SPEECH
SVERIGES RIKSBANK
DATE:
16 December 2020
SE-103 37 Stockholm
SPEAKER: (Brunkebergstorg 11)
Deputy Governor Per Jansson
VENUE:
Handelsbanken
Tel +46 8 787 00 00
Fax +46 8 21 05 31
registratorn@riksbank.se
www.riksbank.se
Some thoughts on the need for changes
to inflation targeting*
We are living in dramatic times. Imagine us looking back on the current situation
in ten years' time. What will we remember? The coronavirus, most definitely.
Regarding the climate, we will perhaps still be talking about the devastating fires in
Australia and California, unless they have been overshadowed by new, even
greater, climate-related disasters.
My own area of profession, monetary policy and financial stability, is obviously far
less dramatic than worldwide epidemics and climate-change effects, but it also
affects people's lives to a high degree. As regards monetary policy, I suspect we may
look back on the current situation as a sort of cut-off point or watershed. The
international discussion on how monetary policy should best be designed is being
brought to a head and the next few years will show which path governments,
parliaments and central banks will choose to go down.
Monetary policy is facing greater challenges
The background is this: Since the global financial crisis, many central banks have
found it difficult to achieve their inflation targets more sustainably, despite very
low policy rates. These low rates have often been complemented by purchases of
various financial assets to make policy more expansionary. This has helped, but
has not been able to prevent inflation tending to be lower than is desirable. Most
recently, some central-bank forecasts, including those of the Riksbank, have also
started to indicate that inflation will continue to be below target for several years
to come.
These problems are not new. In a speech in 2016, I warned that we could end up
in a situation where it would take longer to achieve the inflation target than we
normally expect.1 I was alluding to the possibility that the Swedish economy might
not develop as favourably as we thought at the time, or that the forces that were
dampening inflation in Sweden and other countries would be stronger and more
persistent than we expected. At that time, monetary policy was more or less at
full throttle, with, among other measures, a repo rate at -0.5 per cent. But also in
countries like the United States, it was feared that monetary policy might have
difficulty fighting the next recession and holding up inflation.2
In the end, inflation in Sweden rose and was close to the target from 2017 until
mid-2019, although this was partly due to rising energy prices. But economic
activity had already started to slow by that time - and then the pandemic struck and
turned virtually everything upside-down. In countries where it had been possible
to raise the policy rate after the global financial crisis, it was cut again very rapidly.
For example, the Federal Reserve cut its policy rate to more or less zero percent,
after having had a policy rate of over 2 per cent as recently as mid-2019.
Unlike before the pandemic, most central banks are now in the same boat in that
their policy rates are at or close to the lower bound. Furthermore, they are also
buying both more and larger volumes of financial assets so that their balance
sheets have reached historically high levels (Figure 1). And all this in a situation
where future economic developments are still very uncertain, and confidence
problems for the inflation target are dawning on the horizon in many places.
... and these challenges will remain even after the
pandemic
The overshadowing task for governments and central banks at the moment is, of
course, to manage the effects of the pandemic and try to prevent it from causing
permanent damage to the economy. But, in a world where interest rates continue
to be very low, the challenges facing monetary policy will remain even after the
worst of the pandemic has been dealt with.
There are two primary challenges. The first is maintaining confidence in the
inflation target so that it can continue to function as a benchmark for price-setting and
wage formation. This is the whole point of inflation targeting - I sometimes call it
the very engine of the policy. The second is trying to ensure that monetary policy
can fight recessions effectively and sustain employment in difficult times. These
two challenges are connected and it is important to understand this. A number of
commentators seem to think that below-target inflation, even in the longer term,
does not matter so much. But what they seem to fail to recognise is that this
would also impair the Riksbank's ability to mitigate declines in GDP and
employment. I will return to these issues in more detail shortly.
For the rest of my speech, I will concentrate on three different themes:
 Why it is important to uphold the inflation target.
 Why it would be even more favourable to increase the target.
 Why we need to take a holistic approach to the interaction between the
different economic objectives we have established in Sweden.
The thesis I will pursue can be briefly summarised as follows: The inflation target
is needed and it could preferably be somewhat higher to give us greater room for
manoeuvre, as this will be needed going forward. We also need to review the
interaction between different economic objectives to improve the functioning of
the Swedish economy.
Removing focus from the inflation target is no solution
Let me start by discussing a few arguments made in the debate about monetary
policy, perhaps here in Sweden in particular, arguments for solutions that would
not tackle the challenges faced by central banks.
A pervading theme in the criticism of the Riksbank's policy is that we take the
inflation target far too seriously. If the Riksbank's ambitions were just toned down,
or the target lowered, monetary policy could be more flexible and have more
latitude. This flexibility would primarily be used to dampen the upturn in asset prices
via increases in the interest rate. This would be beneficial, it is claimed, as rising
stock markets and housing prices benefit the rich and monetary policy contributes
in this way to greater inequality.3
I would firstly like to emphasise that our inflation targeting is indeed flexible. But
flexibility requires firmly established public confidence in the inflation target. If
there is doubt about this, policy must focus on maintaining or re-establishing that
confidence. I will say more about why this is important in a moment.
So, in slightly more concrete terms, what then might a scenario in which we
removed focus from the inflation target look like? My starting-point here is a future
situation where the pandemic is under control, and most things are more or less
back to normal, but inflation is still low. Assume that the Riksbank were to
announce that the inflation target is no longer as important. Assume also, for
simplicity and to clarify my point, that the Riksbank starts to aim to dampen asset
prices by raising the interest rate.
The more or less inevitable outcome in such a situation is that inflation, which has
already been below target since the financial crisis, would fall. There are several
reasons for this: First, a rate hike would not only dampen asset prices but also
result in lower demand in the economy and a stronger Swedish krona. Second,
inflation expectations would fall when it became clear that the Riksbank was no longer
trying to uphold the inflation target. This would, in turn, affect, for example, wage
formation, which would no longer have a clear anchor - wage growth generally
would gradually fall for everyone in Sweden to offset the effect of higher real
wage costs on companies' competitiveness. Expectations of lower inflation would
subsequently spread more and more through the economy. In all likelihood, the
end-result would be inflation and inflation expectations becoming stuck at a
significantly lower level than today.
... as the interest-rate tool would lose its power
Before I complete my train of thought here, let me reiterate the challenges facing
monetary policy around the world: Ensuring that the inflation target continues to
constitute a benchmark for price-setting and wage formation, and that monetary
policy shall have room going forward to fight recessions effectively and sustain
employment in difficult times.
It is abundantly clear that the first challenge cannot be met if the scenario I
described were to be realised and inflation expectations and inflation become
permanently stuck below the target. Of course, stable inflation of, say, just above
zero per cent, can also provide a benchmark for price-setting and wage formation.
If we were to accept inflation being permanently at this level, however, it would
have substantial consequences. Assume that we went the whole hog and lowered
the inflation target. This would mean that we are "moving the goalposts", so to
speak, thereby trying to make the target easier to achieve. This may create
expectations of the same thing happening next time the target becomes difficult to
meet and thus reduce confidence in the inflation-targeting regime as such.
But the disadvantages are greater than this, which has to do with the second
challenge - ensuring monetary policy has room to fight recessions effectively and
sustain employment in difficult times.
The fact that global real interest rates have fallen and are now at historically low
levels means that the level at which central-bank policy rates are "neutral" - that
is to say, neither expansionary nor contractionary - is also historically low. When
central banks conduct monetary policy via the policy rate, they adjust it in the way
illustrated by the thick line in Figure 2, where the thin line is the neutral rate,
determined by the general real interest-rate level. A rate lower than the neutral one
stimulates demand and inflation, while a rate higher than the neutral one has the
opposite effect. Central banks must therefore consider the neutral rate when they
set their policy rate.
As the neutral interest rate is currently at a historically low level, the central
bank's policy rate needs to be very low to have an expansionary effect. This is why
policy rates in many countries are currently at or close to the lower bound. A key
circumstance here is that the average nominal rate level (regardless of whether it
relates to central-bank policy rates or general global interest rates) is affected by
how high inflation is on average. If average inflation is very low, say close to zero,
instead of being at the target of 2 per cent on average, interest rates will also, on
average, be about 2 percentage points lower.4
If, in turn, inflation and inflation expectations were to become stuck close to zero,
as in the example above, there would be little room for lowering interest rates if
this were necessary (See Figure 3). Quite soon, the policy rate will hit the bound at
which it is deemed impossible to cut further. Therefore, removing focus from the
inflation target would ultimately not give monetary policy more latitude, as many
people seem to think, but instead restrict its room for manoeuvre.
Problems for the Swedish economy as a whole
The crucial factor here is understanding the serious negative consequences this
would have for the Swedish economy as a whole as it will become more difficult
to sustain employment and output when economic activity is weak. The purpose
of the inflation target is not just to give the Riksbank a well-defined task. It is an
important economic target that contributes to good economic development in
Sweden.
A point that often seems to be overlooked is that a poorly functioning
interestrate tool also reduces the ability to fulfil objectives other than the price stability
objective, whatever they might be. Assume, for example, that the objective was
indeed to dampen the prices of various assets, such as equities and housing, or
fluctuations in lending. Although it would be possible to raise the interest rate
more or less unhindered, it would not be possible to lower it very much to
counter a fall in asset prices or lending. Another effect that also seems to be
overlooked is that a very low rate on average would imply that the policy rate would
have to be in negative territory more often, something which critics of the
Riksbank's policy would prefer to avoid.
A review of the monetary-policy framework is
underway
Let me now turn to the issue of how central banks can actually try to meet the
challenges they are facing - maintaining credibility in the inflation target and
preserving monetary policy's room for manoeuvre.
One observation is that things are beginning to happen in the world of central
banking. Several countries have evaluated, or are in the process of evaluating,
their monetary-policy framework. The Federal Reserve (Fed) made certain
changes to its strategy in August, and the European Central Bank (ECB) and Bank
of Canada, for example, are carrying out reviews that will be completed in 2021.
The Fed's adjustments are the only concrete changes so far, so I will focus on
them.5
These were the first major adjustments since 2012, when the inflation target was
introduced in the United States. The review prior to the adjustments was
motivated by three important changes in conditions since the target was introduced:

The neutral interest rate has continued to fall and is currently historically
low.

Inflation and inflation expectations have systematically undershot the
target of 2 per cent.

Prior to the pandemic, unemployment in the United States had fallen to
its lowest level in 50 years without having had any noticeable impact on
the development of inflation.
The first two are conditions that have also affected Sweden and many other
countries, as I noted at the beginning of my speech.
Practical implications of the Fed's modified strategy
Two of the Fed's changes to its strategy in particular have had a more concrete
effect on monetary policy. First, monetary policy shall aim to overshoot 2 per cent
for a period of time if inflation has previously undershot 2 per cent. Previous
target deviations should thus be compensated for by deviations in the other
direction, in contrast to conventional inflation targeting where such deviations are
seen as "bygones" that do not need to be compensated for.
Second, the Fed has announced that it intends to react differently to
developments on the labour market. The previous wording in the strategy document was
that monetary policy decisions were to be guided by deviations from maximum
employment. These deviations could of course be both positive and negative.
According to the new wording, decisions will in future be based on an assessment of
the extent to which employment falls short of maximum employment. In practice,
this means that low unemployment or high employment as such will not trigger
monetary tightening, unless inflation picks up at the same time.
During his speech at Jackson Hole in August, Fed Chair Jerome Powell called the
modified strategy a "flexible form of average inflation targeting". What the Fed is
most concerned about is that if inflation does not even reach the target level on
average over a long period of time, this risks sooner or later spilling over to
longterm inflation expectations in the economy. The decision-makers at the Fed
therefore want to make it clear that they are striving for average inflation of 2 per cent
- "average inflation targeting". However, they have not committed to any specific
time period for calculating the mean value - hence the term "flexible".
It is of course far too early to comment on what the outcome of the strategy
changes will be. Opinion is divided among economists. US economists were asked
in a survey whether they thought the changes would make any significant
difference over the next ten years. A third of the respondents thought the changes
would not make much difference, slightly less than a third thought they would,
while the rest were uncertain.6
Application still unclear
A common reaction has been that there are some ambiguities regarding the exact
application of the new strategy. These include the time period for which the Fed
intends average inflation to be 2 per cent. What is clear is that the Fed's aim is for
inflation to overshoot 2 per cent for a period of time if it has previously undershot
2 per cent.
Short periods below and above the target will most likely be unproblematic. But
my spontaneous reaction is that there will be challenges if a central bank aims to
overshoot the 2-percent target for several years to compensate for a previous
several-year period of below-target inflation, without specifying in more detail
either how long or by how much the target is to be overshot. This risks leading to
quite long periods of uncertainty as to which inflation rate the central bank is
striving for, even if average inflation (over a very long period of time) is ultimately
2 per cent. I doubt this would work particularly well in a country like Sweden,
where the inflation target is intended as the basis for wage agreements that often
run for several years.
One way to see the Fed's changes is as a new strategy to uphold the target of 2
per cent as a long-term, nominal anchor in the economy and to reduce the risk of
long-term inflation expectations gradually sliding downward and becoming stuck
at a level lower than the target. But even if this were to be successful, which I
believe it very well can be, the problems associated with having a policy rate at its
lower bound relatively often will still remain. When the general, global
interestrate level is very low, developments over recent years show that the interest rate
tends to hit its lower bound in recessions, even when there is confidence in
inflation being 2 per cent in the long run.
A higher inflation target is a more sustainable solution
In a speech I gave in 2018, I discussed different changes that could be made to the
monetary-policy framework.7 My conclusion was that raising the inflation target
would be the best of the proposals circulating in the international discussion. This
is still my view and, if anything, I am now even more convinced.
The advantages of a higher inflation target are simply a mirror image of the
disadvantages of a lower target where inflation and inflation expectations become
stuck at a level below the current target of 2 per cent. With higher average
inflation, nominal rates, including the policy rate, will also be higher on average. This
provides more room for cutting the policy rate in difficult times and makes it
easier to sustain employment (Figure 4). With a higher target, the interest rate will
thus be a more effective tool that increases monetary policy's latitude.8
Another, perhaps less obvious, advantage of a higher target is that quantitative
easing would also be more effective.9 One of the aims of purchasing various bonds
is to lower rates further out on the yield curve. As all nominal rates are higher
with a higher inflation target, it will also be possible to reduce longer rates more.
Is a higher inflation target unrealistic?
All things considered, therefore, a higher target is not necessarily more difficult to
maintain than a lower one, which may seem paradoxical. It may even be easier as
the interest rate will be a more effective tool in that it will not be at its lower
bound as often.
A common objection is that a target of, say, 3 per cent would be unrealistic and
will never be reached, let alone on a persistent basis. A very rapid increase in
inflation to this level would not, of course, be particularly likely. But I think parallels
can be drawn here with when we introduced the current target. At that time, too,
many considered the new target - persistent inflation of 2 per cent - to be
unrealistic. It also took a few years to establish confidence in the target among
economic agents, but we got there in the end (Figure 5). I think we should have the
same attitude here. Given sufficient consensus on the benefits to the Swedish
economy of a 3-percent inflation target, which I am convinced it would have, it
should not be impossible to achieve this.
There is no doubt that there have been structural forces pushing down inflation
for quite a long time and these have recently been given more impetus by the
pandemic. But they will not last forever. An interesting hypothesis is that these
forces are gradually starting to subside and go into reverse.10 The idea here is that
the low inflation of the last few decades has been a result of globalisation and
demographic factors. The primary manifestation of globalisation is the entrance of
China into the global economy. This has contributed to quite a dramatic increase
in the total global working population over recent decades. Those who work
produce more than they consume while the opposite is true for the young and old. In
very simplified terms, demographic distribution in the world can thereby be said
to have increased global supply and dampened global demand for goods and
services. In addition, the bargaining power of employees has weakened, especially in
the western world, which has stifled wages. In economic terms, this can be seen
as a global, long-term, positive supply effect, which, consistent with the textbook,
also puts a dampener on price growth.
Both in China and in the West, however, populations are now ageing and the
working population is decreasing (Figure 6).11 In the coming decades, there is
likely to be a trend in the opposite direction, that is, fewer people working and
more requiring support. It is perfectly possible that this could lead to the forces
pushing up inflation becoming stronger, while the forces dampening it become
weaker. As I said, this is a hypothesis and it remains to be seen how much truth
there is in it. As a minimum, however, I think it shows that it is impossible to
assume unequivocally that structural forces will have a restraining effect on inflation
for the foreseeable future.
Inflation expectations play a key role
The world's central banks are now expected to conduct expansionary policy for
many years to come, for example, with policy rate close to zero (Figure 7). I find it
hard to believe that this will not have any effect on inflation at all and to envisage
us living for ever, or even for such a short period of, say, five years or so, in a
world where it is impossible to have inflation of a couple of per cent or slightly
higher than that. Moreover, as I mentioned earlier, structural forces that have
been pushing down inflation for a long time may turn and start having the
opposite effect, and central banks can be the driving force behind creating consensus
on the benefits to the economy of slightly higher inflation, perhaps around 3 per
cent on average.
Expectations obviously play a major role here. I usually try to illustrate my
thinking by asking straightforward yes-no questions, so let me do the same thing now.
Assume that the Riksbank were shortly to announce a higher inflation target. I
wish to stress that this is not something currently being discussed and serves only
to clarify my arguments.

If the Riksbank were to raise the inflation target, would it affect monetary
policy in a more expansionary direction?

If the answer to this question is yes, would it in turn affect the expected
inflation rate, at least in the slightly longer term?
I think it is very difficult to answer no to the first question. It would mean that the
higher, more ambitious target would not be expected to have any effect at all on
the behaviour of the Riksbank. And if one answers yes to the first question but no
to the second question, it means one believes that, if the Riksbank, for example,
keeps the policy rate at zero per cent or lower for a number of years longer than it
otherwise would have done, it would have no effect at all on inflation. This is, of
course, not particularly reasonable either.
It is worth noting here that if the expected inflation rate rises (the answer to both
questions is yes), it will, in addition to the effect on the interest rate caused by the
Riksbank's increased efforts to achieve the more ambitious target, further affect
the real interest rate in an expansionary direction. It is important in the context to
understand that a given change in the real interest rate is of the same significance
to the economy regardless of whether it is due to higher inflation expectations or
a lower nominal rate. All in all, this may then result in significantly more
expansionary monetary policy, which constitutes an important foundation stone for
building confidence in the new, higher inflation target.12
It may very well be the case that an increase in the inflation target could be a big
enough change to influence expectations. A historical parallel is developments in
conjunction with the abandonment of the gold standard in the early 1930s.
Inflation expectations increased substantially in countries that left the gold standard
by devaluing or abandoning the convertibility to gold.13 This was also a period
which saw weak development in the real economy, but it was nevertheless
possible to influence inflation expectations. Correspondingly, it is possible that an
increase in the inflation target, in contrast to minor changes in the framework,
would constitute a sufficiently strong signal of change.
Greater acceptance of a higher inflation target
How likely is it then in practice that central banks' inflation targets will actually be
raised? When a panel of European economists was recently asked what changes
the ECB should make, a third argued that the ECB's inflation target should be
raised, while about 15 per cent neither supported nor opposed an increase.14
Many are still therefore sceptical about an increase and it is of course one thing to
have an opinion as an analyst or academic economist and another to adopt a
position as an economic policy-maker. But my impression is nevertheless that support
for raising central banks' inflation targets is gradually increasing, both within and
outside academia. As I noted earlier, central banks around the world have started
to reconsider their strategies and frameworks. This may gradually lead to greater
openness to solutions that may at first seem very far-reaching.
It is worth mentioning that the discussion continues in the United States despite
the Fed having recently changed its strategy. Some also think that a more
sustainable solution would be to raise the inflation target.15 As regards practical
implementation, an argument is that it would be easier to implement an increase if
several major central banks, like the Fed, ECB and Bank of Japan, were to take this
step simultaneously. There is also a view that an increase would be facilitated by a
two-step process, in which the Fed communicates that its primary priority is to
return inflation to the current target, and then, when this has been achieved, that it
will review the target in light of the neutral interest rate having fallen further
since 2012, when the current 2-percent target was introduced.
A holistic approach is required to the interaction
between the different economic objectives
But perhaps just reviewing monetary policy and implementing reforms to it is not
enough. We maybe need to take a wider approach. What I have in mind is that we
now need to give thought to our economic objectives and guidelines to a greater
extent than before and, in particular, how we see the interaction between them. I
intend to focus on Sweden and four of our economic objectives:

the inflation target
 long-term sustainable public finances

financial stability
 well-functioning wage formation.
These objectives have their origin in the crisis of the early 1990s and
developments in the decades before that, when flaws in all these areas had caused major
problems for the Swedish economy.16
Can the interaction between fiscal and monetary policy be
formalised?
As I have discussed, central banks have recently had difficulty making monetary
policy sufficiently expansionary to affect demand, sustain employment and keep
up inflation. A theme in the international debate has therefore been that fiscal
policy needs to play a greater stabilising role than it has in recent decades.
One thing I think we need to consider is whether the support from fiscal policy to
monetary policy should be formalised in some way and if so, how? This must not,
of course, lead to fiscal policy becoming so expansionary so as to undermine the
sustainability of public finances. Fundamentally, it is a matter of finding a balance
so that two of the economic objectives we agree on - the inflation target and
long-term sustainability in public finances - can both be upheld going forward. It
should be possible to both find such a balance and hopefully formalise it, at least
partially.17
Expansionary monetary policy imposes requirements on
macroprudential policy and regulatory frameworks
Another interaction we may need to ponder more over is the one between
monetary policy and our policies to maintain financial stability. As I have already
mentioned, expansionary monetary policy causes asset prices to rise. If these rise for
too long in a way that is decoupled from developments in the rest of the
economy, what are usually referred to as economic fundamentals, financial imbalances
emerge that can ultimately result in a financial crisis.
As we have seen, the low level of interest rates is largely due to the historically
low global real interest rates. But the expansionary monetary policy has pushed
up asset prices further. Why then is it not simply a question of raising the policy
rate to counteract the increase? As I have already argued, this would basically
mean, in the present situation, relinquishing one of our economic objectives - the
inflation target - in this case in order to try to mitigate the threat to another -
financial stability. I also explained why this is not a particularly sensible strategy: If
we relinquish the inflation target, we also render the interest-rate tool much less
effective. We will no doubt be able to slow the increase in asset prices and credit
growth by raising the policy rate, but we will not be able to counteract declines
with any great strength, neither in asset prices nor in the economy as a whole, as
the interest rate on average is too low and will regularly hit its lower bound.
A better distribution of economic responsibility is therefore to let
macroprudential policy and a well-designed regulatory framework manage financial imbalances
so that monetary policy can take care of what it is most suitable for - ensuring
that there is a credible anchor for price-setting and wage formation and stabilising
the business cycle. Here we have made some progress, but in a world where real
interest rates are low and monetary policy needs to be expansionary for a long
time, major challenges remain.
The interaction between wage formation and the economic
objectives is in need of review
This leads me on to the last point and the interaction between the inflation target
and wage formation. When inflation targeting was introduced in 1993, it was far
from obvious that it would succeed where the previous policy with a fixed
exchange rate had failed to constitute a fixed anchor for price-setting and wage
formation. But after a few years, it was clear that it was working. The inflation target
has helped provide greater orderliness in the Swedish economy by constituting
precisely such a benchmark and has probably been an important explanation, but
obviously not the only one, for the Swedish economy having developed so
favourably since the crisis in the early 1990s.
Since then, wage formation has been reformed in various respects. One important
reform is the Industrial Agreement, under which the manufacturing and mining
industries have set the benchmark for wage negotiations and ultimately steered
wage-cost increases in the entire economy for over twenty years.18 In this way,
international competitiveness is taken into account when Swedish wages are set.
For many years, the inflation target and the Industrial Agreement interacted well
with each other. But recently, when the problem has been too low rather than
too high inflation, this has not worked as smoothly. One can perhaps say that
wage formation has been steered by two different norms, the inflation target and
the benchmark set by the industrial sector, which are no longer pulling in the
same direction.
In recent years, the significance of the industrial sector's ben