unclear?
Let me now move on to the third type of criticism. It claims that monetary policy has been
unclear and difficult to comprehend, particularly in recent years. According to some, it has
been difficult to understand the motives behind some of the decisions and it has not been
very clear why the decisions reached were preferable to the alternatives.
I can have some understanding of this criticism and I will return to this. But first I would like to
discuss the question of what is meant by a clear monetary policy. It is not self-evident, as we
shall see, and different people appear to mean slightly different things.
A theory-based policy is not necessarily clearer
The academic literature on monetary policy often describes inflation targeting as the central
bank minimising a so-called loss function. This loss function is a weighted sum of a measure
of the variability of inflation and the variability of the real economy. The loss function can,
somewhat simplified, be written as
,
where π is the forecast for inflation, π* is the inflation target and
y-y* is the forecast for
resource utilisation in the economy. The parameter λ represents the importance the central
bank gives to stabilising the real economy in relation to stabilising inflation.14
It is thus a question of finding the interest rate that minimises the squared forecast deviations
between actual inflation and the inflation target during the forecast period and the squared
forecasts for resource utilisation.15
This theoretical description has been very useful in
developing the policy of inflation targeting. It captures in an intuitive and relatively simple way
the essence of inflation targeting and it has helped to structure our thinking.16
However, the step from theory to practice is far from as simple and straightforward as one
might think. One often gets the impression from the current debate that "clarity" in monetary
policy means that the central bank should follow this theoretical description very closely.
Accordingly, monetary policy decisions should be justified on the basis of a detailed
quantified path for both resource utilisation and the deviation of inflation from the target.
The expression "nothing is as practical as a good theory" probably applies in many ways, but
to be really practical also requires that the theory captures the central elements as they
appear in real life and - in particular - that one is aware of its shortcomings and faults.
Measurement and estimation problems make the step from theory to practice
difficult...
One circumstance that very much complicates the step from theory to practice is that while
the variables in the loss function are well specified in theory, in practice it is far from obvious
how they should be measured. Resource utilisation, y-y*, can be regarded as a summarising
measure of developments in the real economy and states how far production resources, that
is, labour and real capital, are used in relation to the level that is sustainable in the long run,
or the "normal" level. Unfortunately, it is not possible to directly observe how high the level of
resource utilisation in the economy is, and nor is there any generally-accepted view of how
this should be calculated. It is thus scarcely possible to say that a particular policy will lead to
resource utilisation increasing or decreasing by exactly this or that figure.17
Sometimes the argument is put forward that it is much easier if one uses the deviation
between actual unemployment and long-run sustainable unemployment, or equilibrium
unemployment, instead of resource utilisation in the loss function. But I am quite sure that
14
Svensson, Lars E.O. (1997), "Inflation Forecast Targeting: Implementing and Monitoring Inflation Targets",
European Economic Review 41, pp. 1111-1146 introduced this type of loss function to analyse so-called
flexible inflation targeting. However, the behavioural assumption that the loss function (or very similar
variations of it) implies, has a long tradition in analyses of monetary policy (for example, Kydland, Finn E. and
Journal of
Edward C. Prescott (1977), "Rules Rather than Discretion: The Inconsistency of Optimal Plans",
Political Economy 85, 473-491.)
15
One can also calculate the mean value of these deviations, what is known as the mean squared gap. The
mean squared gap for inflation and resource utilisation can then be drawn in as points in a figure; see, for
instance, the article "A method for assessing different monetary policy alternatives" in the Material for
assessing monetary policy 2011, Sveriges Riksbank.
16
See, for example, Apel, Mikael, Per Jansson and Lars Heikensten (2007), "The role of academics in monetary
policy: a study of Swedish inflation targeting", Sveriges Riksbank Economic Review 2007:1, pp. 21-58.
17
The document "Monetary policy in Sweden 2010", Sveriges Riksbank, summarises the Riksbank's monetary
policy strategy. It is stated there (p. 5) that monetary policy "in addition to stabilising inflation around the
inflation target, also strives to stabilise output and employment around long-term sustainable paths". However,
this does not mean that policy needs to be pegged to specific numerical estimates of these paths; see the
continued discussion in this speech.
anyone who has ever tried to estimate equilibrium unemployment will agree with me that it is
not much easier than estimating normal resource utilisation or the long-run sustainable GDP
trend. Unemployment data is perhaps not revised as often and as much as GDP data, but
this is not the only reason why estimates of equilibrium unemployment are extremely
uncertain and difficult to use as a basis for economic policy decisions.18
... as does the fact that more than one person makes the decisions
However, the gap between theory and practice is not only about measurement and
estimation problems. Problems of this type would be difficult enough to handle even if the
monetary policy decisions were made by a single decision-maker. But in reality we are six
individuals who decide on the repo rate. And as these issues are ultimately a question of
judgement it is up to each member of the Executive Board to make his or her best estimate
of which measure or measures of the development of the real economy he or she believes
monetary policy should focus on to, as it says in the preparatory works of the Sveriges
Riksbank Act, "support the objectives of general economic policy for the purpose of attaining
sustainable growth and a high level of employment".
She or he may also make the assessment that factors other than the forecast for inflation
and various measures of resource utilisation should in some situations be taken into account
in the monetary policy decisions. This may be a question of paying attention to economic
developments in the longer term, beyond the forecast horizon, or risks that are difficult to
quantify relating to the financial parts of the economy.
The fact is that one of the main aims of having an Executive Board is that its members
should have slightly different views on things. When the Executive Board was established in
1999 the more or less explicit aim was that it would consist of people with different
backgrounds, experience and knowledge. The idea behind this "diversification" is that
committees tend to make better decisions than individual policymakers, as a committee can
"pool" its experience and knowledge.19 And in order to have something to "pool", the people
on the committee should of course not be too alike.
I believe that everyone who has ever been a member of the Executive Board of the Riksbank
agrees with the general wording that the Riksbank should stabilise inflation around 2 per cent
and at the same time help to stabilise the real economy. This is also the essence of the
Sveriges Riksbank Act and its preparatory works. However, this does not mean that actual
monetary policy can be linked to the theoretical description in a simple and very strict way.
My impression is that among both the present and former members of the Executive board
there is a lot of scepticism towards far-reaching and strict parallels between theory and
practice. Such parallels would paint far too simple a picture of monetary policy and would
give the impression that there is a precision and exactness in monetary policy - a possibility
to "fine tune" - that simply does not exist. This would possibly give an illusion of "clarity" but
would, as I see it, merely be a chimera.20
The Riksbank is hardly unique in this respect. I have no doubt that such scepticism also
exists in the monetary policy committees of other countries. As far as I know, there is no
central bank that literally conducts and describes its monetary policy in accordance with the
simple loss function that I showed earlier. The central bank that comes closest is probably
Norges Bank, but it too has recently taken some steps away from a too theory-based
interpretation of practical policy in terms of the simple loss function.21
An incorrect estimate of the equilibrium level leads to incorrect policies
One of the risks of a policy that ambitiously tries to stabilise the real economy around a
numerical, long-term target for, for instance, production or employment, is that the estimate
may be incorrect. If so, this will lead to policy being conducted incorrectly. If the estimate of
the long-term sustainable rate of production or employment is too high, monetary policy will
be too expansionary, which can lead to problems with the nominal anchor. It has been
claimed that this is an important explanation of the high rate of i