Lars Nyberg: The framework of modern central banking
Speech by Mr Lars Nyberg, Deputy Governor of the Sveriges Riksbank, at the Conference on
Reforming the State Bank of Vietnam, Hanoi, 21 March 2006.
* * *
Thank you for inviting me to this conference on reforming the State Bank of Vietnam. I imagine that
one reason why I have been invited here is that the central bank I represent, Sveriges Riksbank in
Sweden, just over a decade ago was in a situation which resembles the one the State Bank of
Vietnam is experiencing now. At that time we had reached a situation where there were strong
reasons - if not imperative ones - for reconsidering the way in which we used to think about monetary
policy. It became clear that a reform of monetary policy and its framework was both desirable and
necessary.
Of course, Sweden is by no means the only country where monetary policy has undergone major
changes in recent times. The view of how best to conduct monetary policy has changed fairly radically
over the past twenty years and this has been reflected in a more or less worldwide reform process.
What I hope to be able to contribute here today - as an introduction to the discussions - is to provide
an overall picture of the ideas that formed the basis for this process and to describe what are today
considered to be the guiding principles for a modern central bank, according to established research
and practical experiences.
What objectives should a central bank have?
The most fundamental question to ask when one is on the point of reforming the monetary policy
framework is, of course, what the objective of monetary policy should be. On a very general level the
objective of monetary policy can be said to be to create an environment where the economy can
develop in the best possible manner. However, this definition is too general to be of any great practical
use, although it excludes some tasks that are sometimes imposed on central banks.
To obtain a more operational definition, it is necessary to take the discussion one step further and ask
the question of how monetary policy can contribute to favourable economic development. On a
fundamental plane, one could say that the central bank's main task should be to ensure that the
payment system in the economy functions efficiently. This means in simple terms that payments and
financial transactions can be made easily and smoothly and entail as little risk as possible. Many
scholars also regard this as the main reason why central banks were originally founded1.
An economy's payment system can be regarded as a sort of infrastructure in roughly the same way as
the country's communications network or energy supply system. It also essentially fulfils the same
purpose, i.e. to ensure that the flows essential to the economy - in this case the flow of money -
functions properly.
However, ensuring that the payment system functions efficiently is also a fairly general definition that
requires further precision. To become more specific, it is necessary to define what characterises an
efficient payment system. I intend to discuss two characteristics here that I perceive to be the most
central - price stability and financial stability.
Price stability
An important component of an efficient payment system is that economic agents have confidence that
the value of the means of payment will remain stable over time, that is in practice that inflation will be
low and stable. One usually expresses this as there being a nominal anchor that prevents inflation and
inflation expectations from drifting off. If households and companies are confident that the general
price level will not change very much, they are better able to plan for the future and need not put effort
into finding ways of protecting themselves against inflation, but can focus on more productive
activities.
Another argument for keeping inflation low focuses on the role of price formation as a signalling
system. When inflation is low and stable it is easier for economic agents to distinguish changes in
relative prices and to adjust their decisions regarding consumption, saving, work and investment
accordingly. High and fluctuating inflation, on the other hand, disrupts the signalling function of the
pricing system and can more easily lead to bad economic decisions. In an environment with low
inflation, the price system can do a better job in allocating resources to uses where they will do most
good. In a broader sense, one could see an efficient pricing system as part of an efficient payment
system - it ensures that the transactions made are based on the best information possible.
Price stability can also be justified for reasons not immediately connected with the efficiency of the
payment system, such as the fact that high and fluctuating inflation tends to give rise to undesirable
distribution effects. For instance, inflation appears to hit poor people hardest as the rich usually have
better opportunities to protect themselves, or even to benefit, from the effects of inflation2. This could
be because, for instance, poor people often have no other opportunity than to retain a large part of
their limited assets in the form of money or because they are to a greater extent than the rich
dependent on public subsidies that are not fully indexed.
Keeping inflation low and stable is currently the most obvious - and definitely the most noticed - task
for modern central banks. The reason for the focus on price stability is of course the negative
experiences of the high and fluctuating inflation many countries experienced in the 1970s and 1980s.
During this period one could say that the central banks' original task of guaranteeing the value of the
means of payment was neglected as other tasks, primarily affecting demand in the economy, were
perceived as more important and more interesting for monetary policy. The consequence was that the
nominal anchor was relinquished and to establish it again proved to require considerable effort.
Let me before I discuss the other important component of an efficient payment system - financial
stability - say something about the most common approaches to attaining price stability. There are
currently two predominant means of trying to ensure that inflation remains at a low and stable level.
One is to tie one's own currency to the currency of a country with a long tradition of low and stable
inflation. The fixed exchange rate thus becomes an intermediate target through which one hopes to
attain the ultimate target - price stability. The other means is to allow the exchange rate to float and to
give the central bank the task of acting more directly to attain low, stable inflation - what is known as
inflation targeting.
The changeover in monetary policy made by Sweden at the beginning of the 1990s meant that we
switched from the first method, fixing the exchange rate, to the second, targeting inflation. The reason
was quite simply that the fixed exchange rate had not functioned very well as a means of keeping
down inflation and establishing a nominal anchor in the economy. For a couple of decades we had
failed to keep price and wage increases in check. However, a fixed exchange rate relationship is not,
of course, compatible with an inflation rate that systematically exceeds that in the country to which the
exchange rate is tied - sooner or later the exchange rate relationship must collapse. The rapid
increases in wages and prices also repeatedly came into collision with the fixed exchange rate and the
result was that the Swedish currency was devaluated on several occasions from the mid-1970s
onwards. The economy was thus characterised by "boom-bust-cycles" with alternate strong
acceleration and sudden braking.
However, the fact that the fixed exchange rate did not work as a nominal anchor in Sweden does not
mean that it could not function well in other countries; it has unquestionably done so in many cases.
So let me therefore move on and mention some general advantages and disadvantages of the two
methods3.
Perhaps the foremost advantage of having a fixed exchange rate regime as a means of keeping
inflation under control is that it makes the task of monetary policy simple and straightforward: it shall
set the key rate in a way that enables the exchange rate relationship to be maintained. This task is
also easy for the general public to understand.
At the same time, it may be a disadvantage that monetary policy is tied to this single task. It cannot
then be used to subdue domestic disruptions that have no equivalent in the country to which the
currency is tied - the anchor country. At the same time, disruptions in the anchor country will
immediately affect the targeting country as interest rate adjustments in the anchor country will lead to
corresponding interest rate adjustments in the targeting country. If, for instance, the interest rate in the
anchor country is raised because demand in that country is increasing, the interest rate in the targeting
country must also be increased in order to maintain the exchange rate relationship, even if the country
is in a recession. A fixed exchange rate regime thus means that it is not possible to conduct an
independent monetary policy. The task of keeping the economy in balance and of steering inflation
more directly cannot thus rest with the central bank. A fixed exchange rate relationship can also be
exposed to speculative attacks if it is not entirely credible. This was the case with the Swedish krona
and several other European currencies at the beginning of the 1990s.
With regard to inflation targeting, I am of course somewhat biased and for obvious reasons find it
easier to point to advantages than disadvantages. One advantage is that a central bank which
conducts inflation targeting is not tied to maintaining a particular exchange rate relationship, but can
be more directly aimed at focussing on what is happening in the domestic economy. Another, partly
related advantage - which I believe has been very important in Sweden's case - is that inflation
targeting means that one specific authority is given a clear responsibility for maintaining price stability.
During the 1970s and 1980s it was not entirely clear where the responsibility for this lay in Sweden.
One could say that the responsibility in practice had been delegated to the social partners, but that the
total economic policy tended at the same time to be so expansionary that it became difficult to
maintain wage and price increases at reasonable levels. A further advantage of inflation targeting is
that the task of monetary policy, in the same way as with a fixed exchange rate regime, is easy for the
general public to understand.
If I am to try to find a disadvantage with inflation targeting, it could be that it is more difficult from a
purely operational point of view for a central bank to steer inflation towards a particular level than to
maintain a particular exchange rate relationship. Inflation targeting is thus much more demanding than
a fixed exchange rate regime with regard to the central bank's analytical work and its ability to
communicate its policy. Whether this is something that should be regarded as a disadvantage or not is
of course a question of judgement. For the Riksbank, the transition to inflation targeting heralded the
start of a fairly comprehensive increase in competence in the field of economics. The number of PhD
economists at the Riksbank has risen sharply in recent years and our research in areas related to
monetary policy has expanded considerably.
Financial stability
Let me now move on to the other central component of an efficient payment system. This concerns the
stability in the financial system; particularly in the financial institutions that supply payment services,
i.e. primarily the banks. Financial stability is currently regarded, parallel to the price stability target, as
the main task of a modern central bank.
The financial system has essentially three main tasks: converting savings into financing, managing risk
and providing efficient channels of payment. Let me give a basic example. A bank receives savings
from households which it then lends to other households or to companies that need to invest. Banks
are specialists at valuing, monitoring and managing credit risks in the households and companies to
which they lend. The bank therefore contributes to ensuring that the mediation of capital in the
economy functions efficiently; it is sufficient that borrowers can convince the bank of their
creditworthiness, they do not need to convince each individual saver. Similarly, savers do not have to
assess the creditworthiness of every borrower; it is enough to be satisfied of the bank's solvency. The
banks can also supply payment services for households and companies by using the existing financial
infrastructure, such as accounts and various routines for transferring funds between financial
institutions.
As these functions are central to an efficient economy, it is evident that major problems can arise if
financial stability is upset. This is aptly illustrated by, for instance, the crises in South East Asia at the
end of the 1990s and by the bank crisis that Sweden and other countries suffered at the beginning of
that same decade.
While the target of maintaining price stability is relatively straightforward and intuitive, it is more difficult
to specify the task of promoting financial stability. This task has also been formulated in slightly
different ways in different central banks' regulations. For instance, the Bank of England's charter says
that it is "responsible for the overall stability of the financial system as a whole", while the
corresponding task in the regulations for Sweden's Riksbank has been expressed in a more indirect
manner: "to promote the efficiency and safety of the payment system"4.
One strategy for maintaining financial stability can briefly be described as consisting of three different
parts: a clear regulatory framework, an efficient day-to-day prudential supervision and oversight and a
preparedness to act strongly and quickly in a crisis. Exactly what role is played by the central bank in
this strategy is also something that varies from country to country.
Many central banks contribute in different ways to the formulation of the regulatory framework for the
financial system, for instance, by giving their views on proposed bills and by participating in
committees where domestic and international legislation is formulated. With regard to the day-to-day
prudential supervision and oversight, one solution that is applied in Sweden and other countries is that
the supervision of the financial sector is delegated to a special, independent authority with the power
to apply sanctions. In other countries the supervision work is done by the central bank itself. In the
cases where supervision is delegated to an independent authority, the central bank usually has an
oversight role that entails regularly monitoring and analysing developments in the financial sector and
presenting its views of the risks in the financial system. Ever since the bank crisis at the beginning of
the 1990s, this has been perceived as a very important task in Sweden; in fact, it could be argued that
the bank crisis was allowed to arise partly because no authority previously had the specific task of
monitoring the overall financial stability. The Riksbank now publishes a twice-yearly report analysing
the stability of the Swedish financial system. In a crisis situation, the central bank plays a very
important role. It may then need to go in and act as lender of last resort, that is, to grant emergency
liquidity assistance (ELA) to banks and financial companies if this is considered necessary to prevent
the financial system from collapsing.
The two objectives of price stability and financial stability are related to each other in different ways, in
addition to both being important components of an efficient payment system. The stability of the
financial system is of course a necessary condition for a policy aimed at price stability, as the latter is
fairly meaningless if the country is threatened with economic collapse. The financial stability objective
can therefore in one sense be said to be superior to the objective of price stability.
At the same time, it is very probable that price stability in the long run promotes financial stability, for
instance, by making the price system function better and thereby reducing the risk of bad investments.
However, price stability is no guarantee of stability in the financial system, which is illustrated, for
instance, by the problems in the Japanese banks at the beginning of the 1990s. There is thus no
reason for central banks to focus solely on the price stability objective and thereby assume that
financial stability will follow automatically - both objectives are important.
Other objectives than price stability and financial stability?
Are there any other objectives than price stability and financial stability that may be suitable for a
modern central bank?
Many countries also have objectives for developments in the real economy written into the regulatory
framework governing the central bank's activities. For instance, in the US legislation it says that the
Federal Reserve shall promote "maximum employment", while the British legislation says that the
Bank of England shall support "the economic policy of Her Majesty's Government, including its
objectives for growth and employment". In Sweden there is no specific objective for real economic
developments written into the law, but it is nevertheless considered to be understood that the
Riksbank - as an authority under the Riksdag, the Swedish parliament - shall support the objectives
of economic policy with the aim of attaining sustainable growth and a high level of employment.
Exactly how the objectives are worded thus varies considerably between countries, often depending
on the fact that changes and modifications have gradually been made to regulations originally written
much earlier. I dare to claim nevertheless that the essence of modern central banks' wording of their
objectives is the same. It is a question of monetary policy, as I said earlier, being first and foremost
aimed at ensuring there is a credible nominal anchor in the economy. As long as this nominal anchor
does not risk coming loose, monetary policy can be aimed at stabilising the real economy. I shall
return to this shortly and for now merely emphasise that the key word here is stabilise the real
economy and nothing else.
It may be interesting to note in this context that the experiences from the period of low, stable inflation
have meant that price stability is now increasingly perceived as both an objective in itself and as a
means of achieving other macroeconomic objectives5.
There are many indications that price stability has beneficial effects on efficiency and growth in the
economy. The reasons can be those I just mentioned, i.e. that the price system functions better as a
signalling mechanism in a low inflation environment and that households and companies can spend
more time on productive activities instead of trying to protect themselves against inflation. Essentially it
is a question of price stability being a necessary condition for an efficient payment system, as I said
earlier.
In addition, the period of low and stable inflation has also been characterised in many countries by
less fluctuations in growth in the real economy than was previously the case. The differences
compared with developments during the inflationist and unstable 1970s, often entitled "The Great
Inflation", have been so notable that this development has been awarded its own title in academic
research - "The Great Moderation"6. Although the reasons for the greater real economic stability are
not entirely clear; there are hypotheses that economies have undergone various types of structural
changes which have subdued the fluctuations - such as improved stock management among
companies and financial innovations - or that the shocks to the economies have quite simply been
smaller than during the 1970s. However, it is most likely that a better monetary policy has played
some role in the increased real economic stability.
We have thus established what a central bank's primary tasks should be: to maintain price stability, to
promote stability in the financial system and - as long as the nominal anchor formed by the price
stability target is not threatened - to try to stabilise the real economy. There may nevertheless be
reason to provide an example of what is not an appropriate objective for a central bank.
As I have tried to emphasise, the real economic objectives that central banks have entail stabilising
real quantities such as production and employment. By stabilising I mean that one tries to reduce the
fluctuations around the long-term trend. However, it is important to realise that this long-term trend
development is not something that monetary policy can directly influence. For example, a country's
long-term growth is determined by developments in the quantity of labour and real capital and
technological progress. The best that monetary policy can do is, as I have already observed, to
indirectly contribute to favourable economic developments by ensuring that inflation is kept low and
stable and that financial stability is good.
Although it might be tempting, it is therefore meaningless - and often counter-productive or even
damaging - to give the central bank the task of "creating" growth or employment. If one tries to affect
growth and employment by systematically keeping interest rates low and increasing liquidity in the
economy, or by allowing public sector projects to be financed directly by the central bank, the profits
will be only short term. Inflation will rise in a way that will sooner or later become difficult to control -
the nominal anchor will loosen - while developments in the real economy risk being poorer than they
would have been otherwise. I believe that it is correct to claim that a lack of insight and excessive
optimism regarding the role monetary policy can play in long-term real economic growth was one
important reason why inflation was so high during the 1970s.
The value of independence
How can one then construct a framework for monetary policy that provides the central bank with the
best possible conditions to carry out its tasks? Here I intend to be fairly brief as this is something that
will be discussed in more detail in the next contribution to this conference. Let me just note that there
is currently general agreement that the central bank should be given the opportunity to work
independent of the political system in order to attain the objective of price stability. It has been
observed that if monetary policy is conducted at arm's length from party politics, there is greater
confidence in the price stability objective. This is linked to the fact that there has often been a
tendency for politicians to use monetary policy for more short-term purposes which have conflicted
with the long-term price stability objective and which have often entailed loosening the nominal anchor.
Making the central bank independent is probably the element of the past decades' monetary reform
process that has triggered the most debate and has been perceived as the most controversial. It is
probably natural for politicians to feel uncomfortable giving the central bank increased independence
as it unavoidably means that they give up some of their decision-making powers, and moreover in a
field perceived to be central. I assume that this is one explanation why, for instance, it took Sweden
until 1999 before there was sufficient political support to grant the Riksbank increased formal
independence and to confirm by law the price stability objective, despite the fact that these reforms
had been proposed when the inflation target was introduced in 1993.
However, the concern among politicians over making central banks independent is quite unwarranted.
The independence does not, of course, mean that the central bank is free to conduct any monetary
policy they wish; it only means that it should be able to use the means at its disposal to meet the
objectives set by the political system without outside intervention. This is usually expressed as the
central bank being instrument independent but not goal independent. The delegation of powers should
be regarded as a means for politicians to ensure that the long-term aim of the monetary policy that
they endeavour to achieve - but have difficulty guaranteeing - can become a reality. Furthermore, a
natural consequence of the independence is that the central bank shall be accountable for its actions
and that monetary policy shall be conducted in a transparent manner7.
It is interesting to note that, despite fairly substantial initial doubts, people have afterwards been very
satisfied with the reforms implemented. Monetary policy therefore appears to have essentially
delivered what was hoped for and I am not aware of any country where making the central bank more
independent has been regretted.
Conclusion
Let me round off. I began by saying that the State Bank of Vietnam is currently in a situation similar to
that of the Swedish Riksbank just over a decade ago. However, it is also the case that the conditions
are different in certain respects. One difference is that the Swedish credit and money markets had
been deregulated completely during the 1980s and early 1990s. This meant, for instance, that the
central government issued bonds, through public auctions and at predetermined times, and actively
attempted to promote the development of a secondary market. Thus, there was already a clear
channel through which monetary policy could have an effect. Another difference was that we in
Sweden had the support of a long tradition of comprehensive production of public statistics that made
our work easier. These are factors that, as I understand it, do not apply to the same extent here in
Vietnam, at least not yet.
Vietnam has thus - like all countries - its own special conditions that may need to be taken into
account and may make it difficult to formulate monetary policy as an exact blueprint of the system in
another country8. However, I would like to say nevertheless that the principles which guide monetary
policy in modern central banks, and which I have described here, are so general that they should be
able to act as guiding stars for monetary policy reform work anywhere in the world.
Essentially it is a question of giving the central bank carefully specified - and realistic - objectives,
granting it independence in its endeavours to meet the objectives and ensuring that it carries out its
work in a transparent manner and is accountable for its actions.
It is my conviction that reforms based on these principles will be beneficial to Vietnam, too.
Thank you.