Lars E O Svensson: Flexible inflation targeting - lessons from the
financial crisis
Speech by Mr Lars E O Svensson, Deputy Governor of the Sveriges Riksbank, at the
workshop "Towards a new framework for monetary policy? Lessons from the crisis",
organized by the Netherlands Bank, Amsterdam, 21 September 2009.
I am grateful to Claes Berg, Ylva Hedén, Jonas Niemeyer, Virginia Queijo von Heideken, Annika Svensson, Ulf
Söderström, Staffan Viotti, Anders Vredin, Karl Walentin and, especially, Björn Lagerwall, for comments and help
with the speech. The views presented here are my own and not necessarily those of other members of the
Riksbank's executive board or staff.
* * *
1. Introduction
The financial crisis has raised some questions regarding monetary policy and how it should
be conducted in relation to financial conditions such as credit growth, asset prices,
imbalances, the risk of creating bubbles and so on. I will discuss two particular questions:
Has monetary policy contributed to the conditions for the crisis? Do the lessons from the
crisis justify any changes in the way best-practice monetary policy should be conducted?
I will lay out my pre-crisis view of best-practice monetary policy - flexible inflation targeting -
and its relation to financial stability and asset prices, discuss the role of monetary policy in
possibly contributing to the current financial crisis and, finally, present my conclusions on
whether flexible inflation targeting needs to be modified in the light of the crisis.
2. Flexible inflation targeting
The Riksbank and all the other inflation-targeting central banks conduct flexible inflation
targeting rather than strict inflation targeting. Flexible inflation targeting means that monetary
policy aims at stabilizing both inflation around the inflation target and the real economy,
whereas strict inflation targeting aims at stabilizing inflation only, without regard to the
stability of the real economy, what Mervyn King (1997) has described as being an "inflation
nutter". By stabilizing the real economy I mean stabilizing resource utilization around a
normal level, keeping in mind that monetary policy cannot affect the long-term level of
resource utilization.
Because of the time lags between monetary-policy actions and their effect on inflation and
the real economy, effective flexible inflation targeting has to rely on forecasts of inflation and
the real economy. Flexible inflation targeting can be described as "forecast targeting": The
central bank chooses a policy-rate path so that the forecast of inflation and resource
utilization "looks good." By a forecast that looks good I mean a forecast either in which
inflation is already on target and resource utilization is already normal, or in which inflation is
approaching the target and resource utilization is approaching a normal level at an
appropriate pace. More precisely, it means a forecast for inflation and resource utilization
that as effectively as possible stabilizes inflation around the inflation target and resource
utilization around its normal level. In the event of conflicting objectives, it achieves a
reasonable compromise between the stability of inflation and the stability of resource
utilization.1 Different central banks express this in slightly different words. The Riksbank has
often used the term "well-balanced" monetary policy.2
The forecasts of inflation and the real economy are then conditional on the central bank's
view of the transmission mechanism, an estimate of the current state of the economy and a
forecast of important exogenous variables. The central bank uses all relevant information
that has an impact on the forecast of inflation and the real economy. In this framework, the
central bank takes financial conditions such as credit growth, asset prices, imbalances,
potential bubbles and so on into account only to the extent that they have an impact on the
forecast of inflation and resource utilization. Inflation and resource utilization are target
variables here, that is, variables that are arguments of the central bank's loss function.
Hence, financial conditions are not target variables. Instead, they are only indicators, as they
provide information about the state of the economy, the transmission mechanism and
exogenous shocks to the central bank. Financial conditions then affect policy rates only to
the extent that they have an impact on the forecast of inflation and resource utilization.3
3. Financial stability as a rarely binding constraint - a pre-crisis view
What is the role of financial stability in a pre-crisis view of flexible inflation targeting?
Maintaining financial stability, including a well-functioning payment system, is, explicitly or
implicitly, an important objective for central banks. In my overview of best-practice monetary
policy in Svensson (2002), long before the crisis but during an ongoing debate about
monetary policy and asset prices, I briefly discussed how this objective can be reconciled
with flexible inflation targeting, how conflicts can arise and how they could be handled.4
One question is whether financial stability belongs in the loss function for the central bank,
together with inflation and resource utilization. I argued that a good way of handling this
additional objective is as a constraint on monetary policy rather than as a separate target
variable that appears in the loss function. The idea is that financial stability is normally
pursued with different instruments, such as supervision and regulation, and is normally not a
concern for monetary policy.
Under normal circumstances, at least in industrialized countries, financial stability is good
and does not impose any constraints on monetary policy. Only rarely, when financial crises
occur, does financial stability impose constraints on monetary policy and force the central
bank to modify its decisions.
The typical constraint that I had in mind was that monetary policy would have to be
temporarily modified in a more expansionary direction, for instance, in order to improve the
situation for a fragile financial sector, perhaps winning some time for a financial sector clean-
up and reform. Interestingly and paradoxically, the constraints financial stability has imposed
on monetary policy recently have rather been in the opposite direction to the one I
anticipated and have prevented the central banks from lowering the policy rate all the way to
zero, or even below, because of concerns about the financial sector.
The financial crisis and the deep recession that has followed it have motivated large cuts in
the policy rate. At the same time, concerns about the possible problems for the financial
market apparently made the Bank of England decide to go no lower than 50 basis points and
initially, in April 2009, prevented the Riksbank from going below 50 basis points, although the
Riksbank later in July lowered the policy rate to 25 basis points.5
How does the central bank know whether the constraint binds or not? I thought that it would
know by continually monitoring the state of the financial sector. In some countries, the central
bank publishes a regular Financial Stability Report of the type pioneered by the Bank of
England and the Riksbank. These reports include an analysis of indicators of the state of the
financial sector, in particular early-warning indicators of potential future problems. They serve
to assure the general public and economic agents that everything is well in the financial
sector when this is the case. They also serve as early warnings of the agents' concerns and
for the financial-regulation authorities when problems show up on the horizon. Early action
could then prevent any financial instability from materializing, thus limiting the probability of
future threats to financial stability and future binding constraints on monetary policy.
The idea of considering financial stability as a possible constraint on monetary policy rather
than a target is consistent with the general idea of seeing financial stability, from a
monetarypolicy point of view, as an aspect of the transmission mechanism of monetary policy, where a
reduction in financial stability typically changes the transmission mechanism and makes it
less efficient.
Asset prices and bubbles
The previous discussion has focused on what the central bank should do when it faces an
ongoing crisis, or receives signals that a crisis is underway. A related issue is to what extent
the central bank should take account of asset prices and, in particular, potential asset-price
bubbles. In the forecast targeting framework described above, asset prices will affect policy
to the extent they are deemed to affect the forecasts of the central bank's target variables,
that is, inflation and resource utilization.
Suppose, however, that a large asset-price increase is deemed to be fragile and a possible
bubble, with a significant risk for a future collapse. Suppose further that a future collapse is
deemed to have undesirable consequences for future inflation and resource utilization. Then
the bank faces a delicate situation. It is possible that a policy-rate path with a higher
policyrate in the near future will be deemed to dampen asset-price increases in the near future and
also reduce the risk or size of a collapse in the more distant future, thus undershooting the
inflation target in the near term but providing a more stable development of inflation and
resource utilization in the medium and longer term. These are examples of situations when
the central bank may choose to respond to asset-price developments. However, the reason
for these responses is that the central bank is concerned with the repercussions for inflation
and resource utilization, not with the asset prices as such. That is, asset prices are not target
variables; they do not enter the loss function.
It goes without saying that in most realistic situations it will be very difficult to judge whether a
particular asset-price movement is a bubble or is grounded in expectations about reasonable
fundamentals, and whether there are repercussions on inflation and resource utilization that
motivate adjustment of the policy-rate path.6 This is obviously an area where good judgment
is crucial. There is no scope for any mechanical adjustment of asset prices or bubbles. The
central bank's reaction will not be stable but shift with its judgment and, counter to substantial
parts of the literature, I do not believe that it is productive to discuss these issues directly in
terms of the central bank's reaction function, for instance as modifications of a Taylor rule
(Svensson 2003b, 2005).
Asset-price movements and asset-price bubbles may directly threaten financial stability and
cause the financial-stability constraints on monetary policy to bind. Thus, the central bank
may want to respond to asset price developments that increase the risk of financial instability
in the future. Again, in many realistic situations, the difficulty in making such judgments will
be very great and there will be insufficient information for taking such preemptive action in
many cases.
Now, is there any reason to modify this view of monetary policy and financial stability given
the experience of the financial crisis so far? Let me approach this question by asking what
the causes of the financial crisis are, what the role of monetary policy is in causing the crisis
and whether a different monetary policy was warranted and could have prevented or reduced
the size of the crisis.
4. The role of monetary policy in the financial crisis
As I see it, the crisis was mainly caused by conditions that had very little to do with monetary
policy and were mostly due to regulatory failures and, to some extent, to specific
circumstances, including the U.S. housing policy to support home ownership for low-income
households.7 The macro conditions preceding the crisis included low world real interest rates
due to global imbalances, as well as the Great Moderation with a long period of very stable
growth and stable low inflation, which led to a systematic underestimation of risk and very
distorted incentives
low risk premia in financial markets. There were for commercial and
investment banks to increase leverage that were made possible by lax regulation and
supervision and the lack of an appropriate bank resolution regime, as well as distorted
incentives to exercise less due diligence in loan origination because of securitisation and to
conduct regulatory arbitrage by setting up off-balance-sheet entities which for various
specific reasons ended up still effectively remaining on the balance sheet. There were also
distorted incentives for traders and fund managers to take excessive risks because of myopic
and asymmetric remuneration contracts. There were eventually enormous information
problems in assessing the risks of extremely complex asset-backed securities, and there was
a huge underestimation of the potential for correlated systemic risks. None of these causes
had anything to do with monetary policy, except that monetary policy may have contributed
to the Great Moderation.
So what was the potential role of monetary policy in contributing to the crisis? The main
argument blaming monetary policy for the crisis is that policy rates in the U.S. were kept too
low during the period 2001-2005, which would have contributed to the build-up of excessive
credit growth and a house-price bubble (Taylor 2007). There are two relevant questions in
this context about U.S. monetary policy during 2001-2005. First, was the low interest rate
reasonable given the information available at the time? Second, could a different monetary
policy with higher interest rates have prevented the crisis?
The first question, whether the low interest rate was reasonable given the available
information, is the relevant one when evaluating monetary policy. It is more relevant to
evaluate policy taking into account the information available ex ante to the policymaker rather
than information ex post that was unknown to the policymaker (see Svensson 2009 on
evaluating monetary policy ex ante and ex post).8 During this time, given the information
available, there was a genuine and well-motivated fear of the U.S. falling into a
Japanesestyle deflationary liquidity trap, and the optimal policy in such a situation is a very
expansionary monetary policy.9 It may be that, in retrospect, the risk of deflation was
exaggerated, but it was impossible to know this ex ante. Hence, I consider the expansionary
policy very appropriate and, adding some ex post evaluation, one can note that it did not lead
ex post to very high inflation and an overheated economy.
The second question, whether a different monetary policy could have prevented the crisis, is
relevant when assessing to what extent monetary policy can be blamed for causing the
crisis, notwithstanding if it was reasonable from an exante perspective. The credit growth and
the housing boom in the U.S. and elsewhere were very powerful. However, I believe that
somewhat higher interest rates would have made little or no difference. In order to stop the
credit growth and housing boom, interest rates would probably have had to be raised very
high so as to cause considerable damage to the real economy. They could have thrown the
U.S. right into Japanese-style deflation and eventually a liquidity trap. Certainly higher
interest rates would have had no impact on the regulatory problems, distorted incentives and
information problems mentioned above (although they could have ended the Great
Moderation with a deep recession and deflation).10
However, perhaps it is possible that the Fed's emphasis on its readiness to relax monetary
policy aggressively in the wake of a sharp fall in asset prices (Greenspan 2002) may have
induced expectations of a floor under future asset prices and contributed to the asset-price
boom (the "Greenspan Put"; see Miller, Weller and Zhang, 2002). Arguably, this is more a
communication issue rather than one of actual policy, and less emphasis on the readiness to
clean up after a sharp fall in asset prices might have been a preferable alternative.
5. Conclusion: does flexible inflation targeting need to be modified in light of the
crisis?
What conclusions can we draw from the financial crisis so far about the conduct of monetary
policy and any need to modify the framework of flexible inflation targeting?
One obvious conclusion is that price stability is not enough to achieve financial stability
(Carney 2009, White 2006). Good flexible inflation targeting by itself does not achieve
financial stability, if anyone ever believed that. Specific policies and instruments are needed
to ensure financial stability.
Another conclusion is that interest-rate policy is not enough to achieve financial stability.
Interest rates are too blunt an instrument for that, and attempts to use interest rates for
financial stability purposes would cause considerable collateral damage to inflation and the
real economy. Instead, the best instruments to achieve financial stability are supervision and
regulation, including appropriate bank resolution regimes. In many countries, the
responsibility for these instruments rests on other authorities than the central bank.
Generally, to the extent financial instability depends on specific distortions, good regulation
should aim to attack these distortions as close to the source as possible. To counter the
observed procyclicality of existing regulation, macro-prudential regulation that is contingent
on the business cycle and financial indicators may need to be introduced to induce better
financial stability. Possible macro-prudential regulation includes variable capital, margin, and
equity/loan requirements. As expressed by Bean (2009), "the best approach is likely to
involve a portfolio of instruments".
What are the specific conclusions for flexible inflation targeting? One old conclusion is that
consideration of the impact of financial factors on the forecast of inflation and resource
utilization may require longer forecast horizons. Several inflation-targeting central banks
(including the Bank of England, Norges Bank and the Riksbank) have for other reasons
already extended their forecast horizon from the previously common two years to three
years. There is nothing that in principle prevents an inflation targeter from considering
forecasts beyond a three-year horizon, but in practice there is usually little information about
anything at longer horizons except the tendency to revert to the long-term average.
What about "leaning against the wind" (as advocated by, for instance, Borio and White, 2003,
and Cecchetti, Genberg and Wadhwani, 2002), the idea that central banks should raise the
interest rate more than what appears to be warranted by inflation and resource utilization to
counter rapid credit growth and rising asset prices? It has sometimes not been quite clear
whether advocates of leaning against the wind mean that credit growth and asset prices
should be considered targets and enter the explicit or implicit loss functions alongside
inflation and resource utilization, or whether they mean that credit growth and asset prices
should still be considered just indicators and are emphasized only because credit growth and
asset prices may have potential negative effects on inflation and resource utilization at a
longer horizon. In the latter case, leaning against the wind is a way to improve the stability of
inflation and resource utilization in the longer run. Then it is completely consistent with
flexible inflation targeting.
However, in line with the previous discussion, other instruments than interest rates are likely
to be much more effective in avoiding excessive credit growth and asset-price booms, since
interest rates that are high enough to have a noticeable effect on credit growth and asset
prices may have strong negative effects on inflation and resource utilization, and a central
bank will probably rarely have sufficient information about the likely beneficial longer-horizon
effects on inflation and resource utilization for the trade-off to be worthwhile and motivated.
One important lesson from the financial crisis is that financial factors may have a very strong
and deteriorating effect on the transmission mechanism, making standard interest-rate policy
much less effective. This motivates more research on how to incorporate financial factors in
the standard models of the transmission mechanism used by central banks, and a rapidly
increasing volume of such research is now being produced by academic and central-bank
researchers and presented at an increasing number of conferences on financial factors and
monetary policy. Important questions include how potential output and neutral real interest
rates are affected by financial factors and financial distortions (Curdia and Woodford 2009,
Walsh 2009), and what impact financial factors have on the general equilibrium effects of
alternative policy-rate paths on inflation and resource utilization forecasts.11 Before such
extensions to the modelling framework are operational, policymakers and staff have to
improvise and apply unusual amounts of judgment on the effects of the financial crisis on the
transmission mechanism. Even with much better analytical foundations concerning the role
of financial factors in the transmission mechanism, there will of course, as always, be
considerable scope for the application of good judgment in monetary policy.
In the end, my main conclusion so far from the crisis is that flexible inflation targeting, applied
in the right way and using all the information about financial factors that is relevant for the
forecast of inflation and resource utilization at any horizon, remains the best-practice
monetary policy before, during, and after the financial crisis. But a better theoretical,
empirical and operational understanding of the role of financial factors in the transmission
mechanism is urgently required and needs much work, work that is already underway in
academia and in central banks.
The outcome might very well be that financial factors are considered to have a larger role in
affecting the transmission mechanism and as indicators of future inflation and resource
utilization. If so, central banks would end up responding more to financial indicators, in the
sense of adjusting the policy rate and policyrate path more to a given change in a financial
indicator. However, this would not mean that financial factors and indicators have become
independent targets besides inflation and resource utilization in the explicit or implicit
centralbank loss function. Instead, it would be a matter of responding appropriately to financial
indicators in order to over time best stabilize inflation around the inflation target and resource
utilization around a normal level.12
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