Lars E O Svensson: Where do central banks go from here?
Speech by Mr Lars E O Svensson, Deputy Governor of the Sveriges Riksbank, at a panel
discussion, Norges Bank Symposium, Oslo, 18 November 2010.
* * *
The opinions expressed here are my own and are not necessarily shared by other members of the Riksbank's
Executive Board or staff. Gabriela Guibourg has contributed to this speech.
It is a great privilege to participate in this symposium and to celebrate the achievements of
Governor Svein Gjedrem. I have had the benefit of having very good contacts with Norges
Bank since the mid 1990s. Under the leadership of Svein and his colleagues and co-workers,
I have seen Norges Bank set up its monetary policy in a way that has made it a model for the
rest of the world. Norges Bank truly deserves the admiration that it receives from central
bankers and academics all over the world. In particular, Svein deserves credit for the novel
interpretation - immediately upon his appointment in 1999 - of the instruction from the
Ministry of Finance to stabilize the exchange rate, namely that the best way to do this in the
longer run was to orient the Bank's monetary policy towards an inflation target. This would
enable the Bank to make the best contribution to economic stability and a stable krone
exchange rate.
As a background to my comments on the topic of this panel, "Where do central banks go
from here?", let me note that, as the world economy recovers from the recent financial crisis
and the Great Recession that followed, a debate is underway regarding the causes of the
crisis and how to reduce the risk of future crises. The role of monetary policy and its relation
to financial stability are also under debate. Some blame the Federal Reserve, saying that its
monetary policy was too expansionary after 2001 and that this laid the foundations for the
crisis. The lesson to be drawn, they argue is that there is a need to modify the framework of
flexible inflation targeting and give a greater role to financial-stability considerations.
In my view, the crisis was largely caused by factors that had very little to do with monetary
policy. Instead, it was mainly caused by regulatory and supervisory failures in combination
with some special circumstances, such as low real interest rates around the world and
housing policy in the United States. Neither do I share the view that there is a need to
fundamentally modify the framework of flexible inflation targeting. Ultimately, my main
conclusion for monetary policy is that flexible inflation targeting - applied in the right way and
in particular using all the information about financial conditions that is relevant for the
forecast of inflation and resource utilisation at any horizon - remains the best-practice
monetary policy before, during, and after the financial crisis.
A conclusion that should be drawn from the crisis is that neither price stability nor
interestrate policy is sufficient to achieve financial stability. Instead, a separate financial-stability
policy is needed. In particular, monetary policy and financial-stability policy need to be
conceptually distinguished, since they have different objectives and different appropriate
instruments, even in cases where the central bank has responsibility for both.1 Financial
stability as an objective of monetary policy makes little sense, but it does makes sense as an
objective of the central bank, if the central bank has the instruments required to fulfil this
responsibility.
Let me elaborate on these issues.
Monetary policy after the crisis
Is there any reason to fundamentally modify the framework of flexible inflation targeting given
the experience of the financial crisis? I think not. Flexible inflation targeting has worked and
continues to work well - before, during and after the crisis. Flexible inflation targeting implies
that the central bank aims at stabilizing both inflation around an inflation target and resource
utilization around a normal level. This implies choosing a policy-rate path such that the
corresponding forecasts of inflation and resource utilisation best stabilise inflation and
resource utilisation. If the central bank uses all relevant information in constructing these
forecasts , including the impact of changes in financial conditions on inflation and resource
utilisation at any horizon, monetary policy will automatically respond in the best possible way
to changing financial conditions (Woodford 2007, 2010a).
One lesson from the financial crisis is that financial conditions may in times of crisis have a
strong and deteriorating effect on the transmission mechanism, making standard interest-rate
policy less effective. This motivates more research on how to incorporate financial conditions
and financial intermediation into the standard models of the transmission mechanism used
by central banks. Much progress has already been made in understanding these effects
(see Adrian and Shin 2010a, Gertler and Kiyotaki 2010 and Woodford 2010a).
The relation between monetary policy and financial-stability policy
As mentioned, an important conclusion from the financial crisis is that neither price stability
nor interest-rate policy are enough to achieve financial stability (Carney 2009, White 2006).
Good flexible inflation targeting by itself does not achieve financial stability. Furthermore, the
policy rate is an ineffective instrument for influencing financial stability, and policy rates high
enough to have a noticeable effect on credit growth and house prices will have a strong
negative effect on inflation and resource utilisation, even in sectors that are not experiencing
any speculative activity. Specific policies and instruments are needed to ensure financial
stability. A good financial-stability policy framework is necessary to ensure financial stability.
Monetary policy cannot serve as a substitute.
In general, it is helpful to conceptually distinguish financial-stability policy from monetary
policy. Different economic policies, such as fiscal policy, monetary policy and labour market
policy can be distinguished according to their objectives, the policy instruments that are
suitable for achieving the relevant objectives, and the authority or authorities who control the
instruments and are responsible for achieving the objectives. From this point of view, it is
clear that monetary policy and financial-stability policy are very different, and understanding
this distinction is important.
Monetary policy, in the form of flexible inflation targeting, has the objective of stabilising
inflation around the inflation target as well as resource utilisation around a normal level.
Under normal circumstances, the suitable instruments are the policy rate and
communication. In times of crisis, as we have seen during the current crisis, other more
unconventional methods can be used, such as lending at a fixed interest rate at longer
maturities, quantitative easing, and so on.
Financial-stability policy has the objective of maintaining and promoting financial stability.
Financial stability can be defined as a situation in which the financial system can fulfil its
main functions of submitting payments, channelling saving into investment, and providing risk
sharing without disruptions that have significant social costs. The available instruments are,
under normal circumstances, supervision, regulation, and financial-stability reports with
analyses and leading indicators that may provide early warnings of stability threats. In times
of crisis, authorities may use instruments such as lending of last resort, variable-rate lending
at longer maturities (credit policy, credit easing), special resolution regimes for financial firms
in trouble, government lending guarantees, government capital injections, and so forth.
My point here is that this has to be taken into account when considering the lessons of the
financial crisis for monetary policy. The interest rate is a blunt and unsuitable instrument for
achieving financial stability and it thus makes little sense to assign the objective of financial
stability to monetary policy. However, it may make sense to assign the objective of financial
stability to the central bank, if the central bank is given control of the appropriate supervisory
and regulatory instruments.
The fact that financial-stability policy and monetary policy are different does not mean that
there is no interaction between them. This interaction need to be considered. Monetary policy
affects asset prices and balance sheets and can thereby affect financial stability.
Financialstability policy directly affects financial conditions, which affect the transmission mechanism
of monetary policy. This means that monetary policy should normally be conducted taking
financial-stability policy into account, and financial-stability policy should be conducted taking
monetary policy into account. This is similar to how fiscal policy is conducted taking monetary
policy into account, and monetary policy is conducted taking fiscal policy into account.
Importantly, under normal conditions, financial stability is handled by financial-stability policy,
not by monetary policy.
However, let us suppose that the appropriate and effective instruments for ensuring financial
stability are not available, for instance because of serious problems with the regulatory and
supervisory framework that cannot be remedied in the short run. In such a second-best
situation, if there is a threat to financial stability, one may argue that, to the extent that policy
rates do have an impact on financial stability, this impact should be taken into consideration
when choosing the policy-rate path to best stabilise inflation and resource utilisation. Such
considerations could result in a lower or higher policy-rate path than otherwise, in order to
trade off less effective stabilisation of inflation and resource utilisation for more financial
stability.2 To the best of my knowledge, the evidence so far indicates that in normal times
such a trade-off is very unfavourable, in the sense that the impact of policy rates on financial
stability is quite small and the impact on inflation and resource utilisation is significantly
greater. Then, in normal times an optimal trade-off would still result in policy rates directed
towards stabilizing inflation and resource utilization with little impact on financial stability.
In particular, it seems clear that monetary policy should not be used to target housing prices.
A considerable amount of research has concluded that policy rates have a modest impact on
housing prices but a substantial impact on output, implying high real costs for using the
policy rate for this purpose (Assenmacher-Wesche and Gerlach 2010). If housing prices are
considered a problem, instruments such as loan-to-value restrictions, amortization
requirements, a property tax, or restrictions on the tax deductibility of mortgage rates are
examples of instruments that have much lower real costs and hence a considerable
comparative advantage compared to the policy rate in affecting housing prices (Svensson
2010b).
Flexible inflation targeting with mean square gaps (MSGs) - another step towards
increased transparency
The adoption of numerical inflation targets has entailed great progress for practical monetary
policy and made it possible to measure and evaluate the target fulfilment of monetary policy
in a much more efficient manner than before. However, the fact that monetary policy is not
just directed towards stabilising inflation, but also towards stabilising resource utilisation has,
in the absence of quantitative measures of stability in these variables, made it difficult to
measure and evaluate target fulfilment in this stability dimension. This makes it difficult to
decide which policy-rate path best stabilizes both inflation and resource utilization.
My suggestion is to use mean squared gaps for the inflation forecast and for the resource-
utilization forecast as measures of the stability of inflation and resource utilization.3 Figure 1
provides an example, using graphs from Norges Bank's Inflation Report of June 2005.
Figure 1
Monetary policy with mean squared gaps (Norges Bank, June 2005)
In figure 1, the top left panel shows three alternative policy-rate paths, the main path chosen
by Norges Bank at the time and two alternative paths, a lower and a higher path. The top
right panel shows the corresponding forecast of inflation according to the index CPI-ATE, the
consumer price index adjusted for tax changes and excluding energy products. The bottom
right panel shows the corresponding forecasts of the output gap, the gap between output and
potential output. These three panels are shown in the June 2005 Inflation Report. We see
that there is a tradeoff between stabilizing inflation and resource utilization, measured as the
output gap. The lower (higher) policy-rate path stabilizes inflation better (worse) around the
inflation target of 2.5 percent but resource utilization worse (better). The Qvigstad (2005)
necessary (but not sufficient) condition for optimal policy is satisfied, namely that the inflation
gap and the output gap should be of opposite signs.
The bottom left panel, with the mean squared gap for inflation plotted along the horizontal
axis and the mean squared gap for output plotted along the vertical axis, has been added by
me. The closer the mean squared gap for inflation and output is to zero, the better inflation or
the output gap is stabilized. The less sloped straight line is an iso-loss line that corresponds
to equal weight on inflation and output-gap stabilization, that is to a "lambda" equal to one.4
With such equal weight, the high policy-rate path is preferred. The steeper straight line
corresponds to lambda equal to 0.3, that is, with a weight on output-gap stabilization equal to
0.3 relative to the weight on inflation stabilization. With such a weight, the main policy-rate
path is about as good as the higher and clearly better than the lower policy-rate path. At the
time, Norges Bank had announced that its decisions were consistent with a relative weight
on output-gap stabilization equal to 0.3 and a relative weight on interest-rate smoothing of
0.2 (Bergo 2007 and Holmsen, Qvigstad, and Røisland 2007). With some weight also on
interest-rate smoothing, the main policy rate is best.
The use of the mean squared gaps is one more step towards more systematic and
transparent inflation targeting, in which central banks can be evaluated and held responsible
for their decisions with even greater accuracy than before, following the introduction of
numerical inflation targets, published forecasts of inflation and the real economy, published
policy-rate paths and other important steps taken in the development of a systematic and
transparent monetary policy.
References
Adrian, Tobias, and Hyun Song Shin (2010a), "Financial Intermediaries and Monetary
Economics," in Friedman, Benjamin M., and Michael Woodford (eds.), Handbook of
Monetary Economics, Volume 3, Elsevier, forthcoming.
Journal of Financial
Adrian, Tobias, and Hyun Song Shin (2010b), "Liquidity and Leverage,"
Intermediation 19, 418-437.
Assenmacher-Wesche, Karin, and Stefan Gerlach (2010), "Monetary policy and Financial
Economic Policy
Imbalances: Facts and Fiction", July 2010, 437-482.
Bergo, Jarle (2007), "Interest Rate Projections in Theory and Practice," Speech on January
26, 2007, www.Norges-Bank.no.
Borio, Claudio, and Haibin Zhu (2008), "Capital Regulation, Risk-taking and Monetary Policy:
A Missing Link in the Transmission Mechanism?" BIS Working Paper 268, www.bis.org.
Carney, Mark (2009), "Some Considerations on Using Monetary Policy to Stabilise Economic
Activity", in Financial Stability and Macroeconomic Policy, Federal Reserve Bank of Kansas
City Jackson Hole Symposium.
Gertler, Mark, and Nobuhiro Kiyotaki (2010), "Financial Intermediation and Credit Policy in
Business Cycle Analysis," in Friedman, Benjamin M., and Michael. Woodford, eds.,
Handbook of Monetary Economics, Volume 3, Elsevier, forthcoming.
Holmsen, Amund, Jan F. Qvigstad, and Øistein Røisland (2007), "Implementing and
Communicating Optimal Monetary Policy," Norges Bank Staff Memo 2007/3.
Qvigstad, Jan F. (2005), "When Does and Interest Rate Path 'Look Good': Criteria for an
Appropriate Future Interest Rate Path - A Practician's Approach", Norges Bank Staff Memo
No. 2005/6.
Svensson, Lars E.O. (2010a), "Inflation Targeting," in Friedman, Benjamin M., and Michael
Woodford, eds., Handbook of Monetary Economics, Volume 3, Elsevier, forthcoming,
www.larseosvensson.net.
Svensson, Lars E.O. (2010b), "Some Problems with Swedish Monetary Policy and Possible
Solutions," speech on November 24, 2010, www.larseosvensson.net.
Svensson, Lars E.O. (2010c), "Why a Lower Repo Rate Path?", speech on February 24, 2010,
www.larseosvensson.net.
White, William R. (2006), "Is Price Stability Enough?" BIS Working Paper No. 205,
www.bis.org.
Woodford, Michael (2007), "The Case for Forecast Targeting as a Monetary Policy Strategy",
Journal of Economic Perspectives, Fall 2007.
Woodford, Michael (2010a), "Financial Intermediation and Macroeconomic Analysis", working
paper, Columbia University, www.columbia.edu/~mw2230.
Woodford, Michael (2010b), "Inflation Targeting and Financial Stability," in progress.