Karolina Ekholm: The interest rate, the exchange rate and inflation
Speech by Ms Karolina Ekholm, Deputy Governor of the Sveriges Riksbank, at a meeting at
Danske Markets, Stockholm, 4 April 2011.
* * *
The views expressed here are my own and are not necessarily shared by the other members of the Executive
Board of the Riksbank or the Riksbank's staff. I would like to thank Johanna Jeansson and Pär Österholm for their
great assistance in the writing of this speech.
Today, I will give an account of my stance at the latest monetary policy meeting in February.
However, I will keep this relatively brief - the main part of my talk will focus on the
significance of the exchange rate in the monetary policy process. There is no target level for
the exchange rate, but, as it affects both inflation and resource utilisation, it is of fundamental
interest to the Riksbank's analysis work. The fact that it is difficult to forecast does not mean
that it can be ignored.
The current situation and the monetary policy decision
In February, the majority of the Riksbank's Executive Board decided to raise the repo rate to
1.5 per cent and to revise the interest rate path upwards slightly. The justification for this
decision was that the Swedish economy remains strong. For example, GDP growth in 2010
was historically strong (see Figure 1). The development of the labour market is also
continuing to be strong, and unemployment has fallen somewhat more steeply than was
anticipated at the monetary policy meeting in December. Furthermore, inflation has
increased at a slightly faster rate due to higher energy and commodity prices. On the whole,
growth abroad is also deemed to be strong. While it is true that developments in Europe are
still uncertain due to the fiscal problems in several European countries, prospects in the
United States are judged to have brightened somewhat.
As you are no doubt aware, on a number of occasions over the last year, I have entered
reservations against monetary policy decisions, including the most recent one in February.
One important argument for me has been that increased interest rate differentials in relation
to other countries may have effects on the exchange rate. During the autumn in particular,
my reservations have essentially been due to my scepticism of the assumption that foreign
central banks will raise their policy rates at the rate specified by the Riksbank's main
scenario. In my opinion, this has meant that the main scenario's repo rate path has given rise
to a considerably larger interest rate differential in relation to other countries than has been
assumed in the Riksbank's forecast. This could lead to a greater appreciation of the Swedish
krona than this forecast suggests, which, in turn, would dampen both inflation and resource
utilisation. My view has been that the further appreciation of the Swedish krona has risked
leading to impaired target fulfilment, and this has been the motivation behind my stance in
favour of a lower repo rate path than that decided upon.
Am I not concerned that a lower repo rate path would lead to excessive inflation, considering
how inflation has increased recently due to higher energy and commodity prices? It remains
to be seen how permanent these increases will be. In our most recent forecast, which
assumed the stabilisation of these prices, underlying inflation, even in the main scenario, was
estimated at less than 2 per cent for most of the forecast period (see Figure 2). On the basis
of this forecast, there is thus scope for a more expansionary monetary policy.
One matter that I intend to address at the next monetary policy decision is the wide gap
between CPI inflation and CPIF inflation that we saw in January and February. This gap is
partly due to a detail, related to mortgage costs, in the calculation method used, which also
results in higher CPI inflation over the rest of the year than was forecast in the monetary
policy report in February. However, in my opinion, the underlying inflationary pressure in the
economy is still low, which, for example, is reflected by the low outcome for CPIF inflation.
Monetary policy has to be forward-looking, as its influence on the economy is subject to a
time-lag. Consequently, the monetary policy significance of temporary variations in the CPI in
the near future should not be exaggerated. However, if long-term inflation expectations and
wage formation risk being tangibly affected, we should consider taking measures.
How should the exchange rate be taken into account?
The Riksbank has no target for the exchange rate, but, in a small, open economy such as
Sweden's, the exchange rate is an important determinant for both inflation and resource
utilisation. However, the analysis of exchange rates is an admittedly difficult area. I will
explain some of the difficulties involved in this analysis, as well as how they have affected my
view of the manner in which the exchange rate should be handled in the monetary policy
analysis.
The exchange rate's empirical relationship with interest rate differentials in relation to
other countries
Let me first clarify my earlier claim that a greater interest rate differential in relation to other
countries than that forecast in the Riksbank's main scenario may lead to a greater
appreciation of the krona than that forecast by the Riksbank.
The theoretical basis for this is formed by a condition known as uncovered interest rate
parity. This is a theoretically fundamental concept and is used frequently. Uncovered interest
rate parity says that the interest rate differential between two countries corresponds to the
anticipated change in the exchange rate during the period in question. For example, if the
one-year interest rate was 2 percentage points higher in Sweden than in the United States,
this would be compatible with a 2-per cent weakening of the Swedish krona against the
US dollar during the year. The logic behind this is that "risk-free" investments in different
currencies ought to have largely the same expected return.
According to uncovered interest rate parity, a higher interest rate in Sweden than abroad
should thus be linked with an expected future weakening of the krona. So how is this
connected to my claim that the krona would become stronger as a consequence of an
increased interest rate differential in relation to other countries? The answer lies in
expectations and in what has already been priced on the market. This can be explained by a
simplified example. Assume that the interest rate is originally as high in Sweden as in the
rest of the world. In that case, uncovered interest rate parity says that the anticipated future
exchange rate will be the same as the current exchange rate. If this expectation of the future
exchange rate is taken for granted, an unexpected interest rate increase in Sweden would
lead to an inflow of capital and an appreciation of the krona. The krona would now be
expected to weaken in the period ahead, as the present rate is stronger than the anticipated
future rate. Note that, on average, the krona will be stronger during the period in question
due to the rise in interest rates in this example. The krona thus appreciates today before
moving towards the same anticipated future exchange rate as previously.
However, empirical support for uncovered interest rate parity is mixed.1 As in all empirical
analysis, it is difficult to isolate the effects of interest rate differentials on the exchange rate.
Furthermore, there are difficulties in measuring expectations, and there may be frictions on
the financial markets that mean that the relationship does not fully hold true. Be that as it
may, the presence of other factors complicating the relationship is hardly reason to
completely disregard it.
The exchange rate is volatile
Another circumstance complicating the analysis is the tendency for floating exchange rates
to be highly volatile. This is illustrated in Figure 3, which shows the development of the
krona's trade-weighted exchange rate. The figure shows that the krona can both depreciate
and appreciate to a relatively large degree over relatively short periods. For example, the
krona depreciated by almost 20 per cent in TCW terms between the second quarter of 2008
and the first quarter of 2009. Unease on the financial markets, which tends to weaken
comparatively small currencies like Sweden's, contributed towards this. Following this, the
krona appreciated strongly and now lies at approximately the same level as prior to the
financial crisis.
This volatility in itself argues that a central bank with an inflation target should not focus
unduly on exchange rate fluctuations.2 If the central bank were to react to every such
fluctuation, monetary policy would also be volatile. This is obviously undesirable as it may
mean that the central bank itself becomes a source of unnecessary disruptions in the
economy.
A volatile exchange rate can be regarded as particularly problematic if the central bank
allows the exchange rate to take a very prominent position in its analysis, for example by
relying on what is known as a Monetary Conditions Index (MCI). An index of this kind is
intended to summarise, in one measurement, the effects of interest rates and the exchange
rate on inflation and resource utilisation. Somewhat simplified, the idea behind the MCI can
be described as this: all other factors being equal, if the exchange rate is strengthened, the
interest rates should be lower, and vice-versa. During several of the initial years of the
inflation-targeting regime, the Riksbank used an MCI in its monetary policy analysis.3 Its
intention during this period was to demonstrate very clearly that, in a small, open economy,
the exchange rate influences inflation and resource utilisation. Today, the Riksbank no longer
uses any such index as a summarising measure. One reason for the abandonment of MCI
was that it could be interpreted in an excessively mechanistic way: when the exchange rate
weakened, MCI tended to be used in a simplified manner as an argument for a higher
interest rate, and vice-versa. Considering the wide fluctuations that can take place in the
exchange rate over short periods, an MCI in which a large weight is placed on the exchange
rate means that very large changes to the interest rate may be demanded to compensate for
exchange rate fluctuations.4
The exchange rate pass-through on import and consumer prices is uncertain
The price of imported consumer goods is partially determined by the exchange rate. If the
krona is weakened, importers must generally pay more in Swedish kronor for goods bought
overseas. Importers must choose how to handle this. Should they increase their prices to
compensate for the increased purchase prices or should they reduce their margins? The
answer to this question depends on a number of factors.
In the short term, importers may avoid price changes, as far as this is possible. Partially, this
is because price changes are intrinsically costly,5 but also because firms often wish to
maintain customer goodwill by not immediately passing increased costs along. Furthermore,
many firms hedge their foreign trade on the foreign exchange forward market so as not to be
affected by short-term exchange rate fluctuations.6
This very time horizon is an important aspect of exchange rate fluctuations. If the change is
deemed to be temporary, it is reasonable to assume that many firms will avoid changing their
prices and that the pass-through will thus be moderate. If, on the other hand, it is deemed to
be permanent, the pass-through should be greater, as otherwise margins will be lower (in the
event of a depreciation of the krona). Another important aspect here is the competitive
situation on the market. On a market characterised by strong competition, it will be more
difficult for a firm to increase prices without losing sales.
The general demand situation can also play a part. It will probably be easier to raise prices in
a period of high economic activity, when many domestic competitors will also have a
tendency to increase their prices, than in periods in which domestic demand is developing
weakly.
Empirical studies suggest that, for example, a weakening of the exchange rate by 4 per cent
will increase import prices by about 2 per cent, which is to say that the pass-through is about
50 per cent over the short term.7 The pass-through on consumer prices will be lesser, as the
price in Sweden for imported goods is also determined by domestic components such as
wages, taxes and transportation costs. A pass-through of about 15 per cent over one year
would seem to be a reasonable assessment.8
Figure 4 illustrates the pass-through of the exchange rate on import prices and consumer
prices. It shows a clear connection between the exchange rate and import prices. The
connection between the exchange rate and consumer prices is weaker.
However, the pass-through of the exchange rate may be non-linear, so that minor or no
adjustments are made in the event of small changes in the exchange rate, and relatively
major adjustments are made in the event of large changes in the exchange rate. But it may
also be the case that relatively large changes in the exchange rate have minor or no effects
on consumer prices, depending on what are known as composition effects. Firms can
choose to import other products or to import from other countries.9
The effects on the economy of the real exchange rate
When the general public discusses exchange rates, this usually means the nominal
exchange rate. However, economists are more focused on the real exchange rate, which
shows the price of foreign goods expressed in Swedish kronor against the price of Swedish
goods in kronor. In other words, the real exchange rate reflects Sweden's purchasing power
and competitiveness. The stronger the real exchange rate becomes, the greater purchasing
power a Swedish krona will have abroad. At the same time, a stronger real exchange rate
means that Swedish-produced goods will be more expensive compared with foreign goods,
and competitiveness will thus decrease.
The real exchange rate is the one that is most important to the real economy; the nominal
exchange rate should primarily be regarded as an asset price that affects the real exchange
rate over the relatively short term. As Figure 5 shows, the nominal and real exchange rates
have co-varied closely during the inflation-targeting regime. The explanation for this is that,
as I mentioned, exchange rates that are determined freely by the market tend to be volatile.
At the same time, most of Sweden's trading partners have monetary policy frameworks
resembling our own, so inflation rate differences are generally fairly minor. The nominal
exchange rate can change rapidly, but prices generally move more slowly. All in all, this
means that short-term fluctuations in the real exchange rate, to a large extent, are driven by
variations in the nominal exchange rate.
Movements in the nominal exchange rate were smaller before 1992, when Sweden had a
fixed exchange-rate regime, even if the devaluations carried out during the 1970s and 1980s
led to relatively large fluctuations. However, even during periods with fixed nominal exchange
rates, large fluctuations took place in the real exchange rate. These were driven by
differences in inflation rates between Sweden and the rest of the world. Between 1982 and
1992, the real exchange rate strengthened markedly, with Swedish competitiveness being
undermined considerably as a result.
Changes in the real exchange rate mainly affect the economy via net exports, in which a
weakening of the real exchange rate tends to increase net exports. Slightly simplified, it could
be said that higher net exports lead to increased resource utilisation, higher wage growth and
thus to higher inflationary pressures. The exchange rate effects arising in inflation via net
exports can thus be seen as being significantly less direct than those arising via import prices,
which I discussed earlier. Changes in the real exchange rate may entail adjustments to the
economy that monetary policy may need to consider. For example, during a real appreciation
of the krona, exporting and import-competing firms may have to review their costs so as to
restore competitiveness. Among other strategies, the firms can achieve this by implementing
operational changes to increase productivity.10 Such adjustments can contribute towards
lower inflationary pressures, as increased productivity lowers unit costs. Another possibility for
some firms is to move operations overseas. For major firms with broad international
operations, it may be relatively easy, in some cases, to reorganise operations so that costs
arise in another currency than Swedish kronor. However, for smaller firms with all of their
production in Sweden, relocating operations overseas is generally associated with high costs.
Monetary policy decision-making in consideration of the exchange rate
I would now like to say a few words about how everything I have said so far about the
exchange rate affects my view of monetary policy analyses and decisions.
As its influence on the economy is subject to a time-lag, monetary policy has to be conducted
in a forward-looking manner. Consequently, forecasts play a decisive role in analyses and
decision-making. At the same time, the exchange rate, like other prices set on financial
markets, is very difficult to forecast.11 Nevertheless, due to its significance for the
development of small, open economies such as Sweden's, it is important to form an
understanding of exchange rate developments.
The Riksbank tries to analyse and forecast the development of the trade-weighted exchange
rate, which is to say the value of the Swedish krona against a basket of the currencies of
Sweden's most important trading partners. Due to the volatile nature of the exchange rate,
no attempts are made to capture short-term variations in it. Instead, the focus lies on the
more long-term trend. The starting point for this a statistical model in which the real
exchange rate is related to relative GDP, the terms of trade and net foreign assets.12
However, the final forecast for the exchange rate considers the fact that the exchange rate
both influences and is influenced by a multitude of other variables, including the interest rate
differential in relation to other countries.13
10
See, for example, Ekholm et al. (2008). Pressure on firms to improve productivity can be seen as a positive
aspect of a strong real exchange rate. A weak real exchange rate is otherwise frequently seen as being
advantageous for a country as it benefits its exporting firms.
11
In the evaluation of different forecast strategies, it has been shown that it is difficult to outperform what is
known as a naïve forecast - that is, using the current actual value as a forecast. See, for example, Meese and
Rogoff (1983). However, a number of other studies show more positive results for the possibilities of making
forecasts, for example Mark (1995) and Gourinchas and Rey (2007).
12
See Sellin (2007) and Lagerwall and Nessén (2009).
13
It may be noted that, as the rate of inflation in Sweden tends to be about the same as it is among most of
Sweden's trading partners, there is a high degree of similarity in the forecasts for the nominal and real
exchange rates.
As I mentioned earlier, the main scenario in the Riksbank's most recent Monetary Policy
Reports is based on a forecast that, in my opinion, expects excessively high policy rates
abroad. One of the most important reasons that I expect lower policy rates is the public
finance situation prevailing in parts of the world. In the United States, the United Kingdom and
large parts of the euro area, there is little to no scope for using fiscal policy to give an extra
boost to the recovery. All that remains, therefore, is relatively expansionary monetary policy.
Moreover, I see a risk that the desire to avoid stronger exchange rates will lead to lower
interest rates in general abroad. When it is not possible to use fiscal policy to stimulate
domestic demand, it is tempting to put one's hope in exports. Countries will then be unwilling
to allow exchange rates to take a direction that will lead to poorer competitiveness for them.
One consequence of my assessment of foreign policy rates is that the main scenario's repo
rate path entails a greater interest rate differential in relation to other countries than was
assumed in the Riksbank's forecast. In the most recent monetary policy decision, the gap
between the main scenario's forecast of foreign policy rates and the forecast I preferred was
certainly significantly narrower than it was during the autumn of 2010 - but, even so, it still
concerned a difference of more than 50 basis points towards the end of the forecast horizon
(see Figure 6). This could mean that the krona will appreciate more than the forecast
suggests.
To illustrate the effects that lower international interest rates would have on Swedish
monetary policy if the actual interest rates were to be adjusted completely towards the
Riksbank's repo rate path, I would like to show you an analysis included in the minutes of the
most recent monetary policy meeting. Figure 7 shows model simulations of the effects on the
CPIF and unemployment, according to the main scenario's repo rate path and according to
the repo rate path I voted for, under the assumption that foreign interest rates will be lower
than in the forecast, particularly towards the end of the forecast period.14 My preferred repo
rate path, which goes up to 3.25 per cent at the end of the forecast period, gives a lower
unemployment forecast than does the main scenario's repo rate path.
It may seem that the target fulfilment of the CPIF forecast is worse, as it lies above 2 per cent
towards the end of the forecast period. However, my assessment is that this is an
overestimate of inflation. Inflationary pressures are influenced by resource utilisation, and it
can probably be expected that the level of resource utilisation that is consistent with
unchanged inflationary pressures will actually rise during the forecast period. In deep
recessions, it is usual for the functioning of the labour market to be impaired initially, as
typically the jobs that have disappeared differ from those arising once the economy has
recovered. However, eventually it does start to function normally. In that case, perhaps
inflationary pressures will be significantly lower towards the end of the forecast period than is
shown by these simulations. The difference in outcome between the two repo rate paths is
partially due to the different development of the exchange rate, but it is, of course, also
largely due to the divergence of the interest rates influencing investments and saving.
The exchange rate effects of choosing another repo rate path are naturally uncertain.
However, the fact that the exchange rate in general is associated with great uncertainty does
not mean that it can be disregarded when decisions are taken on the repo rate path. And, in
my opinion, neither does the fact that market interest rates do not fully incorporate the repo
rate path - possibly because they are influenced by foreign interest rates to a large degree -
form a strong argument for disregarding the potential exchange rate effects of increased
interest rate differentials. As a matter of principle, I consider that monetary policy should be a
matter of choosing the repo rate path that gives the forecast for inflation and resource
utilisation with the best target fulfilment when fully incorporated into expectations. Another
principle is that high uncertainty is not an argument for refraining from using the best forecast
as a basis for decisions.
Conclusion
In summary, I would like to say that, even if there are factors suggesting that the significance
of the exchange rate should not be exaggerated, it is my opinion that it should be considered
in monetary policy decisions. Recently, the development of the exchange rate has been an
important reason for the reservations I have entered against monetary policy decisions.
The Swedish economy grew very strongly during 2010, but this should be seen in the light of
the very steep fall that started in 2008 and continued in 2009. My assessment is that there
are still relatively many unutilised resources in the Swedish economy and that both resource
utilisation and inflationary pressures will continue to be lower than normal over large parts of
the Riksbank's forecast period. Contributing to this is the fact that the krona has (nominally)
strengthened by about 10 per cent over the last year, which is more than was previously
expected. As a stronger krona dampens both inflationary pressures and resource utilisation, I
believe that a lower repo rate path than that decided upon would lead to better target
fulfilment.
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