Irma Rosenberg: The objective of monetary policy
Speech by Ms Irma Rosenberg, Deputy Governor of the Sveriges Riksbank, at a meeting arranged by
Öhman Fondkommission, Stockholm, 14 February 2006.
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A discussion has recently taken place in the media on the objective of monetary policy. Some have
argued that we should have more objectives while others considered that we already work with too
many objectives and that this has created a lack of clarity. In my opinion this discussion is a bit
misleading. We have one objective: keeping inflation low and stable. However, in our efforts to achieve
this objective, we have, like many other central banks, opted to be flexible to avoid exposing the
economy to strain.
Our statutory objective is to maintain price stability. It has been left to the Riksbank to decide on the
detailed interpretation of this objective. We have defined it as meaning that inflation should be 2 per
cent. However, monetary policy affects the economy with a time lag and is simply not precise enough
to maintain inflation at a constant 2 per cent. The inflation target includes a tolerance interval of +/-
one percentage point to underline that temporary deviations are permitted, provided that these are not
too large. For further clarity, we apply the principle that in the event of any deviation, inflation should
normally be brought back to the target within a two-year period. When we set the interest rate, we
must accordingly base our decision on an inflation forecast. In most cases, this two-year horizon
provides us with the scope to return gradually to the target without having to apply monetary policy
with such force as to create unnecessary fluctuations in the real economy. Occasionally in the wake of
a major disturbance, there may even be grounds to allow a period of more than two years to return to
the target. In such cases, however, we should communicate this clearly. Like most central banks with
inflation targets, we apply what is usually referred to as a flexible inflation target policy.
When we decided at the most recent monetary policy meeting to increase the repo rate, we once
again had to take into account the continuing rapid increase in house prices and household debt. This
was not because we have a target for household debt or house prices. However, it is important for us
to monitor the trend in the housing market, bearing in mind both financial stability and price stability.
As far as financial stability is concerned, there are no indications that house prices or household debt
constitute a threat to the banking system. We produce regular analyses and reports on such matters in
our six-monthly stability reports.
As far as the work with price stability is concerned, we must take into account the effect that house
prices have on household saving and consumption decisions through their impact on wealth and thus
the level of demand in the economy as a whole. For households with debts, the scope for consumption
is also affected by interest rate adjustments if the share of income used for interest payment changes.
Accordingly, we take this into consideration when we make our inflation assessment. There has been
a swift increase in household debt and house prices over a long period. One potential cause of
concern, which we cannot disregard, is that if this trend continues at the same rapid rate, a situation
could develop where, at a later date, there is a risk of a considerable slowdown in growth and
employment as a result of households finding themselves compelled to increase savings owing to a
heavy debt burden. The risks involved here are very difficult to quantify in forecasts or pinpoint in time,
but could none the less be a threat to macroeconomic stability. Inflation could then also revert to a
state that might prove difficult to deal with. However, it should be underlined that the likelihood of such
a scenario arising is regarded as slight, in particular when we have identified it in good time. We have
taken these factors into consideration even if they have not been crucial for our monetary policy
decisions.
The Riksbank does not have a target for the krona exchange rate. However, since the exchange rate
is one of many factors affecting growth and inflation, we must naturally take the path of the krona into
consideration in the inflation assessment. The exchange rate affects inflation directly and generally
relatively quickly through prices of imported goods and services. The exchange rate also affects
inflationary pressure indirectly and usually with a long time lag, by its impact on the level of activity. A
weaker krona entails, everything else being equal, greater demand for Swedish goods and services,
which in turn leads to an increase in resource utilisation. The exchange rate can also affect inflation
expectations indirectly.
I would now like to move on to inflation prospects and monetary policy. In the December Inflation
Report, we made the assessment that international growth would be good this year and in the next few
years but would slow down somewhat. New information prior to our January meeting suggested that
development would be stronger than expected. This applied primarily to the euro area and Asia while
the latest US statistics indicated that the trend was more or less in line with the assessment made in
December. Overall, the international prospects for growth and thus the growth of the Swedish export
market seemed slightly stronger in January than in December. In my view, this assessment still holds
good.
The assessment in December for the Swedish economy was that growth would increase this year but
subsequently slow down slightly in the next few years. In January, according to revised GDP statistics,
growth in Sweden was considerably stronger from the final quarter of 2004 onwards than indicated by
the information available at the beginning of December. Several indicators of economic activity also
suggested a stronger development than expected. New information made available since our January
meeting appear to confirm this. According to the National Institute of Economic Research's most
recent Business Tendency Survey, the level of economic activity continued to improve in the fourth
quarter of 2005 and firms were very optimistic about the future. Household expectations have also
become more optimistic about their own finances and the Swedish economy. In the light of these
developments, it seems reasonable to adjust the GDP forecasts for 2005 and 2006 upwards slightly
compared with our expectations in December.
The situation in the Swedish labour market appeared to be somewhat brighter in January and the
number of those employed increased slightly more than expected. However, the trend for the number
of hours worked was surprisingly weak and productivity growth in the business sector was therefore
stronger than expected. There is no apparent reason to make any substantial change to that
assessment either. The labour market is improving although domestic cost pressures are expected to
remain subdued. Overall, this means that inflation is expected to approach the target during the
forecast period, more or less as we said in December. Given the strong growth in demand, we
envisage a relatively moderate increase in inflation.
However, it is important to bear in mind that the inflation assessment in December was based on the
assumption that a gradual increase of the repo rate would be initiated at the beginning of 2006. In
January, we also decided to raise the key rate. In view of the favourable economic climate, the
Executive Board judged that a further increase of the repo rate was justified. In my opinion, the
information that has subsequently become available does not warrant any change to this conclusion
pending our next meeting.