Mr Bäckström reports on the current situation for monetary policy in Sweden
Speech by the Governor of the Bank of Sweden, Mr Urban Bäckström, to the Standing
Committee on Finance in Stockholm on 13/11/98.
First a word of thanks to the Committee for the invitation to discuss the current situation for
monetary policy. A good deal has happened in the global economy since our previous discussion
with the Committee last March. The crisis in the emerging markets in Asia, regarded initially as a
regional concern, has continued to spread, first to emerging markets in other parts of the world
and then, mainly via financial markets, to the industrialised countries. This has altered the
economic climate.
The Swedish economy in perspective
Five years with good growth and low inflation
Let us begin, however, by shifting our attention from recent events and noting that since the
crisis in the early 1990s, economic development in Sweden has been rather good. Relatively high
growth has been combined with a rate of inflation that has remained low. Since the summer of
1993, total output (GDP) has been rising at an average annual rate of almost 3%. That more or
less matches the growth rate during the upswing in the 1980s (Fig. 1).
CPI and Underlying Inflation
yearly average
3 3
CPI
Underlying inflation
Domestic underlying inflation
2 2
1 1
0 0
1995 1996 1997 1998
Source: Statistics Sweden
Fig. 1
It is markedly higher, however, than the average annual rate of 2% which was achieved in the
two decades from 1970 and 1990; it also exceeds what can be regarded as the sustainable
longterm rate. One important reason why inflation could still be kept at a low level in recent years is
that in this period the economy has had a reserve of unutilised capacity. That, in turn, is a
consequence of the deep recession that preceded the upswing, plus the fact that the growth of
capacity has been high. Moreover, inflation expectations have gradually stabilised around the 2%
inflation target (Fig. 2). Recently, however, and in certain earlier periods, transitory price
movements have brought the average annual change in the consumer price index (CPI) just
outside the inflation target's lower tolerance interval.
GDP growth 1982-1998
billions of SEK, seasonally-adjusted data
Trend 1993-1998
400 400
around 3%
Trend 1982-1990
around 3%
360 360
320 320
280 280
82 84 86 88 90 92 94 96 98
Sources: Statistics Sweden and the Riksbank
Fig. 2
Large transitory price effects
The nature of transitory price effects and the appropriate monetary policy response were matters
that I discussed in detail with the Committee last March. So now I shall simply reiterate the
Riksbank's view that as long as more long-term inflation expectations are unaffected, transitory
price movements should be a subordinate consideration in monetary policy. A contrary opinion
would necessitate drastic monetary policy measures that might have destabilising effects on
output and employment, which is clearly undesirable. In theory, a CPI change figure that is
higher than the current 0.4% could of course be engineered simply by raising the interest rate.
That would fuel CPI inflation via higher house mortgage rates. It need hardly be said that that is
not the way to conduct monetary policy. It should be borne in mind that a monetary policy target
formulated in terms of the change in the CPI has major advantages. The CPI is a broad and
wellknown measure of inflation. But the construction of the CPI does pose problems, not least for
this Committee, when it comes to assessing monetary policy's past performance. This will be
still more important if the Riksbank is accorded the independent status which the Riksdag
(Sweden's parliament) will shortly be voting on. The use of a target variable, such as the CPI,
which necessitates frequent reference to factors that cause temporary deviations, is not an ideal
solution. There are grounds for supposing, however, that sizeable transient price movements of
the type we have experienced recently are not commonplace. They derive predominantly from
the marked improvement in recent years in economic policy's credibility. There have been few
periods in the past when, for example, house mortgage rates have dropped from about 14% to the
present level around 5%. So the problems with targeting CPI inflation should not be exaggerated.
In order to facilitate the assessment of monetary policy, the Riksbank has arranged for Statistics
Sweden to supplement its CPI statistics with figures for various indicators of underlying
inflation. Another matter to bear in mind is the lag before monetary policy measures affect the
economy. If the rate of inflation happens to move outside the tolerance interval in one month, the
central bank is not capable of bringing inflation directly back on target in the following month.
That is why the central bank needs to present an inflation forecast, which has two main
advantages. One is that the central bank can be explicit about the time horizon at which inflation
is to be returned to the target. The other is that people in general can judge for themselves
whether monetary policy can be considered to be properly balanced. If the forecast deviates from
the inflation target at the time horizon at which monetary policy exerts its main effect - 12 to 24
months - then the instrumental rate has to be adjusted.
Jobless growth
Although Sweden has experienced five years of good economic growth, there has been no
corresponding reduction of unemployment. The picture since 1993 speaks for itself: a clear
upturn in the output curve, while the low level of employment is still virtually unchanged
(Fig. 3). This suggests that neither low demand nor a poor growth potential are primarily
responsible for the weak development of employment.
GDP and Employment
seasonally-adjusted data, index: Q3 1980=100,
140 115
GDP
(left scale)
110
120
105
100
Employment
100
(right scale)
95
80 90
82 84 86 88 90 92 94 96 98
Source: Statistics Sweden
Fig. 3
Part of the problem with employment may be that much of the growth in the past five years
seems to have occurred in sectors that are capital-intensive. More balanced growth in the future
would presumably result in stronger demand for labour. But the weak employment trend
probably also stems from more fundamental factors. For several decades now, the general
structure of business activities in Sweden has tended to move towards a growing input of capital
at the expense of labour. The fact that certain countries have achieved a sustained improvement
in employment is often explained not so much by high growth as by a production process that has
been generally more labour-intensive. If an economy is characterised by the combination of high,
stable growth and weak employment, this points to the existence of structural problems. It should
be added that Sweden shares the problem of jobless growth with other countries in Europe,
though not with all.
Monetary policy to date
Warning lights a year ago
A year ago there were many indications that economic growth in Sweden would continue at a
high rate. It also looked as though capacity utilisation would rise in the coming years and lead to
some increase in inflation. The crisis in Asia was expected to ease inflationary pressure to some
extent but not sufficiently. As most of the warning lights were thus blinking red, the Riksbank
adjusted its policy stance; in December 1997 the repo rate was raised from 4.10 to 4.35%. In my
statement to this Committee in October 1997, I described the planned policy realignment as a
movement from an expansionary to a more neutral monetary stance. It amounted to keeping the
economy moving at the rate which is structurally feasible, not to arresting its movement. A
gradual monetary policy adjustment would bring the path of growth into line with the sustainable
long-term trend, thereby protecting the economy from capacity shortages and inflation. A small
interest rate increase at an early stage was intended to prevent problems from arising later on and
requiring larger interest hikes to bring inflation back to the targeted rate. In this way, both the
price level and growth would be more stable. In the December 1997 Inflation Report, however,
we included a risk scenario that pointed to lower inflation compared with the main scenario. We
noted: "As regards inflation, however, a substantial impact from the economic crisis in Asia does
presuppose that the situation deteriorates so much that international activity is seriously
weakened." As things turned out, the effects of the Asian crisis did exceed our assumption for
the main scenario. During the first half of this year the main assessment was revised successively
downwards. As a result, the monetary policy adjustment did not continue as envisaged earlier. In
view of the risks of a weaker trend, the repo rate was left unchanged during the spring. In
connection with the June Inflation Report, the Riksbank concluded that inflation prospects had
changed; our inflation forecast, based on an unchanged repo rate, pointed to a rate of price
increases 12 to 24 months ahead that was below the 2% target. In accordance with the
Riksbank's procedure, at the beginning of the summer the repo rate was therefore lowered from
4.35% to 4.10%.
Increased financial market unrest and lower international growth
In the September Inflation Report the Riksbank noted that the real economic situation was still
relatively bright. In our main scenario, growth was expected to remain stable while inflation
slowly moved up towards the target in the coming one to two years. However, this path for
inflation did start from a lower level. The risk of slower international growth on account of the
Asian crisis had grown but the picture was also complicated by the marked weakening of the
krona, which could have a contrary effect on inflation. In the current exchange rate regime, the
Riksbank does not target the level of the exchange rate but this is still one of the factors that has
to be weighed into the assessment of future inflation. In the context of monetary policy, the most
pertinent aspect in recent years has proved to be the extent to which the exchange rate affects
inflation via its impact on production, primarily in the export sector. The effects that a weaker
exchange rate may have on import prices should be a secondary consideration, along with other
transitory price movements, as long as more long-term inflation expectations are unaffected.
During September and part of October - before and immediately after the publication of the
Inflation Report - the monetary policy environment was turbulent and difficult to assess. Neither
was the uncertainty confined to the international scene. It also came from the general election in
Sweden and the future direction of fiscal policy. All in all, this prompted the Riksbank to keep
the repo rate unchanged. The possibility of a lower rate would be considered when inflation
prospects were clearer. During the autumn the financial unrest continued to grow. The Russian
Government's suspension of payments in mid August and the problems that emerged in late
September with the U.S. hedge fund Long Term Capital Management contributed to the much
more nervous atmosphere. Share prices dropped around the world and the financial crisis went
on spreading to other emerging markets that had previously been spared. There was a risk that
the falling stock markets and the wider extent of the crisis would elicit effects via decreased
export demand and more cautious behaviour among consumers and firms. At the same time, the
problems with Long Term Capital Management aroused fears of a considerably more serious risk
that had not attracted so much attention earlier - the risk of banks becoming so cautious with
credit that this, by itself, would paralyse the global economy. When the banks are bent on
reducing exposures and slimming balance sheets in order to avoid loan losses, borrowers have
less access to capital. If risk aversion becomes unduly pronounced, even sound borrowers are
liable to be hit, with serious effects on the total level of activity in the global economy. One sign
of an imminent credit squeeze was the growing spread in market interest rates between the
soundest borrowers and others. In this way it was envisaged that the financial crisis would have
negative effects on the real economy. Forecasters altered their assessments and the global
prospects for growth and inflation were revised downwards. The Riksbank likewise adjusted its
assessment of developments in the rest of the world.
The current monetary stance
Repo rate cut on 3 November
The assessment that growth in the rest of the world will be weaker than we counted on earlier led
the Riksbank to conclude that with an unchanged repo rate, in the coming 12 to 24 months the
rate of inflation would be below the target. Resource utilisation would be lower and inflationary
pressure would decrease. Signs of this were discernible in recent statistics: net exports had
weakened, stocks were accumulating and corporate borrowing was rising somewhat more
slowly. The financial unrest had also had some negative impact on household confidence, which
could mean that consumption rises more slowly than expected earlier. The effects on inflation
from the slowing tendencies were judged to be greater than the stimulus from the weaker
exchange rate. Moreover, the financial market unrest had tended to subside. Under these
circumstances, on 3rd November the Riksbank lowered the repo rate 25 basis points to 3.85%. It
should be noted that the Riksbank's downward revision of demand and inflation prospects in the
Swedish economy is not dramatic. In the September Inflation Report the path for inflation was
already below 2% for much of the forecast period. But the revision is of an order that affects
conditions for the Riksbank's operations. In order to provide more room for manoeuvre in the
formation of monetary policy, yesterday the Governing Board decided to lower the corridor
surrounding the repo rate: the deposit rate was reduced by 0.5 percentage points to 3.25% and the
lending rate likewise 0.5 percentage points to 4.75%. The concern about an involuntary
contraction of credit - and the serious consequences it might have - has also prompted the
central banks to heighten surveillance of the financial system. For the Riksbank this concerns
contacts with the major banks as well as increased oversight of bank financing in cooperation
with the Financial Supervisory Authority. On the whole, the Swedish banking system appears to
be stable. This conclusion is elaborated in the year's second Financial Market Report, which we
published yesterday. Lending to the most problem-burdened countries is relatively low.
Moreover, the banks have built up liquidity reserves as a precaution against a worsening of the
situation in the international markets. The supply of credit in the Swedish market does not appear
to have suffered to date. Neither has the Riksbank seen any indications that the Swedish banks
intend to curtail their lending to domestic sectors. Recently the global financial unrest seems to
have become somewhat less pronounced. It is difficult to tell whether this could be a sign of the
calm associated with being in a hurricane's eye - whether the international financial turbulence
will return or whether the cyclone is receding. The Riksbank is therefore continuing to analyse
the banking system with heightened readiness until the situation has become more stable. The
course of events in the international arena has warranted measures of a short-term nature in order
to safeguard the functioning of the global financial system. Interest rates have been reduced
recently in a number of countries, for example. In the longer term, work must focus on the
construction of international rules and systems that limit the risk of - and preferably prevent -
crises of this type from happening at all. What has happened reveals clear shortcomings in how
the global financial system functions. But it should also be underscored that "free trade" in the
financial domain can very probably confer large welfare gains, just as free trade does in the case
of goods and services. The conditions for forecasting in general and for inflation-targeting
monetary policy in particular have been illustrated by what has happened in recent years. A set of
indicators has to be relied on in an endeavour to form a definite opinion about future
developments. Central banks are unfortunately not in a position to wait for a complete picture
before acting. It takes time for our actions to elicit their full effect; when all the pieces of the
puzzle are finally available, the time for action has passed. The continuous fulfilment of the
monetary policy target would then probably require more drastic measures; such a near-sighted
policy would lead to greater economic instability. The course of the Asian crisis and its
contagious effects in the industrialised countries is having a larger impact than we counted on
earlier. I cannot rule out the possibility that in order to fulfil the inflation target, further
adjustments of the monetary stance will be called for in the same direction as recently. A weaker
development in the rest of the world also affects conditions in Sweden.