Svante Öberg: Monetary policy and the elusive resource utilisation
Speech by Mr Svante Öberg, First Deputy Governor of the Sveriges Riksbank, at
Handelsbanken, Stockholm, 25 May 2009.
The original speech, which contains various links to the documents mentioned, can be found on the Sveriges
Riksbank's website.
* * *
Resource utilisation is falling rapidly and is unusually low. But it is difficult to determine
exactly how low it is. And it is difficult to ascertain what consequences the low resource
utilisation will have for inflation and monetary policy. These are the questions I intend to
discuss in my speech today.
I have divided my speech into four parts. I shall begin by discussing the importance of
resource utilisation for monetary policy and pointing out the differences as to how the targets
for inflation and resource utilisation can be expressed. After that I shall discuss different
measures of resource utilisation. I shall go on to describe monetary policy and resource
utilisation at present and I shall conclude with a few summarising comments.
I wish to make clear from the start that I will not make any new assessment today of the
appropriate direction for monetary policy in relation to the Monetary Policy Update that was
published at the end of April. I also want to point out that the picture I paint of resource
utilisation and monetary policy here is not necessarily shared completely by my colleagues
on the Executive Board of the Riksbank.
Resource utilisation is important for monetary policy
When we members of the Executive Board make decisions on monetary policy we take into
account both inflation and resource utilisation. Our monetary policy is normally aimed at
attaining the inflation target of two per cent a couple of years ahead. If we are also able to
support economic policy in general without neglecting the inflation target, then we do so. At
present this means that we can also use monetary policy to try to mitigate the current
economic recession.
It is fairly easy to follow inflation. Inflation is measured by means of a well-established and
relatively uncontroversial instrument, the annual change in the consumer price index - the
CPI. Of course, there are other measures of inflation that we regularly follow, such as the
CPI with a fixed interest rate - the CPIF, the CPI with a fixed interest rate excluding energy,
the EU-harmonised measure HICP, and a number of measures of what is known as
underlying inflation. But we always clearly state that it is the CPI that is our target variable.
We only use the other inflation measures to analyse and better understand developments in
inflation.
However, it is much more difficult to determine the degree of resource utilisation. On a
general level, resource utilisation refers to how much of the available labour and capital
assets are used. In practice, one tries to measure it in several different ways. For example,
GDP in relation to trend GDP, employment ratio, unemployment and capacity utilisation. I will
take up a number of these measures a little later on.
It is also fairly simple to see how inflation relates to the set target, but it is much more difficult
to gain an impression of what the target for resource utilisation should be. We express the
inflation target as being that the annual change in the CPI should be two per cent, but we do
not have an equally well-defined target for resource utilisation. Instead, we usually say that
we endeavour to reduce the fluctuations in the real economy.
Resource utilisation is important in a monetary policy context for two reasons. Firstly, it is
related to important targets in economic policy, such as a high GDP, a high level of
employment and low unemployment. The economic recession we are now experiencing
means that GDP will fall by around 4.5 per cent this year, that employment will fall by almost
300,000 persons in three years, and that unemployment will reach approximately 11 per cent
in two years' time, all according to our most recent forecasts in April. The expansionary
monetary policy we are now conducting is thus partly motivated by an aim to limit the depth
of the recession.
Secondly, resource utilisation is important because it is an indicator of future inflationary
pressures. But a difficult question is how resource utilisation co-varies with inflation. My
impression is that the connection between resource utilisation and inflation has been weaker
over the past two decades than it was before. But the connection probably still remains,
albeit in a weaker form. This means that in our monetary policy we also have to take into
account what effects resource utilisation has on inflation in the slightly longer term. I will
return to this issue later on.
Different measures of resource utilisation
There is no clear-cut means of defining resource utilisation, nor of measuring it. When one
tries to measure resource utilisation one is faced with different alternatives. For example, one
can draw conclusions regarding resource utilisation in the economy by comparing output or
employment with a trend, normal or ideal level. Examples of this approach include the GDP
gap, the employment gap and the flexprice gap. Another alternative with regard to measuring
resource utilisation is to use as a base responses to direct questions put to companies
regarding, for instance, their utilisation of labour and capital. Both of these approaches have
inherent difficulties. In the first case, one must relate actual output or employment to a trend,
normal or ideal level that is difficult to determine, and in the second case one must rely on
the companies' own assessments of their resource utilisation.
GDP gap
A common means of measuring resource utilisation is to relate actual GDP to a long-term or
trend level of GDP. This GDP level is also often called potential GDP, despite the word
potential implying that GDP cannot be greater than this level. The measure obtained by
relating actual GDP to potential GDP - what is known as a GDP gap - has the advantage of
being easy to understand. It is also close to a number of concepts that are used in monetary
policy analysis. The so-called Taylor rule often used to describe how monetary policy is
conducted contains such a GDP gap. When one talks about the target for monetary policy
being to minimise deviations in inflation from the target and fluctuations in the real economy,
the latter is often illustrated with a GDP gap.
But it is not entirely clear how one should measure the long-term or trend level of GDP. A
common method for determining this GDP level is to use some statistical tool to find a trend
in the available GDP statistics. The Hodrick-Prescott filter, or HP filter, is one such tool. This
filter is used to obtain an HP trend which is a cross between a linear trend and the uneven
curve showing the actual GDP outcome. Such HP trends are regularly reported in the
Riksbank's Monetary Policy Reports.
Figure 1 shows actual GDP, potential GDP measured as an HP trend and the GDP gap,
which is the difference between these. The actual GDP gap is stated as a percentage of
GDP, measured on the right-hand scale, and in the figure this becomes a form of enlarged
image of the difference between actual and potential GDP. The dotted parts of the curves
represent the Riksbank's forecasts from the April Monetary Policy Update. One can draw the
conclusion from this figure that resource utilisation in terms of the GDP gap has recently
fallen below the normal level and that we are assuming that it will remain negative over the
coming years.
There are both advantages and disadvantages in measuring resource utilisation with the aid
of the GDP gap. One advantage is that this method does not require any other information
than historical GDP data. One disadvantage is that when using this method it is difficult to
estimate the trend and thereby the GDP gap at the end of the time series and it is precisely
the GDP gap at the end of the series that is the most interesting part. This problem becomes
particularly troublesome in a recession like the current one. This is because experiences of
previous recessions imply that some of the output capacity that is lost after a fall in resource
utilisation never returns when the upturn comes. Quite simply, it is easier to wind up
companies than to build them up. To some extent these problems are dealt with in the
Riksbank's calculations, in that the calculation of the trend level of GDP is affected by the
outcomes for years of weak GDP growth and by parts of the fall in productivity being
assumed to be permanent.
Another consequence of using HP filters to find the trend-based GDP gap is that one risks
interpreting an increase in growth that is due to a temporary rise in productivity as an
increase in resource utilisation. But in a situation with sticky prices an increase in productivity
may actually lead to a decline in resource utilisation as the increase in productivity makes it
possible to use fewer resources to produce the same volume as before. If we were in such a
case to use a trend-based output gap as a base, there is a risk that monetary policy would
become contractionary when it needed to be expansionary.
The difficulty with the trend-adjustment method is thus to distinguish from current
developments what constitutes changes in the trend and what are deviations from the trend,
that is, changes in resource utilisation.
Flexprice gap
A theoretically interesting measure of resource utilisation that has gained increased attention
in the research on monetary policy is the so-called flexprice gap. This is a measure that
relates actual output to potential output in an economy with entirely flexible prices and
wages.
The advantage of this measure is that it has a well-defined theoretical base. To calculate the
flexprice gap one tries to determine the level of output that would be attained without some of
the imperfections that the real economy suffers from. One can, for instance, use as a base a
dynamic stochastic general equilibrium model of the New Keynesian type, where the primary
reason for inefficient resource utilisation is that prices and wages are slow to adjust to new
circumstances. Such a model makes it possible to obtain a measure of the effective output
that would arise if both prices and wages were entirely flexible - the flexprice output. The
difference between actual output and the calculated flexprice output is the flexprice gap. If
one has a good model for calculating the flexprice gap, one avoids the problems with the
trend-based measure of managing disruptions caused by productivity shocks.1
However, this measure also has disadvantages. The results of the calculations are sensitive
to the exact design of the model. Nor is it as easy to interpret these results, which is partly
because the flexprice output varies more over time than the measure of the trend in GDP
usually used. The flexprice gap is therefore not yet used in practice in our monetary policy
work.2
Nevertheless, I can show how it looks when it is calculated using the Riksbank's macro
model RAMSES.3 Figure 2 shows that the flexprice gap occasionally differs somewhat from
the GDP gap. The fluctuations in the flexprice gap have in general been slightly less, which is
partly because the flexprice gap only captures the fluctuations in GDP that can be explained
by sticky prices and wages. However, the flexprice gap and the GDP gap do provide a
uniform picture of the recent development towards an excessively low level of resource
utilisation in the economy. The fact that the flexprice gap is now negative is currently
interpreted to mean that output is now lower than it would have been if prices and wages had
adjusted to the changes that have recently affected the economy.
Labour market gaps
Another type of measure focuses on utilisation of labour. These are based on Statistics
Sweden's labour force surveys and on the National Accounts. Figure 3 shows two such
measures: unemployment and the employment rate, that is, what percentage of the
population of working age is employed. The curves provide a consistent picture of changes in
resource utilisation over time. At the same time, they show that the crisis of the 1990s
permanently raised unemployment and reduced the employment rate. This makes it difficult
to determine what is a long-term sustainable level for resource utilisation in the labour
market.
From the perspective of general politics, it is normally regarded as an advantage if
employment is high and unemployment is low. But in a monetary policy perspective it may be
a problem if resource utilisation is so high that inflation risks overshooting the target. If
resource utilisation is so low that inflation risks undershooting the target, the general political
and monetary policy implications coincide.
An estimate of what level of employment can be regarded as normal can be obtained by
calculating an HP-based trend similar to that used for calculating the GDP gap. This can be
considered to represent a normal situation in the labour market, without temporary
disruptions that affect the supply of or demand for labour. Gaps that measure the actual
deviation in employment from the normal level, either in the number of persons or in the
number of hours worked, are called labour market gaps. Figure 4 shows two such labour
market-based gaps.
Capacity utilisation
But neither the number of persons employed nor the number of hours worked provides a
really good picture of resource utilisation. During a severe cutback in output such as in the
current economic situation, companies tend to a large extent to retain their employees,
although they have less work for them to do. To obtain a better picture of resource utilisation
the labour market statistics need to be supplemented with data from, for instance, Statistics
Sweden's data on capacity utilisation in industry and the National Institute of Economic
Research's Economic Tendency Survey.
Figure 5 shows capacity utilisation in industry as reported by the companies. According to
figures from Statistics Sweden, capacity utilisation in industry reached a peak of around 91
per cent in the first quarter of 2007, and has since fallen to around 78 per cent in the first
quarter of 2009. According to the National Institute of Economic Research's Economic
Tendency Survey, capacity utilisation in industry during the same period has fallen from
around 88 per cent to around 72 per cent. In both cases a large fall is reported. But these
data concern only a small percentage of the economy and do not in general provide the
same picture as, for instance, the GDP gap also shown in the Figure.
Aggregate measure of resource utilisation
At the Riksbank we have also produced an aggregate measure of resource utilisation. But
this is not intended to replace all other measures; it will be used as a generic complement to
the other measures.
The aggregate measure of resource utilisation has been produced with the aid of a principal
component analysis. This is a statistical method that extracts the common component from a
large amount of data. Figure 6 shows the results of one such analysis, where around thirty
labour market and business tendency indicators have been used to extract a common
component for resource utilisation. To be comparable to the traditional, trend-related
measures of resource utilisation the indicator has been normalised so that its standard
deviation coincides with that of the GDP gap.
The figure illustrates two important conditions. Firstly, the aggregate measure of resource
utilisation follows the GDP gap very well. Secondly, the labour market gap lags a few
quarters behind both the resource utilisation indicator and the GDP gaps.
One disadvantage of this measure is that it is not suitable for forecasts of resource utilisation
short of making forecasts of all of the indicators included. As the measure coincides so well
with the GDP gap, I believe that it provides some support for the argument that GDP
forecasts are a good indicator of how resource utilisation will develop in the future, however
with some reservations, and I will return to these later.
Which measure of resource utilisation is best?
My conclusions are firstly, that the various measures of resource utilisation provide a similar
picture of the economic cycles. However, the more precise picture varies quite substantially
between the measures. Each individual measure offers some extra piece of information in
addition to what is contained in the other measures. But this does not prevent it from being
very useful to continue developing aggregate measures of resource utilisation.
Secondly, all of the measures described show that resource utilisation has recently fallen
rapidly. The GDP gap, the flexprice gap and the indicator that is intended to provide an
aggregate measure of resource utilisation show that resource utilisation is already below the
normal level. The labour market gaps are lagging behind, but will, according to our current
forecast, soon point to labour force use of below normal levels.
The GDP gap that is based on an HP trend for GDP indicates that resource utilisation is
falling by around 10 percentage points from the peak level in 2007 to a trough in 2010.
Although we have used a gradually declining output capacity as a basis for the calculation of
the HP trend, this fall in the GDP gap probably gives an exaggerated picture of the fall in
resource utilisation during the period as the potential output level ought to have fallen more
than is reflected in the HP trend. The deeper and longer the economic recession is, the
larger the output capacity that can be expected to disappear. The resource utilisation
indicator shows the same picture as the GDP gap, but there are no forecasts for this.
The employment rate and unemployment will deteriorate by around 5 percentage points from
2008 to 2011 according to the forecast we made in April. These measures, which are not
related to any normal level, show a slightly smaller, but similar, deterioration in resource
utilisation to that described by the hours gap and the employment gap. But for these two later
measures it is also a question of the deeper and more prolonged the recession is, the greater
the part of the fall in employment and hours that will be interpreted as a weakening in the
labour market trend that will not disappear in the next economic upturn. In this case we will
have what is usually termed persistence in unemployment, a phenomenon that has proved
common in many countries.
To illustrate the significance of the recession for the calculations of the HP trend and the
trend gap, one can compare the calculations of the future trend levels of GDP and
employment in the calculations made in October 2008 and April 2009. The trend level for
GDP in the fourth quarter of 2011 is approximately 5 per cent lower in the more recent
calculations and the trend level for employment is approximately 2.5 per cent lower. The
recession is thus assumed to have lowered the potential level of GDP and employment and
thus also reduced the GDP and employment gaps.
Monetary policy and resource utilisation in the current situation
At the most recent monetary policy meeting at the end of April we made a substantial
downward revision to the forecast for GDP growth in the world in relation to the February
forecast. My assessment was then that our main scenario, with a decline in GDP in the world
of around 1 per cent this year and an increase of just over 2 per cent next year was
reasonable. But at the same time I considered that there was a risk that the recession would
even be deeper and more protracted than we predicted. My reasoning was based on the fact
that recessions that arise as a consequence of financial crises and recessions that are
synchronised between several countries are normally followed by slow recoveries.
Sweden was in a severe recession in April and we are still. We were assuming a fall in GDP
of around 4.5 per cent this year and a weak recovery next year. As in the case of
international developments, my assessment was that on balance the predominant risks were
that the recession could be deeper and more prolonged. CPI inflation was expected to be
negative this year, but underlying CPI inflation with a fixed interest rate, the CPIF, was
expected to be close to 2 per cent throughout the entire forecast period. In my opinion, there
was no reason to worry about deflation and no reason to worry about high inflation. We
decided to cut the policy rate to 0.5 per cent.
Today I would like to take up two questions in the current situation that are linked to
monetary policy. These are the link between resource utilisation and inflation, and the limits
for stabilisation policy.
Monetary policy affects inflation through its impact on the exchange rate and thereby
resource utilisation in the economy, but also through its influence on demand and inflation
expectations. It may appear strange that inflation is calculated to be close to the target of two
per cent, despite the fact that resource utilisation has fallen rapidly and is so low during the
forecast period.
There are two explanations for this. Firstly, the connection between resource utilisation and
inflation is weaker now than before. I mentioned this in my introduction. And this is probably
because a changeover to a credible monetary policy that is aimed at stabilising inflation will
lead to the connection between resource utilisation and inflation weakening. Stable inflation
expectations close to the inflation target quite simply provide less scope for other variables to
affect inflation.4
But the connection is not negligible. The expansionary monetary policy in the world as a
whole, the large GDP growth in the world during the years 2004-2007 and the increasingly
high resource utilisation finally led to substantial rises in energy, food and other commodity
prices in the world market, and thereby also to rising consumer prices. The forecasts now
being made both by international organisations and by ourselves indicate that inflation in the
world over the coming years will be positive, despite the low resource utilisation, but slightly
lower than was normal a few years ago.
The other explanation as to why inflation in Sweden is remaining close to the target despite
the low resource utilisation is that there are other factors than resource utilisation which exert
upward pressure on prices. One such factor is that unit labour costs have been increasing by
around 5 per cent a year during the period 2007-2009. Slightly higher wage agreements, but
above all falling productivity, have contributed to pushing up unit labour costs, something that
will change in the future as companies reduce their workforces. Another factor that is
underpinning inflation is the weak krona.
Given this, the assessment I made at the most recent monetary policy meeting was, as I
recently mentioned, that there was no reason to worry about either deflation or high inflation
during the forecast period. Resource utilisation is not so low that it could lead to deflation, but
it is sufficiently low to prevent inflation from becoming too high.
The second question I would like to take up is the limits for stabilisation policy. There are
limits as to what stabilisation policy can achieve with regard to alleviating the consequences
for the Swedish economy of such a powerful and global economic recession as the one we
are undergoing. For fiscal policy the limits are set by what is considered compatible with a
long-term sustainable development in public sector finances. Monetary policy is to some
extent limited by the fact that there is a floor under which the repo rate cannot be cut. It is not
possible to avoid an international economic downturn entirely, but it is possible to prevent it
from becoming too deep.
In monetary policy it is also necessary to take into account what might happen further ahead
if one conducts a very expansionary monetary policy over a long period of time. In particular
the experiences of the years with low interest rates and rapid international growth prior to the
current financial crisis indicate that one may also need to take into account the more
longterm consequences of monetary policy and at what pace inflation should be brought back on
target.
There is also reason to take into account not only the total amount of spare resources in the
economy, but also the composition of those resources. For an export-dependent country
such as Sweden it is important, for instance, to take into account to what extent a large fall in
exports could be replaced by other parts of demand through expansionary monetary policy
and at what rate this could be done without inflation problems arising. Correspondingly, one
may need to take into account the extent to which the labour supply will decline as a result of
the depth and length of the recession when assessing what consequences a coming
recovery may have for wage formation.
The conclusion I draw from this is that it is important not to overestimate the available
resources in the economy over the coming years. We must try to make the best possible
assessments of the amount of resources that will disappear more permanently as a result of
the recession and of how quickly output can increase without causing inflation problems.
Otherwise there is a risk that we will conduct an expansionary monetary policy for too long
and thus risk inflation problems later on.
One necessary condition for conducting effective monetary policy is that the financial system
functions. Since last autumn the Riksbank has taken a number of measures to safeguard
financial stability, in particular the extensive lending to the banks. We have recently decided
to extend the eligible counterparties for our monetary policy operations and to offer the banks
the opportunity to borrow from the Riksbank not merely at maturities of three months and six
months, but also at twelve months.
If economic developments should prove to be much worse than we are now predicting, there
may be reason to proceed with more unconventional measures to support the economy. One
possibility is to do as they have in a number of other countries and purchase government,
mortgage and corporate bonds. We are currently examining the experiences of other
countries and analysing the advantages and disadvantages of this type of measure. For
instance, we need to consider to what extent it is the Riksbank that is best suited to carry out
this type of measure and whether it might instead be a task for a government agency.
Summary
I would like to summarise my speech as follows:
Resource utilisation is falling rapidly and is at an unusually low level. All of the measures of
resource utilisation that we have provide the same general picture.
But it is difficult to ascertain how low it is and when it will turn around. Different measures
paint different pictures on this issue. The GDP gap implies that resource utilisation will fall to
minus 4-5 per cent at the beginning of 2010 before it turns around, and the employment gap
points to resource utilisation falling to minus 3 per cent in 2011 before the labour market
begins to improve. However, in both of these cases the measures are based on very
uncertain estimates of the available resources in the economy.
It is also difficult to ascertain what consequences the low resource utilisation will have for
inflation and monetary policy. The assessment we made at the most recent monetary policy
meeting was that the policy rate ought to be cut to 0.5 per cent. With this cut and the low
level of the policy rate that we envisaged, resource utilisation would show an upturn and
underlying inflation would be close to two per cent during the forecast period. If
developments were to prove much more negative, there is a possibility to proceed with more
unconventional measures.
Figure 1. GDP gap
SEK million and percentage deviation from HP-trend respectively,
seasonally-adjusted data
1 000 000 5
GDP (left scale)
HP trend (left scale)
900 000 4
GDP gap (right scale)
800 000 3
700 000 2
600 000 1
500 000 0
-1
400 000
300 000 -2
200 000 -3
100 000 -4
0 -5
80 85 90 95 00 05 10
Note. Trend calculated using the Hodrick-Prescott filter. Broken lines refer to the Riksbank's forecasts.
Sources: Statistics Sweden and the Riksbank
Figure 2. Flexprice gap
Percentage deviation from HP trend and flexprice output
respectively, seasonally-adjusted data
5 5
GDP gap
4 4
Flexprice gap
3 3
2 2
1 1
0 0
-1 -1
-2 -2
-3 -3
-4 -4
-5 -5
94 96 98 00 02 04 06 08
Note. Trend calculated using the Hodrick-Prescott filter. Flexprice gap calculated using the Riksbank's
macro model RAMSES. Broken lines refer to the Riksbank's forecasts.
Sources: Statistics Sweden and the Riksbank
Figure 3. Employment and unemployment
Per cent, seasonally-adjusted data
85
Employment rate (left scale)
84
83
Unemployment ages 16-64 (right scale)
82
Unemployment ages 15-74 (right scale)
81
80
79
78
77
76 9876543210
75 10
74 11
73 12
72 13
71 14
70 15
80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10 12
Note. Broken lines refer to the Riksbank's forecasts.
Sources: Statistics Sweden and the Riksbank
Figure 4. Labour market gaps
Percentage deviation from HP trend, seasonally-adjusted data
5 5
Hours worked gap
4 4
Employment gap
3 3
2 2
1 1
0 0
-1 -1
-2 -2
-3 -3
-4 -4
-5 -5
80 84 88 92 96 00 04 08 12
Note. Trend calculated using the Hodrick-Prescott filter. Broken lines refer to the Riksbank's forecasts.
Sources: Statistics Sweden and the Riksbank
Figure 5. Capacity utilisation in industry
Index and percentage deviation from HP trend respectively,
seasonally-adjusted data
100 5
4
95
3
2
90
1
85 0
-1
80
-2
-3
75 Statistics Sweden, actual capacity utilisation in industry (left scale)
NIER, current capacity utilisation in manufacturing industry (left scale)
-4
GDP gap (right scale)
70 -5
96 98 00 02 04 06 08
Note. Trend calculated using the Hodrick-Prescott filter. Broken lines refer to the Riksbank's forecasts.
Sources: National Institute of Economic Research, Statistics Sweden and the Riksbank
Figure 6. Resource utilisation indicator
Index and percentage deviation from HP trend respectively,
seasonally-adjusted data
5 5
4 4
3 3
2 2
1 1
0 0
-1 -1
-2 -2
Resource utilisation indicator
-3 -3
Hours worked gap
Employment gap
-4 -4
GDP gap
-5 -5
96 97 98 99 00 01 02 03 04 05 06 07 08
Note. Trend calculated using the Hodrick-Prescott filter. The standard deviation of the resource utilisation
indicator is normalised to that of the GDP gap. Broken lines refer to the Riksbank's forecasts.
Sources: Statistics Sweden and the Riksbank
BIS Review 66/2009