Lars Heikensten: Monetary policy - some current issues
Speech by Mr Lars Heikensten, Governor of the Sveriges Riksbank, at the Stockholm School of
Economics, Economic Association, Stockholm, 10 February 2004.
* * *
Let me begin by thanking you for the invitation to come here to the economic association. It has
become something of a tradition that the Riksbank Governor comes here once a year to talk about
current issues regarding monetary policy. I think this is excellent, particularly as it contributes to a
lively, in-depth discussion of monetary policy in society. Those who have followed the Riksbank and
monetary policy in recent years know that transparency and clarity have been guiding principles in our
work.
Today I intend to provide some perspective on monetary policy by means of a backward glance over
the past ten years. This is a natural foundation for the current discussion on interest rates which I will
address a little later. I have no intention of giving any new monetary policy signals today, but to give an
account of the basis for our repo rate decision last week. One particularly interesting question at
present is productivity growth, which appears to have been better than expected last year. The
conclusions that can be drawn from this development are my third theme. Finally, I shall give my views
on the recent monetary policy debate, something I have been asked about on numerous occasions in
the past couple of months.
The results of inflation targeting
My retrospective begins in autumn 1992, when the krona moved from a fixed exchange rate to a
floating rate. It was then important to find a new anchor for monetary policy as rapidly as possible. The
alternative chosen was inflation targeting. In January 1993 the Riksbank stated in a press release that
the change in CPI inflation would in future be limited to 2 per cent a year with a tolerance interval of
± 1 percentage point.
The floating exchange rate and the inflation target constituted a drastic changeover of monetary
policy. There were also a number of problems in the initial stages. The decision to introduce inflation
targeting was controversial and much criticised in the public debate. Naturally, the Riksbank had no
experience of this type of monetary policy regime and even in countries where it was already
established it was a relatively new phenomenon. Moreover, the experiences of Swedish stabilisation
policy in both the monetary policy and fiscal policy fields during the 1970s and 1980s were less than
positive. This meant that there was considerable opposition at first and many believed the new regime
would be short-lived.
The Riksbank had to balance the need to create confidence in the new, price stability-based regime
against the need to conduct less restrictive monetary policy to soften the effects of the economic crisis.
It was a difficult starting point for many reasons, including the fact that public finances were in very
poor shape. There were also problems with inflation. When the crisis began, the Swedish inflation rate
fell significantly, but up to 1995-96 it was still far above the target level. The problems were
emphasised by developments in inflation expectations. It was not until 1997 that expectations
stabilised around 2 per cent. (Figure 1).
1. Inflation expectations among money market
agents and actual inflation
Percentage 12-month change
5 5
Jan '95
4 4
Mar '03
Feb '96
3 3
Feb '97
CPI
2 2
Feb '98
Mar '01
Nov '03
1 1
Mar '99
0 0
-1 -1
1994 1996 1998 2000 2002 2004 2006 2008
Sources: Prospera and Statistics Sweden
However, around the mid-1990s confidence in economic policy increased. By then, the economy had
grown for a couple of years, stimulated primarily by the weak krona rate. When drastic measures were
taken to improve public finances, interest rates fell. Monetary policy contributed to this development by
consistently fending off all tendencies towards excessively high inflation. It was now possible to have
more stable economic growth. During the period 1995-2001, economic growth was an average of
3 per cent, which can be compared with an average of 2.4 per cent during the two previous decades.
(Figure 2).
Developments in the labour market also indicate that the measures taken were successful. I recall that
some economists wanted to interpret the high level of unemployment following the crisis years as an
indication that the changeover of monetary policy regime had raised the economy's equilibrium
unemployment level and caused a permanent deterioration in employment. However, once the crisis
had been overcome and the new policy was established, the labour market situation soon improved.
Unemployment is currently around 4-5 per cent, which can be compared with figures of above 8 per
cent in the mid-1990s. However, we still have some way to go to return to what was considered full
employment prior to the crisis years 1991-93.
2. GDP growth in Sweden 1970-2002
7 7
Annual growth
6 6
Average 1970-1989
Average 1995-2001
5 5
4 4
3 3
2
2
1 1
0 0
-1
-1
-2 -2
-3 -3
1970 1975 1980 1985 1990 1995 2000
Sources: Statistics Sweden and the
All of this has been achieved parallel with a low inflation rate and during the period as a whole inflation
has been in line with the Riksbank's target. From 1993 to the present day, the increase in CPI inflation
has averaged 1.9 per cent, while the measure of underlying inflation on which we usually choose to
base our monetary policy decisions - UND1X - has risen by an average of 2.1 per cent. (Figure 3).
3. CPI and UND1X inflation
Percentage 12-month change
14 14
12 12
10 10
CPI
UND1X
8 8
6 6
4 4
2 2
0 0
-2 -2
1990 1992 1994 1996 1998 2000 2002 2004
Sources: Statistics Sweden and the
It is not easy to determine what effect the various changes in economic policy have had individually.
However, when taken as a whole they have led to an overall changeover in stabilisation policy. A
clearer allocation of roles has been created in economic policy. The task of monetary policy is to attain
price stability, while fiscal policy is to secure a long-term sustainable development in public finances.
The government and the Riksdag (parliament) also have the task of increasing the number of those in
regular employment to 80 per cent. This clear allocation of roles is an important reason behind the
more successful economic policy over the past ten years.
The current monetary policy situation
The international recovery is increasingly evident
During 2001 there was a downturn in global economic activity, which was partly due to the financial
setback following on from the stock market bubble in the second half of the 1990s. Resource utilisation
fell and growth in the OECD area as a whole was 1 per cent that year. The downturn was remarkable
symmetrical and counteracted by a series of interest rate cuts throughout the western world. Sweden
was also affected by this downturn, of course, although to a lesser extent than many other countries,
particularly because fiscal policy was more expansionary, but also due to the krona being
undervalued. Resource utilisation was therefore assessed to be higher in Sweden than in many other
areas, which affected the relative interest rate situation.
At the beginning of 2002, a wave of optimism began to spread, but it proved short-lived. The main
reason for this was the increasing geopolitical unease concerning Iraq and later the war in Iraq. A
recovery in the global economy was still expected, but at a later date. The weak economic activity led
to further easing of economic policy during 2003. The United States Federal Reserve, the Riksbank
and other central banks continued to cut their instrumental rates to all-time low levels.
Now most indications are that both the Riksbank and other analysts were slightly too pessimistic in
connection with the Iraq war, particularly with regard to the view of economic activity in the US
economy, but also developments in Asia. During the second half of 2003 we have had reason to make
a further upward revision to our assessments of global economy growth and the picture of the global
economy as a whole looks good at present.
The US economy is expected to grow at a slightly more rapid rate than we estimated in the December
Inflation Report. In the short term, the most significant cause for concern in the US economy is that
employment is still weak. Of course, the combination of rapid growth in GDP and a weak labour
market mean that productivity growth is good, but the dismal labour market situation could
nevertheless create uncertainty among households and contribute to subduing consumption.
However, it is difficult to believe that it would put an end to the upturn we are seeing now.
There are also signs of an upturn in the euro area now, although the picture is not as clear-cut as in
the United States. Business tendency surveys for industry show an increased optimism, while
industrial production is slowly beginning to rise. Developments in Asia, central and eastern Europe
also appear to be slightly stronger than was previously assumed. However, the stronger euro may
lead to a slightly slower upturn in the euro area.
All in all, the picture of international economic activity now looks somewhat brighter than we
anticipated in December. The upturn in economic activity appears to be proceeding roughly as we had
anticipated it would.
The Swedish economy has also turned
We assumed in the December Inflation Report that growth in Sweden would gradually increase during
the course of 2003 and would amount to 1.5 per cent for the whole year. During 2004 and 2005
growth was expected to be around 2.5 per cent, which is in total a slightly more rapid rate than the
Riksbank considers sustainable in the long-term without inflation rising.
The new statistics support this scenario, although the picture is not clear-cut. For instance, the
National Accounts for Q3 indicate an increase in growth compared with earlier quarters, in line with the
forecast in the Inflation Report. Other indicators of a recovery are the purchasing managers index and
the National Institute of Economic Research's business tendency surveys, as well as the fact that retail
trade continues to show good growth. Counteracting this is the fact that manufacturing output was
weak during October and November and the number of new orders declined. In addition, new
estimates for public finances indicate that public consumption this year may be somewhat weaker than
was assumed in December. This is mainly connected with the financial situation in local government.
The local government sector as a whole shows a deficit, which must be redressed over the coming
years.
Although the dollar has weakened against the Swedish krona, in terms of the TCW index the krona
has not appreciated as much. This is mainly because the krona, contrary to many expectations, has
weakened against the euro. The most recent National Accounts figures and foreign trade statistics
also indicate that we have so far been slightly too pessimistic with regard to Swedish exports.
The most evident cause for concern is the labour market, which has developed more weakly than
expected, particularly towards the end of 2003. The strained financial situation in the public sector
would seem to indicate weak employment growth for at least the coming year, while the economic
upturn will probably only lead to a relatively small increase in employment in the private sector. There
is, of course, a risk that the weak labour market will affect households' expectations and consumption
propensity; a risk that we pointed out already in December and which may have been reinforced. The
higher the rate of unemployment, the more caution households will probably show when purchasing
and consuming. This could in turn lead to a risk of lower growth during 2004.
All in all, the view of the demand situation in Sweden remains essentially the same as in December;
demand will increase and approach the economy's long-term sustainable level.
Lower domestic cost pressure
The relationship between unit labour costs and inflation is usually fairly clear. Thus, when we made a
downward revision to the figures for unit labour costs in December, it was not entirely insignificant for
the inflation forecast. The background was primarily the signs we saw of an improvement in
productivity growth, combined with a weaker labour market. I shall return to the subject of productivity
in more detail in a moment.
With regard to wage developments, the wage bargaining rounds are currently a central issue. Their
outcome will have great significance for the rate of wage increase and thereby also to a large extent
for inflation in coming years. It is clear that the labour market situation calls for moderate wage
increases. Unlike the situation prevailing during the two previous bargaining rounds, unemployment
has increased and employment has declined recently. Nor are there any labour shortages, other than
in a few areas. It is also a positive sign that the rate of wage increase has been declining over the past
year and that the same applied to expected inflation. Given the present low inflation rate, even limited
nominal wage increases will lead to a fairly good development in real wages, which trade union
representatives usually emphasise. The nominal wage increases put forward now are lower than those
of recent years. Meanwhile, there is of course always a risk of shocks from the actual negotiation
process. It is not unthinkable that some of the increase in productivity is used as justification for higher
wage-paying capacity. This could be particularly worrying if the wage negotiations assume that the
improvement in productivity is permanent and it later shows a rapid decline.
At our meeting last week we considered that there was reason to make a further slight downward
revision to unit labour cost figures, which in turn had effects on domestic inflationary pressure. The
labour market has been weak and most indications are that there is reason to be slightly more
pessimistic with regard to employment in future. The rate of wage increase could therefore be slightly
lower than we assumed in December. Meanwhile, productivity growth has continued to be higher than
expected and we believe that it may rise even further in the near future. Inflation has also been a little
lower than anticipated. We are expecting a low underlying inflationary pressure in the short term, but
this will probably increase as economic activity picks up. However, import prices are very important to
our assessment of future inflation. These have had a significantly subduing effect in recent times, but
an upward turn appears probable over the coming year. All in all, our assessment is that inflation will
begin to rise later this spring and gradually approach our target level two years ahead. However, we
do not believe that this upturn will be particularly dramatic.
Let me emphasise that the changes that have occurred since our December meeting are not
particularly great. They mainly entail some signs that domestic cost pressure could be lower than
anticipated. As early as December we made some adjustments to our estimates in this respect, but
the signs were fairly new then and a majority of the Executive Board preferred to await further
information that would make the picture clearer.
Given this, the assessment was that inflation would be slightly lower throughout the forecast period
than was assumed in December; a conclusion that was not particularly sensitive to the choice of
inflation measure. The Executive Board of the Riksbank therefore decided to cut the repo rate by
0.25 percentage points.
One question that has been raised in the debate is whether it is too late to cut the rate now, given the
economic recovery. This is not the decisive issue for us. Our method of working means that we base
our decisions on inflation forecasts. These show that there is scope to cut the rate. In the short term,
inflation is expected to be much lower than 2 per cent and to cautiously approach the target level only
1-2 years from now. It would therefore appear that there is plenty of time for an upward adjustment of
the interest rate in the future if our forecasts indicate this is necessary. The situation would be different
if there was reason to expect a rapid economic upturn now, which could threaten fulfilment of the
inflation target in the shorter term. A cut in the interest rate can perhaps also be regarded as an
insurance against weaker growth in demand; although we have assumed a clear improvement in
economic activity, this is not guaranteed.
Finally, I should like to comment on an element in the present discussions on monetary policy. Many
debators have shown a tendency to argue as though it were possible to conduct a perfect, fine-tuning
policy. I believe it is almost impossible. I think that it is always possible to claim with hindsight that a
little bit more or a little bit less could have been achieved either earlier or later. However, the
Riksbank's most important contribution is not this type of "fine-tuning", but rather maintaining the
inflation target and upholding confidence in price stability. When we achieve this, we can contribute to
stabilising real growth in production and employment. But this is not our main objective.
Productivity growth - an expansion
Last year, employment in the business sector showed an unexpectedly weak increase, while growth
was roughly as expected. This was reflected, as I have already mentioned, in the fact that productivity
growth was unusually good. The most recent National Accounts figures also indicate a stronger
productivity growth last year than we assumed in our December assessment. The question is what this
implies about the future; is what we are seeing a sign of higher productivity growth which will continue
over a number of years or is it a temporary rise as a result of an improvement in economic activity? Or
is the upturn perhaps a chimera and the result of statistical problems connected with, for instance,
difficulties in measuring productivity in certain sectors, such as the telecom industry?
In the United States, the pattern of a weak growth in employment, combined with a recovery in
economic activity has been established for a number of years. According to the National Bureau of
Economic Research, NBER, the US economy bottomed out in November 2001. Although the size of
the decline in employment measured varies from one source of statistics to another, the overall picture
is still clear; employment has been weaker than anticipated, while economic growth has been
stronger. This phenomenon is known as jobless growth, or jobless recovery.
The parallels to the recent developments in Sweden are obvious (Figure 4). Despite the increasingly
clear signals of stronger economic activity, growth in the labour market is very slow, particularly in the
business sector. Productivity growth is tangible in both the United States and Sweden, while many
countries in Europe are still struggling with a relatively weak growth. However, one important
difference in the comparison between the United States and Sweden is that both the rate of growth
and the increase have been much more dramatic in the United States. The same applies to the size of
the decline in employment, which has been much more significant in the United States. This means
that comparisons between Sweden and the United States should be interpreted with caution.
4. Productivity in the economy as a
whole
Percentage change
12-month
5.0 5.0
productivity
4.5 4.5
average 1981-1990
4.0 4.0
average 1991-2002
3.5 3.5
3.0 3.0
2.5 2.5
2.0 2.0
1.5 1.5
1.0 1.0
0.5 0.5
0.0 0.0
-0.5 -0.5
1981 1983 1985 19871989199119931995199719992001
Source : Statistics Sweden
There is reason to reflect over the explanations that might lie behind a productivity increase of a more
fundamental nature, similar to that we have seen in the United States in recent years. Personally, I
have found it helpful to use the events of the late 1990s as a starting point; a period when productivity
was also surprisingly strong. The driving force behind this development is usually said to be
technological progress in information and communications technology, which led to productivity
increases in the IT-producing industry and price falls on IT products. In addition, there was extensive
investment in IT capital in other industries, also stimulated by favourable price developments, which
resulted in higher productivity outside of the IT sector. Expressed in a different way, productivity
growth at this stage was said to be driven by increases in total factor productivity within the
IT-producing industry and by an increased IT capital intensity in other sectors of the economy.
Some analysts have pointed to the possibility that the recent productivity increase could be at least
partly due to IT capital now making an efficiency impact on production even outside the sectors
producing IT capital, where it has enabled rationalisation of labour and a reduction of the investment
requirement. This theory thus explains the combination of rapid productivity growth, weak employment
growth and a slow increase in investment, which has recently characterised both the US and Swedish
economies.
So what - apart from the actual developments in productivity, employment and investment - indicates
that this is the explanation?
One piece of the puzzle that supports this theory is that the improvements in productivity can scarcely
be explained merely by business cycle effects. This becomes clear if we study productivity growth in
the corresponding phase of the business cycle during earlier periods (Figure 5). The measure of
economic activity we have chosen is, however, more or less arbitrary and does not entirely correspond
to the assessment of resource utilisation in the Riksbank's Inflation Report. Nevertheless, this does not
appear to affect the general conclusion that productivity growth is unusually rapid at present, bearing
in mind economic activity and could thus be a sign of a sustained change.
5. Business cycle for labour productivity in business sector 8
quarters before and 4 quarters after business activity trough
in four most recent business
cycles
Percentage 12-month change (5 quarters sliding average)
5 5
Current stage in business cycle
Business activity trough
4 4
3 3
2 2
1 1
0 0
2003Q3
1993Q2
1982Q4 1996Q3
1981Q1 - 1984Q1 1991Q3 - 1994Q3 1995Q4 - 1997Q4 2002Q1 -2003Q3
-1 -1
-8 -4 0 4 -8 -4 0 4 -8 -4 0 4 -8 -4 0 4
.
Note . Business activity trough are noted in the quarters when the output gap, calculated with an HP filter, was as it largest
Another piece of the puzzle is the development of factor productivity (Figure 6). As I mentioned earlier,
a more rapid growth in factor productivity at aggregate level could be a sign that IT capital is being
used more efficiently even outside of the sectors producing IT capital. The best method would be to
study factor productivity excluding the sectors producing IT capital, but this is not an easy task, due to
various statistical problems. The calculations of factor productivity we have made at the Riksbank
indicate a relatively clear upturn in recent years.
6. Capital deepening and TFP growth
Percentage 12-month change (5 quarters sliding average)
6 6
Capital deepening TFP growth
5 5
4 4
3 3
2 2
1 1
0 0
-1 -1
-2 -2
72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04
Sources: Statistics Sweden and the
It is also interesting in this context to compare how developments in Sweden compare with other
countries, particularly the United States. These comparisons are made more difficult by the fact that
comparable statistics are hard to find. However, the statistics that are available indicate the factor
productivity growth is relatively good in Sweden; much better than in the euro area, for instance.
To summarise, we can conclude that there has been an upturn in productivity development in recent
years. Earlier economic patterns are not being repeated entirely. However, it is difficult at present to
establish what lies behind the upturn. The situation is reminiscent to some extent of that we saw for a
few years at the end of the 1990s. Then, as now, there was reason for a wait-and-see policy, but not
to reject outright the idea that what we see is a clear change. In any case, some importance should be
attached to the new figures when taking a policy stance, although we must try even harder to
understand what is happening.
The monetary policy debate
Allow me to say a few words in conclusion regarding the recent, lively debate on monetary policy. This
is because I have received many questions on this subject in recent weeks. However, it is not always
easy to get a subtle message across when the media debate is so intense. I therefore decided at an
early stage of the discussion to take up this question in greater depth here at the Economics
association, a suitable forum for a penetrating and relatively non-media discussion.
Before I try to explain my views on some elements of the discussion, I cannot resist pointing out that I
found the tone of the discussion somewhat surprising. Sweden has come through the recent economic
slowdown better than many other countries. Personally, I also felt much greater concern over
economic developments and monetary policy at the end of spring and beginning of summer 2003 than
I have done in recent months. The reason is simple. At the end of last spring, the inflation rate was still
high. Although we believed it would fall, there was a clear risk that it could become entrenched.
Meanwhile, there was considerable uncertainty over international economic activity; would there be a
turnaround and if so, when? This could mean we are forced to make difficult judgements. For instance,
we might be forced to raise the interest rate even if economic activity weakened. Now the situation is
fundamentally much better, with declining inflationary pressure combined with increasing growth.
Nevertheless, the debate is much tougher. Why, one might ask.
What can be said about the discussion itself? Let me begin by pointing out the obvious; it is good to
have a vivid, lively discussion of monetary policy. A central bank that has been given clear,
independent responsibility for monetary policy has good reason to be open about the bases for its
decisions. This facilitates a more exact discussion of monetary policy as well as assessment
afterwards. An open debate forces and encourages us to improve our arguments and to continuously
develop methods and assessments, in other words to become better. This is all for the good and in
actual fact one of the most important motives behind the openness we have striven to achieve over
the past ten years.
Various assessments of the situation have been made recently, both by external analysts and within
the Riksbank. For instance, in December two of my colleagues believed we should cut the repo rate.
Essentially, I think that the debate has been factual in that the demands for rate cuts have usually
been based on assessments of future inflation differing from those made by the Riksbank. It is only in
exceptional cases that these exhortations appear to have been based on inflation targeting as such
being questioned.
However, this does not mean that all elements of the discussion have been good and clear-cut. One
issue that has led to questions and been discussed considerably is that some leading politicians have
actively involved themselves in the debate and on repeated occasions expressed very specific
requirements for immediate interest rate cuts and in one case even a change in our meeting schedule.
The question is whether this is appropriate or even wise.
This is not a new issue, and it is one I have faced on numerous occasions since I began work at the
Riksbank. My point of view has always been that we have a statutory task to perform. We shall
perform this independently and to the best of our abilities. The law is crystal clear; we are not allowed
to accept political instructions or even advice. Moreover, even before the new legislation was in place
we had chosen to design a clear framework for our work. Our target of maintaining price stability has
been specified as an inflation rate of 2 per cent. We have also "tied" our actions in other ways, such as
publishing forecasts and systematically following particular working methods. This enables those
outside of the bank to assess our actions and motives and thereby to be sure that we are not taking
account of inappropriate considerations. Given this, over the years I have had a fairly relaxed attitude
to politicians' interference in the general debate.
However, this issue has further implications than such. Over the Christmas holidays I read a book by
the former US Treasury Secretary Robert Rubin.1 He takes up this issue and motivates why he
strongly advised President Clinton against holding public opinions on monetary policy, advice followed
by the President. According to Rubin, there is always a risk that the bond market will be affected if
there is the slightest suspicion that the central banks' actions are governed by political pressure.2 I
think that the fact that he - with his decades of experience on Wall Street - brings up this argument and
that he does so despite the widespread respect enjoyed by Greenspan's Federal Reserve, shows that
the argument cannot be waved aside. One could object that the Riksbank's legal independence is
greater than that of the Federal Reserve. On the other hand, the low-inflation regime is relatively new
in Sweden and our market is also small and influenced to a large degree by external agents, who
often lack in-depth knowledge of how our system works.
At present, the economic and political developments in Sweden are so stable that political
manoeuvring of the type we have seen hardly has any effect on the markets, although some concern
has been expressed by foreign analysts. However, politicians who enter the discussion with strong
opinions in a stable situation should probably reflect over how they might act in future in more
problematic situations.
Rubin also points out that the president was able, by showing a clear respect for the Federal
Reserve's independence, to increase his own credibility and build-up confidence in economic policy in
the United States and in the functioning of the financial markets. This is a view I can sympathise with.
The question is then how we in Sweden should act to ensure that confidence in our total economic
policy is as great as possible. Essentially, this of course means doing the right things. In our case,
ensuring price stability in accordance with our own definition. However, I believe that the ways in
which the authorities responsible for fiscal policy and monetary policy cooperate can also play a role
here. In this aspect I can see clear advantages in the interplay between government and central bank
in the United States and the United Kingdom. Maintaining mutual respect for one another's tasks, they
have a close cooperation to conduct an overall policy that will benefit their country as much as
possible. This is a desirable form of cooperation, particularly for small countries and I believe that we
in Sweden have come a long way towards this since the mid-1990s. It would be a negative
development if the pattern were broken and we instead slipped into a form of interplay similar to that in
continental Europe, where national finance ministers blame their problems on the ECB and where
sharp words are regularly aimed in the opposite direction.
Thank you.