SPEECH
DATE:
31 May 2022
SPEAKER:
Governor Stefan Ingves
VENUE:
Swedish Economic Association
Inflation targeting for nearly 30 years -
a robust framework for all times?1
I would like to begin by thanking you for the opportunity once again to come here
and address the Swedish Economic Association. It is always a great pleasure to
have this opportunity. When I was here last year I talked about how the
Riksbank's three main areas - monetary policy, financial stability and payments - are
interrelated. This year I intend to focus on monetary policy and the Swedish
inflation-targeting policy, which will soon be 30 years old, but I will also address some
aspects of financial stability and payments that are linked to monetary policy.
"The sky is the limit."
These were the words of Riksbank Governor Bengt Dennis when he drastically
raised the policy rate to 500 per cent 30 years ago, or more specifically on 16
September 1992.2 Just over two months later, the Riksbank announced that the fixed
exchange rate for the krona would be abandoned. After another two months, it
was announced that monetary policy would be aimed at a price stability target.
Inflation would be stabilised at 2 per cent with effect from 1995.
At this time, inflation targeting was a relatively new concept. Only three countries
had previously introduced an inflation target: New Zealand in 1990, Canada in
1991 and the United Kingdom in 1992. There was therefore considerable
uncertainty as to how it would work.
It is now almost 30 years since the inflation target was introduced. During this
time, inflation has been slightly lower on average - around 0.4 percentage points
- than the formal target of 2 per cent. This is not desirable, but it is a margin of
error that is of a size that one probably has to expect. Long-term inflation
expectations have been stable despite the fact that we have been hit by two major
economic crises: the global financial crisis 2008-2009 and the 2020 pandemic. The
low and stable inflation has also probably been a contributing factor to the good
economic development that we have experienced since the inflation target was
introduced.
These experiences would indicate that inflation targeting has worked well in
Sweden - even surprisingly well - for almost 30 years. In particular, when one
considers the situation at the time of its introduction: high and varying inflation, low
growth, high unemployment and accelerated government debt. Does this mean
that we should expect inflation targeting to work equally well during the next 30
years? In today's speech, I will look ahead and give my view on this question.
I will begin by discussing some of the basic conditions that need to be in place for
the inflation targeting policy to function: a well-functioning payment system,
stable public finances and the need for monetary policy to have an effective
toolbox.
After that, I shall address two challenges that the inflation targeting policy needs
to deal with going forward: firstly, that the Swedish inflation target has not been
tested in an environment with sharply rising prices until now and, secondly the
economic consequences of climate change.
Finally, I shall give my view on how inflation targeting can be improved so that it is
equally successful in the future. It is primarily in two areas that the monetary
policy framework needs to be modified:

Some of the macroprudential tools, such as the countercyclical capital
buffer should lie with the Riksbank.
 Financial stability should have a certain weight in monetary policy
decisions, that is, be an argument in the Riksbank's objective function.
But before I come to this, however, I shall begin with a historical retrospective and
describe the monetary systems that we have tried before and which have led to
today's inflation policy. In this context, I shall also describe the characteristics of
inflation targeting and present statistics showing how economic developments
have been during the period of inflation targeting, compared with the fixed
exchange rate period in the 1970s and 1980s.
From copper standard to inflation targeting
In 1624, the copper standard was introduced in Sweden.3 Prior to this, we had
mainly used silver coins, but also gold coins to a lesser extent. Copper coins came
into the picture as there was a lack of silver and gold following the prolonged wars
being fought at this time. Moreover, Sweden had plenty of copper from Falu
copper mine, which accounted for a large share of Europe's copper supply.
The copper coins were large and therefore for natural reasons rather clumsy and
difficult to use. The largest copper coin - usually considered the world's largest
coin - weighed almost 20 kg.
The copper coins were not just bulky. They also made the monetary system more
complicated, because silver coins and, to a certain extent, gold coins were still
being used. However, the copper standard was not abolished until 1777, when the
silver standard was introduced. Almost 100 years later, in 1873, Sweden and
Denmark formed the Scandinavian Coin Union. Norway joined a few years later.
The Coin Union was based on a gold standard and lasted for more than 40 years,
until the First World War. After the war, Sweden re-introduced the gold standard,
but this time independently. The ambition was to return to the same gold parity
that had applied before the war.
In September 1931 - in the wake of the Great Depression - Sweden left the gold
standard. In its place, a price level target was introduced. From now on, the
Riksbank's task would be to stabilise the domestic price level. This was an historical
event, as it was the first and so far only time in history that a country had
introduced a price level target.4
The basic idea of the price level target was similar to the current inflation
targeting policy, but with the difference that the target was expressed in terms of the
general level of prices, not the rate of change in prices. However, the realisation
that price stability could function as a nominal anchor and anchor price
expectations was new at this time. Some economists also realised that monetary policy
should be understandable and transparent to the public, roughly as the current
inflation targeting policy works:5
"The overwhelming majority of the Riksdag cannot have any other idea from
this bill than that the subject is so extraordinarily complex that a normal mortal
cannot comprehend it, but that it is best to leave the whole matter in the hands
of the 'currency-saving authorities'. Although such an effect is not intended, it is
nevertheless deplorable. The Swedish people should be able to form an opinion,
at least in broad terms, both on the meaning of monetary policy and on the
need for the measures intended to support this policy. This is, in any case, a clear
democratic requirement."
The economic ideas that paved the way for the introduction of the price level
target had been presented by the Swedish economist Knut Wicksell 30 years earlier.
In April 1898, Mr Wicksell gave a talk at the Swedish Economic Society under the
heading "The money rate's influence on goods prices".
Mr Wicksell proposed that the objective of monetary policy should be to stabilise
the price level. He also set out a simple rule of action as to how this should be
done. The central bank should raise the policy rate if the price level rises until the
rate of increase has stopped and correspondingly lower the policy rate if the price
level falls. In other words, Mr Wicksell's policy rule is similar to today's so-called
Taylor rule, which has become a benchmark for central banks when setting
interest rates.6
Sweden coped with the strains of the 1930s better than most other countries.
One lesson from the time of the price level target, which is sometimes
highlighted, is that the price level target could raise inflation expectations at a time
when there was an overall risk of deflation.7
The price level policy lasted until 1937, when the Riksbank received other targets
from the Riksdag, in addition to the price stability target.8 After the Second World
War, Sweden joined the recently-established fixed exchange rate system Bretton
Woods, which in practice acted as a gold standard. The Member States linked
their exchange rates to the US dollar and the United States then guaranteed that
the dollar could be redeemed at a fixed price in gold.
But at the beginning of 1971, President Nixon suspended the right to redeem
dollars for gold, and in March 1973 the system was finally put to rest when the dollar
began to float freely against other currencies. This would turn out to be the end of
the gold standard as a monetary system in the world.
Sweden then joined the European Community's monetary cooperation 'the
currency snake' or 'the snake in the tunnel' as it was also known. The idea of the
currency snake was to allow the currency of each Member State ("the snake") to
move freely against the other currencies within a relatively narrow range ("the
tunnel"), without any link to gold. In practice, it was the West German Mark that
acted as anchor for price stability.
During the 1970s, the world was faced with recurring economic problems
culminating in the oil price shocks in 1973 and 1979. In Sweden, monetary policy during
this period was characterised by repeated devaluations when politicians tried to
maintain Swedish competitiveness in the shadow of poorly functioning wage
formation and an overly expansionary fiscal policy. All in all, these factors
contributed to high inflation rates.
In this environment, there were also several rounds of deregulation. In the
mid1980s, the domestic regulations on the credit market were abolished.9 The
Riksbank could thus no longer limit the lending of commercial banks. As a result, loans
increased rapidly and both equity and property prices rose. At the end of the
1980s, currency regulation was also abolished, which opened the way for capital
to flow out of Sweden. The foundation for the coming 1990s crisis was thus laid.
In the early 1990s, the government implemented a major tax reform that made
borrowing more expensive, among other things. At the same time, real interest
rates had now begun to rise internationally. This created problems for the
financial system. Share and real estate prices began to fall. The negative effects on the
economy were substantial and ultimately led to a banking and currency crisis.
The crisis in the foreign exchange market pushed the krona down in line with an
ever-increasing outflow of capital. The Riksbank tried to defend the fixed
exchange rate as far as possible with large interest rate hikes, but this was a policy
that was doomed to fail.
In November 1992, the fixed exchange rate was abandoned and the krona began
to float. Just two months later, the General Council of the Riksbank announced
that the target for Swedish monetary policy would be to limit inflation to 2 per
cent per year with an interval of plus/minus 1 per cent. A new monetary policy era
had begun, an era of inflation targeting policy, which is still in place today, almost
30 years later.
What characterises inflation targeting?
Inflation targeting was a relatively new phenomenon at that time. Only three
countries had previously introduced an inflation target: New Zealand, Canada and
the United Kingdom. The difference from the current situation is striking. Today,
inflation targeting is the most common framework in developed industrial nations
and inflation targets are becoming increasingly common in emerging market
economies. The large central banks in the United States, the euro area and Japan
all have inflation targets and many smaller economies such as Switzerland, the
Czech Republic, Norway, Poland, South Korea and Australia base their monetary
policy on a target for inflation.
Inflation targeting policy consists of several different components, which may vary
slightly from country to country. On an overall level, the aim of the inflation target
is to establish a high level of credibility for low and stable inflation in society. This
helps households and companies make balanced economic decisions, which in
turn provides the conditions for long-term and sustainable economic growth.
The most prominent characteristic of inflation targeting policy is a quantified
target for inflation, but both the level of the target and the way inflation is measured
can vary. Many countries have a target of 2%, but in emerging market economies
it is not uncommon for the target to be higher. In some countries, the set target is
a range, as in Switzerland, for example, where it is between 0% and 2%. There is
also no complete consensus on the most appropriate measure of inflation. By
definition, inflation is the change in the general price level, which would indicate a
broad measure that includes as many prices as possible.
Most central banks use the change in some variant of the consumer price index as
a measure of inflation. Since 2017, we in Sweden have chosen to use the change
in the consumer price index with a fixed interest rate as target variable. The
Consumer Price Index has two main advantages: It is well known to the general public
and is published at short and regular intervals.
Inflation targeting policy does not have to mean that the central bank only cares
about inflation. The Riksbank and several other central banks conduct what is
known as flexible inflation targeting. This means that, in addition to inflation,
some importance is attached to stabilising production and employment, as long as
the inflation target is not threatened. In the wake of the global financial crisis in
2008-2009, there have been renewed discussions of whether inflation targeting
policy should also be complemented by a financial stability target. I will return to
this later in my speech.
Other features of inflation targeting policy are that the central bank has a high
degree of independence, which means that monetary policy decisions are taken
without interference from the government or parliament. This contributes to
increasing confidence in monetary policy and the inflation target and thus increases
their credibility.10
At the same time, if a central bank has a high degree of independence, there
needs to be opportunities for democratic scrutiny, that is, the central bank must
be able to be held publicly accountable for its decisions and assessments.
Transparency and openness are important to facilitate this.
Democratic scrutiny of monetary policy can take different forms in different
countries. In Sweden, the General Council has a controlling function by having the right
to insight into all of the operations. The National Audit Office shall, within the
framework of the annual audit, review the Riksbank's annual report and decide on
discharge from responsibility. The Riksdag Committee on Finance regularly
evaluates and monitors monetary policy, and every five years a major evaluation is
carried out by independent experts.
The Riksbank publishes a Monetary Policy Report five times a year, in which
monetary policy decisions are explained and justified. A report is also published once a
year in which the Riksbank reports on the conduct of monetary policy during the
previous year and further discusses the reasons behind it. In addition, the
discussion of monetary policy decisions by individual members is published around ten
days after the meeting. Since 2007, the Riksbank has also published forecasts for
its policy rate, which contributes to increasing transparency.
Inflation targeting 1995-2022: Low and stable inflation
and good economic development
The Swedish financial crisis at the beginning of the 1990s led to a severe economic
downturn. At the same time, however, the crisis was the starting point for a series
of necessary economic reforms in various areas. The Riksbank's introduction of an
inflation target was only one of these reforms.
There was broad agreement that fiscal policy needed to be reviewed. The
situation at the time was not sustainable, with large government budget deficits, which
were largely financed by loans abroad. A new fiscal policy framework with surplus
targets and expenditure ceilings was therefore an important element in fiscal
policy reform. A later element was the establishment of a Fiscal Policy Council of
external experts in 2007. The Council's task would be to evaluate fiscal policy. Other
reforms included the pension system, the restructuring of insolvent banks in order
to protect the public interest, and the role of the Industrial Agreement as a wage
norm for the labour market. A well-functioning wage formation that generates
wage increases consistent with the inflation target is of particular importance to
avoid price and wage spirals driving inflation up.
This comprehensive package of reforms, combined with favourable international
developments, laid the foundation for an almost 30-year period of low and stable
inflation, especially if we compare with the previous fixed exchange rate period
1973-1992, see Figure 1. It is also notable that inflation expectations have been
adapted towards 2 per cent during the period with an inflation target, see Figure
2.
Economic developments have been favourable during the period of inflation
targeting compared with the previous fixed exchange rate period. Figure 3 shows
that GDP growth and real wage growth have been higher and the current account
has moved from deficit to surplus. Moreover, the high government debt has
decreased significantly, see Figure 4. In other words, the inflation targeting policy
has worked well over almost 30 years, but it has also proved to work well in two
different economic crises.
Inflation targeting has been tested in two crises: the global
financial crisis 2008-2009 and the pandemic 2020
The global financial crisis broke out with full force when Lehman Brothers
collapsed in autumn 2008. The deep economic downturn that followed impacted
many economies for a long time. The financial crisis became a test of how well the
inflation targeting policy could cope with a crisis that was characterised by great
unease on the financial markets.
The Riksbank, like many other central banks, acted very quickly when the crisis
broke out. In a joint and coordinated action, policy rates in several countries were
cut in autumn 2008. Other measures were taken to increase liquidity in the
financial system, such as offering long-term loans and foreign currency loans, accepting
more securities as collateral for loans, and expanding the circle of monetary policy
counterparties. In other words, the Riksbank acted as a financial intermediary
and, with its actions, was able to allay the financial market unrest.
The powerful measures taken by the Riksbank and other authorities contributed
to reducing the costs of the crisis and to maintaining both the supply of credit and
the functioning of the financial system more generally. This in turn meant that
confidence in the inflation target was maintained. The inflation targeting policy
had thus passed the test.
The inflation targeting policy was then subjected to a new test in connection with
the outbreak of the pandemic at the beginning of 2020. The pandemic caused a
deep economic downturn, but much was different from previous crises. It was
clear at an early stage that this crisis would be different from both the global
financial crisis and the Swedish 1990s crisis. The economic costs of the pandemic
were primarily due to the comprehensive measures needed to reduce the spread
of infection. There were thus no fundamental economic imbalances that needed
to be corrected. But at the same time this meant that developments were very
uncertain in both the short and the longer term. There was no previous
experience to learn from, at least not in modern times.
The majority of the Riksbank's measures were implemented at the beginning of
the pandemic. It was important to act quickly, broadly and on a large scale. The
Riksbank therefore put in place a package of measures to secure liquidity and
credit supply in the financial system, to ensure that the impact of monetary policy
worked normally and that interest rates could remain low. The measures targeted
banks and financial markets, but the real aim was to ensure that credit granting to
households and businesses could be maintained, to mitigate the economic
consequences of the pandemic.
Asset purchases during the pandemic were designed to support the economy and
facilitate the Riksbank's attainment of the inflation target. It was important to act
quickly and powerfully to ensure that the credit supply continued to function and
to maintain the low interest rates.
When the pandemic broke out, we had limited opportunities to use certain
monetary policy tools. The possibilities for buying government bonds were limited,
because they had been part of monetary policy since 2015 and the portfolio was
already large. The possibility of lowering the policy rate, which was close to the
lower bound, was also limited. It was therefore necessary to purchase securities
other than government bonds, mainly mortgage bonds but also municipal bonds
and smaller amounts of commercial paper.
The Riksbank's measures were implemented in parallel with measures taken by
the government and other authorities, which included short-time work
compensation schemes, transition support, strengthened safety nets for those who lost
their jobs and reduced counter-cyclical capital buffers. The overall crisis
management measures succeeded in mitigating the economic consequences of the
pandemic. From a monetary policy perspective, we found that the supply of credit
and confidence in the inflation target could be maintained and that inflation
remained close to the target. The inflation targeting policy had also passed this test.
What are the basic prerequisites?
For the inflation targeting policy to work, a number of basic conditions need to be
in place. I shall discuss three of them: The first concerns an efficient payment
system.
An efficient payment system
We currently have three types of money in Sweden. The first is cash. The second
is the deposits by commercial banks into accounts with the Riksbank, so-called
reserves.11 These are not available to the general public, but are used by commercial
banks to make secure payments between one another in the Riksbank's payment
system, RIX.12 Cash and reserves are so-called central bank money, or more
specifically Riksbank money. The third type of money is commercial bank money, which
is the deposits made by the public into accounts with commercial banks. This
money is thus issued by private operators. Commercial bank money can be used
as a digital means of payment by the public if the accounts are linked to a
payment service, such as Visa, Mastercard, Swish or Apple Pay.
One difference between central bank money and commercial bank money is that
the Riksbank's money is safer, as the Riksbank cannot go bankrupt and can always
provide money. Commercial bank money, on the other hand, is a claim on private
banks, which can go bankrupt. To make commercial bank money safer, there are
various types of regulations, such as capital requirements and the deposit
guarantee.13
Use of cash has been declining over a long period of time in Sweden. If cash were
to cease to be used entirely, the general public would no longer have access to
money issued by the Riksbank. This has caused the Riksbank to consider a central
bank digital currency, a so-called CBDC or e-krona as it is called in Sweden.14 The
e-krona would be an electronic means of payment, but it should still mimic the
characteristics of cash as far as possible.15
The Riksbank's mandate includes promoting a secure and efficient payment
system and the e-krona is an important part of this work. A well-functioning payment
system is a prerequisite for a country to be able to use its own currency, which in
turn is a prerequisite for conducting one's own monetary policy.
A state-owned means of payment creates confidence in the payment system and
in the commercial bank money. Central bank money can be said to act as a
'nominal anchor' for commercial bank money, as it can be converted 1:1 into central
bank money. From a user perspective, it is likely that the e-krona may also
facilitate international payments and contribute to the development of new and more
efficient payment services.
Cryptocurrencies - an additional competitor to national
currencies?
The new digital technology creates not only opportunities for a CBDC, but also for
other types of private digital money, so-called cryptocurrencies. Since the
introduction of the Bitcoin cryptocurrency in 2009, the emergence of new
cryptocurrencies has almost exploded.
Cryptocurrencies currently function primarily as financial assets. But this may
change and cryptocurrencies may potentially compete with domestic currencies.
In some countries, such as El Salvador and the Central African Republic, it is in
principle possible to use Bitcoin for payments, although it is unclear to me to what
extent this actually happens and how it works.
One type of cryptocurrency is stablecoins. The value of stablecoins is linked to the
value of other assets, such as national currencies or gold. Stablecoins may
therefore be more stable than the cryptocurrencies not linked to any asset class, such
as Bitcoin.
Stablecoins may thus in principle be relatively stable, but they may nevertheless
present risks to the financial system. If they were to be widely used and based on
a currency other than the domestic currency, the scope for conducting one's own
monetary policy and for taking action in the event of a financial crisis would be
limited. A CBDC of one's own is one way of addressing these risks.
The design of the e-krona
An e-krona can be designed in different ways depending on how it is intended to
be used and what you want to achieve with it. It is important that a future e-krona
is designed to meet the needs of the future payment market. Accessibility and
increased competition in the payment market are two areas that have been raised
in the Riksbank's e-krona project.
It is also important to design the e-krona so that it does not have any negative
consequences for monetary policy and financial stability. If, for example, large
parts of the general public's deposits with commercial banks were to be
converted into e-krona, this could have a negative effect on the commercial banks
opportunities for funding. The risks of a bank run could increase in the event of
financial crises, which would have a negative impact on the financial system.
These risks can be managed in different ways. For example, with an e-krona that
is largely cash-like and whose primary purpose is to give the public access to
digital central bank money, it is possible to limit the amount of commercial bank
money that can be converted into e-krona. Another option could be to introduce
a fee/compensation on digital wallets with e-krona and that the fee can then
change depending on whether you want to increase or decrease the demand for
e-krona.
The Riksbank is currently investigating how best to design the e-krona so that it
promotes an efficient payment system and makes payments simple in our
increasingly digital surroundings with low cash use, and does not have any negative
effects on monetary policy and financial stability. It is an important project in
today's world where the Swedish krona is exposed to competition.
Stable public finances
On a very basic level, monetary policy and fiscal policy are linked to one another
through the government's combined budget restriction, that is, the Riksbank's
profits or losses are part of the government's budget. This has implications for the
conduct of monetary policy.
First and foremost, this means that sound public finances are a prerequisite for
keeping inflation low and stable. If the government's future capacity to obtain
taxes were to be less than future expenditure, the credibility of the inflation
target would be undermined. This is usually called 'fiscal dominance' and can lead to
rising inflation.16 To avoid this, for example, the EU placed restrictions on both the
size of budget deficits and public debt prior to the introduction of the euro. The
budget deficit was limited to a maximum of 3% of GDP and the central
government debt to a maximum of 60% of GDP.
Another connection between monetary policy and fiscal policy concerns the
possibility to stabilise the economy. The policy rate was for a long time close to its
lower bound and there were therefore limited opportunities to stimulate the
economy by further lowering the policy rate.17 This raised the question of what
role fiscal policy should play in stabilising the economy when the possibilities for
monetary policy are limited.18 The discussion has primarily concerned whether the
fiscal policy framework needs to be reviewed.
Possibilities to use fiscal policy more actively
One important precondition for fiscal policy stimulation to be effective requires
that households and companies have a high level of confidence in fiscal policy. In
principle, this means that public finances should be in good condition: that the
government's budget is under control and that public debt is low and stable.
The fiscal policy framework contains a number of policy targets to ensure stable
public finances, that is, a debt anchor, an expenditure ceiling, a surplus target for
the entire public sector and balanced local government finances.19
The debt anchor is a benchmark for how large the consolidated gross debt shall
be in the medium term and is set at 35 per cent of GDP. The expenditure ceiling
sets a maximum level for how much money the government can spend each year.
The government proposes a limit, and it is then Parliament that takes decisions a
few years ahead. The surplus target entails general government net lending
amounting to one third of a per cent of GDP on average over a business cycle.
Swedish government finances are in good condition compared to many other
countries, for example the public sector debt to GDP ratio is relatively low, see
Figure 5. The fiscal policy room for manoeuvre can therefore be greater than that
in other countries. In addition, the long-term real interest rate is low and probably
lower than long-term growth, which is another factor that affects the room for
manoeuvre.20
There is no formal measure of fiscal policy room for manoeuvre, but a benchmark
can be the primary surplus as a percentage of GDP, that is, government revenue
minus expenditure, excluding capital income and interest expenditure as a
percentage of GDP.
It can be shown, on the basis of the government's budget restriction, that the
primary surplus as a percentage of GDP in the long-term is a function of the central
government debt as a percentage of GDP (the sovereign debt ratio) and the size
of the long-term real interest rate relative to the growth rate.21
According to this relationship, one can have a long-term deficit in central
government finances while the debt ratio is constant, provided that the long-term real
interest rate is lower than the long-term growth rate. This means that the
economy can be stimulated by a deficit in finances while the government debt ratio
remains constant. In other words, confidence in fiscal policy does not need to
deteriorate, despite a budget deficit.
We can illustrate what this means in practice with a few simple examples of
calculations. Assume that the government debt ratio is in line with the 35 per cent debt
anchor and that long-term growth is 2 per cent. Figure 6 shows how the primary
budget balance as a percentage of GDP is affected by different levels of the
longterm real interest rate under these conditions.
If the long-term real interest rate is -1 per cent, the budget deficit may be 1 per
cent as a percentage of GDP. The measure of fiscal policy margin is therefore
consistent with a deficit of 1 per cent. If the long-term real interest rate were instead
to be 3 per cent, a primary surplus of 0.3 per cent as a percentage of GDP is
required for the government debt ratio to be constant.22 The scope for fiscal
stimulus thus decreases as the long-term real interest rate rises.
Risks with using fiscal policy more actively
This type of calculation should be interpreted with caution. Firstly, we assume in
the example above that the financial deficit does not affect the real interest rate
or growth, which need not be the case. There is also considerable uncertainty
regarding the level of the long-term real interest rate. Although it has fallen for a
long time, it may be wise not to base economic policy on the premise that i