Mr Bäckström elucidates the economic situation in Sweden
and describes the consequences it may have for future monetary policy
Speech given by Mr Urban Bäckström, Governor of the Sveriges Riksbank at Föreningssparbanken,
Ulricehamn on 1 September 1999.
* * *
First a word of thanks for the invitation to visit Ulricehamn and talk about something that is close to
the heart of a Riksbank governor, namely Sweden's economic situation. I shall be describing the
situation as I see it and saying something about the consequences it may have for future monetary
policy.
Unexpectedly strong trend
The new statistics in recent months show that economic activity is stronger than most forecasters had
foreseen as recently as in the spring. The growth of both domestic and external demand has been
higher than expected. Relative to the first half of 1998, the GDP growth rate for the first six months of
this year is an estimated 3.7%.
Most observers are in the process of revising their forecasts upwards, if they have not already done so.
In the Inflation Report last June the Riksbank judged that growth this year would reach 2.5%, followed
by 3% next year as well as in 2001. When the Executive Board discussed monetary policy on
12 August, however, our assessment was that this year's growth rate would be 3.5%. We also saw
grounds for an upward revision of growth in the next two years, though the prospects for that period
are more uncertain.
It is not just total output that has exceeded expectations. The same applies to employment. In the first
half of 1999 there were approximately 100,000 new jobs compared with the same period last year.
Much of the increase occurred in the private sector. This has been accompanied by decreased
unemployment, if one disregards the temporary seasonal upturn during the summer. However, the
reduction of unemployment is less marked than the increase in employment because many people are
returning to the labour market now that jobs are becoming available.
Meanwhile, price increases have been moderate. The underlying rate of inflation (UNDIX, which
measures inflation excluding interest expenditure, indirect taxes and subsidies) fluctuated during the
spring between 12-month figures of 1.0 and 1.5%. Other indexes also point to low inflation, despite an
increase in some commodity prices, oil in particular.
Altogether, then, the Swedish economy is developing very well. We are now entering the seventh year
of favourable economic growth - an average annual rate of about 3% - since the upturn in the summer
of 1993. Today, moreover, there is no immediate threat to price stability.
Market interest rates rising
The better economic situation and expectations that inflationary pressure will be somewhat higher than
before have caused a worldwide increase in market rates of interest. Sweden is no exception. During
the summer the five-year T-bond rate, for example, has moved up just over 1.0 percentage point.
Along with this increase, the spread between T-bond and other interest rates has widened. In other
words, the rates for long borrowing by housing institutes and firms have risen relatively more than the
rate the Treasury has to pay for government borrowing with the same maturity. Since June, the rate for
a five-year housing bond has moved up around 1.3 percentage points.
Similar shifts have been noted in the international financial markets. Spreads of this kind often tend to
widen when the future path of interest rates becomes more uncertain. Besides the uncertainty about
interest rate tendencies in the cyclical upswing, a contribution to the wider spreads is said to have
come from the turn of the millennium: concern about limited liquidity at the turn of the year is
considered to induce some investors and borrowers to try to carry out transactions earlier.
In this context I should like to take the opportunity to underscore that the Riksbank, with its
responsibility for monetary policy and financial stability, has the instruments that are needed to
manage any liquidity problems that may arise. Together with the extensive preparatory work that has
been done in the financial sector, this means that the turn of the millennium should not be seen as a
serious problem.
The revised expectations of future inflationary pressure have entailed an adjustment of expectations
about monetary policy. Price setting in the financial markets includes built-in expectations that in the
coming years many central banks, including the Riksbank, will be raising their instrumental rates.
A point worth noting is that, if they continue, today's higher market interest rates will have a direct
impact on inflation from household interest expenditure, just as the recent years' steeply falling
interest rates had a sharp downward effect on inflation. In that case, the higher interest expenditure
would pull CPI inflation upwards fairly rapidly towards the targeted rate and above inflation's
underlying rate (UNDIX). Monetary policy would then face the same situation, albeit in reverse, as on
so many occasions in the recent past. An attempt to counter the tendency by tightening the monetary
stance would accentuate the direct impact and add to the increase in CPI inflation. That is why it is
inflation excluding transitory factors that is the focal point for monetary policy.
Central issues for monetary policy in an upward phase
About a fortnight ago the Executive Board of the Riksbank confirmed that the stronger growth can
lead to increased price pressure. Monetary policy may accordingly need to be conducted in a less
expansionary direction in the future.
But the Board also emphasised that the Swedish economy is not yet in such a situation. The trade-off
between inflation and growth is uncertain and earlier relationships therefore have to be tested in the
light of new information.
I consider that this conclusion still holds.
When the Riksbank begins to talk of a less expansionary monetary stance, I can imagine it raises a
number of questions. I should like to take this opportunity of discussing some of them.
One such question could be: Why must the Riksbank spoil the party? The Swedish economy has
finally begun a period of good growth, rising employment and decreased unemployment, while
inflation is low. So why do central bank representatives have to talk about the need to raise the interest
rate in such a situation? May it not lead to a renewed increase in unemployment?
Another question is how strongly the Swedish economy can expand without risks for inflation. Can it
be the case that even the Swedish economy is displaying new tendencies, as certain observers argue
has happened in the United States, that is, that growth can be higher without inflation taking off? If so,
why is the Riksbank talking of a need to raise interest rates?
Let me begin with the first question.
Why spoil the party?
History teaches that when the growth of demand outpaces the economy's long-term output trend, this
leads in time to risks of capacity shortages and bottlenecks that result in turn in rising prices and
wages. At the same time, as it takes one to two years for an adjustment of the instrumental rate to
affect the economy, the central bank's monetary policy decisions have to be based on assessments of
the future. Faced with the risk of a situation of this type occurring, it is therefore better to try to slow
things down with a small interest rate increase at an early stage. Demand growth can then be brought
into line with the growth of production capacity and result in a more stable path. By acting in good
time in a manner that is predictable, it is hopefully possible to avoid interest rate adjustments that are
more drastic. Meanwhile, economic agents can continue to count on stable, low inflation.
An example of the good results that can be achieved with a forward-looking monetary policy is the US
economy. With a judicious and timely tightening of the monetary stance, the Federal Reserve has
contributed to a long period of sustainable growth. Since the gradual increase from 3% between 1993
and 1994, the fed funds rate has fluctuated between around 4.5 and 6%. This has accompanied a
notably good economic development, with the longest postwar period of unbroken growth. The latent
inflationary pressure has been held in check without arresting growth. Similar reasoning lay behind
last week's interest rate increase. The positive trend has been aided by the consolidation of federal
finances.
On the other hand, if inflation has already risen to a high level that is expected to last, the central bank
may have to resort instead to larger interest rate increases to signal its determination to fulfil the
inflation target. That weakens economic activity and risks a renewed increase in unemployment.
Thus far the argument - and the question of which alternative is most advantageous - seems fairly
simple. But that is where the difficulties begin. How is the central bank to arrive at an interest rate
increase that is appropriate in its timing as well as its size? A large, abrupt increase might lead to
demand being curbed too early and too much, along with the risk of inflation falling below the price
stability target of 2%1. That is naturally not desirable. Which brings me to the second question: What
rate of GDP growth can the Swedish economy sustain without inflation taking off?
How strongly can the Swedish economy grow?
In situations involving rapid changes, there is a tendency to affix labels such as the new economy. The
logical implication is the existence of an old economy that works less well. I find this misleading.
There have been periods in Sweden's economic history when the economy performed exceedingly
well; one example is the 1950s and 1960s. There have also been periods that were less successful, for
instance the 1970s and 1980s.
The concept of a new economy might be apposite if the comparison is confined to the present and the
preceding decade. There are signs that the Swedish economy is functioning better in the 1990s than it
did in the 1980s. But what does this concept actually stand for?
One of the many interpretations of the new economy is that long-term growth's trajectory has shifted
upwards on account of a better productivity trend. For a given input of the production factors labour
and capital, the economy is able to sustain higher overall growth. It follows that if the supply side of
the economy works better, then its demand side can expand more rapidly without leading to
bottlenecks and inflation.
One of the driving forces behind the new and better functioning of the US economy is sometimes said
to be the rapid advances in data and telecommunications. By improving production and distribution
processes, the innovations are seen as a basis for stronger productivity growth.
Some consider that, for the United States, the potential growth rate has been raised from 2 to 3%. It
also looks as though the potential growth rate for Sweden has become somewhat higher - still
compared with the 1980s - but it does not seem to have reached an annual rate of as much as 3%.
A common, but not entirely certain estimate is that today the Swedish economy can sustain an annual
growth rate of between 2 and 2.5%. Growth above this level leads to decreased unemployment and
vice versa. But it is not just the strength of demand growth that determines the level of unemployment.
Other factors, such as economic structures, are also involved and at some level of unemployment the
only result of additional growth stimuli is bottlenecks and shortages. Wage costs will then rise in a
way that conflicts with low and stable inflation.
The GDP growth rate of 3.7% for the first half of this year accordingly exceeds any reasonable
assessment of the Swedish economy's long-term potential. For a time, however, such a high growth
rate can be feasible if firms are able to recruit the necessary labour, for instance because the economy
is recovering from a situation with high unemployment. That has been the case in Sweden's labour
market and pressure from wages and prices has thereby been able to remain low. Neither are any
dramatic changes foreseen in respect of wages in the near future. But how long can this situation last
in the present economic upswing? How far can unemployment be reduced without firms encountering
recruitment problems more generally?
Even with the high unemployment at present, it is, for example, already difficult to recruit computer
consultants and some other occupational categories. The situation in certain segments of the
Stockholm labour market is also tighter than in other parts of Sweden. But so far, the bottleneck
problems seem to be fairly restricted. As yet there are no indications of more widespread shortages. It
is a positive sign that the matching of job seekers and job vacancies is still running comparatively
smoothly, as it is that although the shortages of skilled workers in manufacturing have grown, the level
remains relatively low. To date this year, moreover, the wage drift statistics show increases that are
lower than expected.
Good credibility promotes price stability
Experience from the 1990s and earlier periods demonstrates that the relationships which are
discernible in economic models have to be constantly questioned and reviewed. Above all, they can
never be adopted uncritically when forecasting the future. So much happens in different economies,
not least as regards economic policies, that earlier truths have to be reassessed continuously.
Inflation has been subdued in recent years for a number of reasons. Imported inflation has been low
because of subdued commodity prices in connection with the Asian crisis. Productivity growth in
Sweden has been better than before. Another major factor is the increased confidence in monetary
policy and economic policy in general. All the survey data, as well as the underlying trend in market
prices, show that no one expects inflation in the somewhat longer run to be anything but 2%.
The inflation target accordingly seems to constitute a clear anchor for price formation. In the 1970s
and 1980s, inflation prospects did not depend on the level of domestic economic activity alone.
Relatively abrupt shifts in more long-term inflation expectations also played a part. Today, there are
no abrupt shifts of that kind. Economic players simply count, with good reason, on the Riksbank
acting if signs of rising inflation were to appear. In such a world, overall price formation centres above
all on the level of economic activity. The improved credibility is thus a further factor that may have
contributed to a level of inflation that is lower despite relatively strong growth.
At the same time, the Riksbank has the major responsibility of keeping a close eye on the more
long-term inflation expectations in order to maintain the credibility that has been built up in recent
years.
Demand assessments difficult
A question that naturally has to be included in the assessments is whether the stronger growth of
demand we have experienced, not least this year, will last. An important matter to bear in mind in this
context is that as long as the monetary stance is expansionary, demand growth will normally be above
its sustainable level. But some restrictive effect has, of course, already started to come from the higher
bond rates in recent months.
However, both the Swedish and the international economy can be exposed to unforeseen shocks. We
need to remember that no one foresaw either the extent or the course of the crisis in Asia. Neither was
attention drawn at an early stage to the risks behind last autumn's international financial unrest. Our
knowledge about phenomena of this type is still limited. It may be asked whether we shall ever be
capable of making definite predictions in this field. The models being tested at present are simply too
rough and ready. They tend to sound the alarm about events that never occur and miss those that
actually happen.
Although the picture looks bright, we know there are countries in the global economy that are
vulnerable, with a situation that may deteriorate. Share prices, moreover, have climbed very high, not
least in the United States. There are also imbalances in the US economy that may affect the future
course of events.
There is also the possibility, however, of demand growth in Sweden becoming even stronger. We do
not know how other components of economic policy will be constructed in detail. I am thinking in
particular of the current discussion about the direction of tax policy. The Riksbank is in no way
opposed to tax cuts. On the contrary, strategic tax reductions could make the Swedish economy
function better and thereby lead to higher growth. But we have a duty to issue a warning about a tax
policy that would give additional force to a growth of consumption that is already rapid and thereby
lead to economic overheating in Sweden. At the same time, I believe that decision-makers are aware
of these risks.
Taken together, all these factors make it difficult to assess the future development of demand. So there
is reason to monitor developments closely.
Conclusion
At present I do not for my part see any direct, immediate threat to price stability in the Swedish
economy. But I do believe that a continuation of strong demand growth, with all else equal, requires
the members of the Riksbank's Executive Board to consider how we can best ensure that economic
growth in Sweden remains stable. How soon and with what safety margin shall demand be brought
back to the rate that is sustainable in the long run? Do we need to take out the insurance provided by
an early, small adjustment of the interest rate? Or can we wait? That is something about which
opinions can differ slightly.
In my opinion, there is no reason as yet to reduce the expansionary effect on the Swedish economy
that monetary policy is currently exerting. A monetary policy adjustment will indeed be called for at
some time in the economic upswing but I still see its timing as an open question. My colleagues and I
on the Executive Board, as well as all those who analyse us, must follow the incoming statistics
closely. New knowledge and new insights must be continuously woven into the analysis.
Maintaining price stability, as the law prescribes, accordingly means that the Riksbank delivers its
contribution to making growth in the Swedish economy sustainable.