Mr. Bäckström discusses the current situation for monetary policy in Sweden
Remarks by the Governor of the Swedish Central Bank, Mr. Urban Bäckström, to the Standing
Committee on Finance, in Stockholm, on 23/10/97.
I should like to thank the Committee for the invitation to discuss the Swedish
economy and the current situation for monetary policy. In my opening remarks today I shall begin by
briefly summarising the recent years' economic tendencies and then consider the present construction
of monetary policy. A look into the future will conclude. What I have to say is based on the latest
inflation report and events since it was published.
From a dual situation to broader expansion
Sweden's economy is now entering the fifth year of expansion since the profound
crisis at the beginning of the decade. Since GDP turned upwards in the summer of 1993, annual
growth has averaged over 2.5 per cent. Annual inflation in this period has averaged only about 2 per
cent. This is a marked contrast with the 1970s and 1980s, when annual growth averaged
approximately 2 per cent and inflation about 8 per cent. In one respect, however, the situation to date
is still dismal, namely as regards the labour market and employment. If an economy is growing well
but employment remains weak and unemployment high, there is a strong probability that the labour
market is affected by structural problems.
Although growth in recent years has been satisfactory, the generation of a broader
upswing in the economy has proved difficult. Initially, about three-quarters of the GDP's increase
came from manufacturing, which represents only about 20 per cent of Sweden's economy. This
meant that bottlenecks occurred fairly quickly, accompanied by various types of inflationary
impulses. Our relatively small industrial sector cannot be expected to sustain a growth rate that is
higher than the total economy achieved in the 1970s and 1980s.
The problem with the dual economy -- a flourishing export-related industrial sector
and a rather weak recovery in sectors with a more domestic orientation -- stemmed in part from low
confidence in economic policy's determination and ability to keep inflation low in the longer run.
This in turn was a consequence of Sweden's poor record in this respect, coupled with serious
problems with government finances. Long bond rates fluctuated widely and in 1994 and 1995 they
actually climbed to the levels of the years of high inflation. The exchange rate continued along its
depreciating path from the 1970s and 1980s. For the Riksbank, the lack of confidence in the direction
of economic policy left little room for manoeuvre. Although the instrumental rate was lowered during
the spring of 1994, virtually all the market rates and particularly those for longer maturities rose.
Sweden was approaching a point where economic policy had to demonstrate that the focus on
stability was a firm commitment.
The monetary tightening and, perhaps to an even greater extent, the fiscal
consolidation gradually generated increased confidence in Sweden's readiness and ability to achieve
low long-term inflation. Against this background, during 1996 it was possible to cut the repo rate to
its lowest level since the early 1960s. Low inflation and decreased inflation expectations also
contributed to falling bond rates, accompanied by an appreciation of the krona from the earlier lows.
Since December 1996 the repo rate has been unchanged at 4.10 per cent.
All in all, conditions were gradually created for a broader economic upswing. With
the time lag that generally applies in economic policy, during 1997 we have observed a mood swing
among households, leading for instance to increased private consumption, while export growth has
been maintained. The Swedish economy is entering a phase of high activity with a combination of
strong domestic demand and strong export growth.
The impact of the Riksbank's current monetary stance will take about two years to
materialise in full. We therefore have to assess the outlook for inflation as far ahead as in 1999. Such
an analysis was presented some weeks ago in the inflation report. I shall be returning shortly to that
report and subsequent developments but first I want to discuss the approach in principle to the
conduct of monetary policy over the complete economic cycle.
Monetary policy in a cyclical perspective
A matter that savers and investors are currently discussing is not whether but when
the Riksbank will raise the instrumental rate. An expected increase in the repo rate is also indicated
by the structure of market rates. The general impression among financial agents seems to be that a
repo rate increase is probable some time in the coming winter.
The timing of a change in the monetary stance is determined by the Riksbank's
assessment of inflation. The simple rule of thumb for the Riksbank can be formulated as follows: if
the assessment of inflation, given an unchanged instrumental rate, points to a rate of inflation one to
two years ahead that is in line with the target, then the monetary stance is well balanced. If the
assessment indicates a risk of inflation rising above (falling below) the target, then the monetary
stance is too expansive (contractive) and the repo rate should therefore be raised (lowered).
The time has not yet come for an increase in the repo rate, but when it does, our action
will hopefully be seen as a natural ingredient of a monetary policy for price stability. Our ambition is
to take predictable and timely measures so that sizeable interest rate movements can be avoided.
Still, it is hardly surprising that the direction of monetary policy is being discussed. At
present Swedish monetary policy's overall impact can be described as expansionary at a time when
activity is becoming stronger.
The short-term real interest rate is between 2 and 2.5 per cent, depending on the
exact maturity and how inflation expectations are measured. How a neutral monetary stance translates
into the short real rate is difficult to determine precisely but it can be said that the current rate is
comparatively low, with an impact on total demand that should be stimulatory. In addition, the level
of the real exchange rate is weak in relation to a reasonable long-term equilibrium. This means that
its effect is stimulatory, too. The combined effect of the short interest rate and the exchange rate is
therefore tending to support the economic upswing.
All else equal, an monetary stance leads to a successive acceleration of
expansionary
demand. In time, this may generate a growth rate that exceeds the economy's long-term potential.
The ability of the economy to cope with a high demand trend is not unlimited. As unutilised
resources are activated and the output gap closes, bottlenecks of various kinds arise in the labour
market or in real capital. It is in such a situation that inflation may accelerate.
In order to avoid the occurrence of shortages and accelerating inflation, the monetary
stance must not remain too expansive for too long in an upward phase. Instead, a timely
adjustment -- bearing in mind the lag associated with monetary policy -- must be made to a more
neutral position before the output gap closes. This promotes a continued growth of demand at a rate
the economy can absorb -- for instance with the help of new investment, improved efficiency and
labour supply -- without generating inflationary bottlenecks. The purpose of such a monetary
adjustment is not to break the expansionary trend but to achieve growth that is more sustainable. In
other words, a shift from an expansionary stance to one that is more neutral is designed to bring the
economy onto the growth path that matches its structure -- not to bring growth to a halt. Neither
should this be described as a contractive turn; it is rather a move that yields a less expansionary
stance.
In the public debate the Riksbank's monetary policy is sometimes described as though
repo rate adjustments were a form of "punishment" or "reward", aimed at measures that have been
taken either by the political system or by labour market organisations in connection with wage
negotiations. My point here has been that interest rate adjustments are a natural feature of monetary
policy's path over the economic cycle. Of course this does not mean that the construction of
monetary policy is not affected by fiscal expansion or contraction, or by low or high wage
settlements. What I want to make clear is that adjustments to the instrumental rate in the course of the
economic cycle are a natural phenomenon and their purpose is to create conditions for sustained
growth and low inflation.
If a central bank waits too long before shifting from an expansive to a more neutral
monetary stance, problems with bottlenecks are liable to become more widespread and the economy
may become overheated. Besides entailing rising inflation, this causes firms and households to start
accustoming themselves to a high level of inflation. Monetary policy may then be forced to adopt a
contractive stance in order to bring inflation back to the target rate. So if the central bank waits too
long, the interest rate increases may be all the larger. In the meantime, moreover, economic
imbalances and tensions may become so great that they lead to economic setbacks. We are familiar
with such a course of events from the 1970s and 1980s, and perhaps not least from the early 1990s.
Against this background, in situations when capacity is coming under pressure, it is
clearly better for a central bank to act at an early stage.
Future inflation
The assessment in the inflation report, published just over a month ago, is that growth
in the Swedish economy will be about 2 per cent in 1997 and around 3 per cent in 1998. In 1999, the
rate is expected to go on accelerating to just over 3 per cent. This assessment envisages that, in an
expanding world market, export growth remains relatively high. This is accompanied by an
accelerating increase in private consumption, while public consumption at least stops falling.
Economic growth in Sweden in 1998 and 1999 would then most probably exceed the
potential rate, which is estimated to be just over 2 per cent in annual terms. The broad rise in all the
major demand components will therefore gradually exert pressure on the available resources. This
successive increase in resource utilisation is already evident in some indicators. A growing
proportion of firms are reporting, for example, that output is being restricted by productive factors
rather than by demand.
The gap between total demand and total resources for production is an important but
elusive indicator of inflationary pressure. The Riksbank considers that the output gap, which is an
attempt to measure the degree of unutilised resources in the total economy, is 2 per cent of GDP.
With the GDP forecast from the inflation report, this means that the gap will narrow by degrees and
close some time during 1999, in any event towards the end of that year.
In the light of the assessments of resource utilisation and other factors, in the inflation
report the Riksbank forecast that the annual increase in the CPI will be around 1 per cent in 1997 and
around 2 per cent in both 1998 and 1999, with some upward tendency in the latter two years. This is
our main scenario.
Like most other forecasts, however, inflation assessments are subject to uncertainty.
Our forecasts as a foundation for monetary policy therefore do not consist of single point estimates of
future inflation. In practice we construct a number of alternative outcomes and assess their
probabilities. Normally there is one main scenario and two alternatives.
Economic activity could be stronger than we have envisaged, so that inflation is
somewhat higher; but it could also be weaker, giving lower inflation. Most of the evidence suggests,
however, that since the inflation report, an outcome which is appreciably weaker than the main
scenario has become less likely.
The forecasts for all the demand components are naturally uncertain. It is, however,
particularly worth discussing the forecast for private consumption, since this component represents
about one-half of total demand. Some factors suggest that the growth of private consumption could
become stronger than most observers count on today.
The background here is that for a number years the growth of household disposable
income has been held back by fiscal consolidation. After 1998, however, the direct restrictive fiscal
impact on household finances is expected to diminish. But in spite of the weak or negative income
trend, private consumption has already been rising for a number of years, albeit rather slowly. The
reason is that, besides the effect of income on private consumption, spending by households, as well
as their view of the future, is influenced by the increase in wealth.
Households have recently become appreciably more optimistic about the future.
House prices and share prices have been rising markedly for some years. The realised and latent
capital gains of households in 1997 add up to the equivalent of about 25 per cent of their income, a
figure that is as high as in the late 1980s. It would be surprising if such an increase in wealth did not
contribute sooner or later to higher consumer demand. The key question, however, is how rapidly
private consumption will grow.
The above applies provided the increase in asset prices is maintained. Since share
prices turned upwards in the autumn of 1992, the increase on the Stockholm Exchange has been one
of the largest since the early 1920s, which is as far back as the statistics go. The overall valuation of
corporate profits is also historically high. The present level of share prices calls for a further rapid
increase in profits for several years to come. Minor changes in this picture of the future could affect
current share prices.
Another element of uncertainty concerns the economy's supply side. We cannot be
sure of just how much the economy can produce without an increase in inflation. Moreover, it is not
only the total reserve of resources that may affect inflation. The rate at which resource utilisation
rises may also be important. A rapid activation of the unutilised resources could generate stronger
inflationary impulses even if surplus capacity still exists at total level.
CPI inflation has moved up sharply during 1997. The 12-month change was down
around 0 per cent for a couple of months last spring but after that it moved up fairly quickly to 1.9 per
cent for September. In September alone the CPI rose 0.9 per cent, which was more than most
observers had expected. The figure also aroused some uncertainty among savers and investors. The
question is whether the increase in inflation represents a new and unforeseen tendency.
The main features of this development are not unexpected. One factor behind the
rising CPI is increased indirect taxes, for instance for tobacco, and higher administered prices.
Another explanation is that the impact on the CPI from the falling interest rates in 1996-1997 is
diminishing. All in all, this means that the CPI is closing in on underlying inflation as measured in
various ways by the Riksbank.
Still, the CPI outcome for September is somewhat higher than the Riksbank had
counted on. Figures for a single month admittedly do not warrant definite conclusions but it is
certainly important to pay heightened attention to price movements in the coming months.
Normally it is underlying or trend inflation that is primarily of interest for monetary
policy. This holds unless transitory price effects influence inflation expectations. In a setting where
inflation expectations are firmly anchored to the inflation target, monetary policy has some room for
manoeuvre. But if expected inflation starts to rise, we must be on the alert, particularly in that the
current monetary stance is stimulatory. The importance of expected inflation for price and wage
formation was evident not least in connection with the 1995 round of wage negotiations. At that time,
expectations of future inflation seem to have been a bit above 4 per cent, which probably contributed
to the excessively high level of the ensuing wage agreements. Now that the Swedish economy is on
the threshold of very important wage negotiations, there must be no doubt that the Riksbank is truly
serious about the inflation target.
Future wage formation is yet another risk factor that the Riksbank has to consider.
There are some encouraging signs that wage formation is moving in the right direction, even though
the parties have gone in for a certain amount of bidding. This tends to be a process that conveys a
varying degree of realism. It is important to bear in mind that wage formation is not just a matter of
the level of wage agreements. The outcome for wages is also conditioned by the wage drift that
mirrors labour supply and demand. The less efficiently the labour market works, the sooner
bottlenecks arise that generate increased wage drift. Tendencies to labour shortages in certain sectors
are already discernible, despite the high unemployment.
Conclusion: monetary stance well balanced; changes in the spectrum of risks
A monetary policy that aims for sustained price stability is not at odds with good
economic growth. This presupposes that the supply side functions so well that growth does not give
rise to inflationary impulses. But if the structure of the economy is such that only moderate growth is
feasible, demand and accordingly the monetary stance must be adjusted accordingly. The alternative
is demand growth that exceeds what the economy is capable of producing without inflationary
bottlenecks. Accelerating inflation is a threat to sustainable growth and may even result in serious
economic setbacks, as history has taught us.
As economic activity becomes stronger and monetary policy adjusts its sights on the
future picture, the Riksbank's monetary stance will have to gradually move away from its current
expansionary position. The timing of such a move has to be assessed in the light of new information
and today one cannot say when it will happen.
Our present assessment is that the monetary stance is well balanced. There has been
some shift in the spectrum of risks but our inflation forecast for the coming years is unchanged.