Irma Rosenberg: Riksbank to introduce own path for the repo rate
Speech by Ms Irma Rosenberg, Deputy Governor of the Sveriges Riksbank, at Danske Bank,
Stockholm, 17 January 2007.
* * *
Thank you for the invitation to come here and speak about monetary policy. The Riksbank is
constantly working on improving the bases for monetary policy decisions and its communication. As
part of this work, we on the Executive Board of the Riksbank decided yesterday that we will publish
our own views on what is a suitable development of the repo rate in connection with the presentation
of the inflation forecasts.1 I intend to devote my speech today to explaining why we have made this
decision and also to mention some other changes we are making in connection with this. However, I
will not on this occasion discuss the current economic situation.
The Riksbank is considered by many experts to be one of the most transparent central banks in the
world.2 We were amongst the first to introduce a numerical inflation target and to publish our inflation
forecasts and the minutes from our monetary policy meetings. This is so that the general public will
understand the reasons for our decisions and also to enable our monetary policy to be evaluated. It
further enables accountability and gives legitimacy to an independent central bank like the Riksbank.
Now we have decided to publish our own forecast for how we believe the repo rate will develop. We
began discussing whether this would be an appropriate direction to take as early as last spring. The
Governor of the Riksbank also signalled in several speeches made in spring 2006 that there was
reason to look more closely into this possibility. It is my hope that with this change we will become
more open and clear in our communication and that it will make it even easier for the general public to
understand how we reason when making our monetary policy decisions.
Let me describe the background to the changes we are now making in the monetary policy analysis
and our communication.
Modern monetary policy is based on openness and clarity
Monetary policy today is largely concerned with influencing the economy through expectations. There
is therefore good reason for the central bank to be clear about how it views future developments in
inflation and also the real economy. Modern academic research into monetary policy also indicates
that monetary policy functions better the clearer and more open the central bank is with regard to its
forecasts and monetary policy considerations.
One question that has been much discussed in recent years both in academic circles and the central
banking world is how clear central banks with a price stability target should be with regard to their own
view of future developments in the policy rate. This discussion is also connected with which
assumption for the policy rate the central bank should use when making forecasts of inflation and the
real economy. Three different approaches exist: (i) That the policy rate is assumed to remain
unchanged during the forecast period, (ii) that the policy rate is assumed to follow market
expectations, or (iii) that the policy rate is assumed to follow a path that the central bank itself
considers to reflect a reasonable future development.3 Regardless of which of these three interest rate
assumptions is used to produce the inflation forecast, the monetary policy decisions made by the
central banks always refer only to the current level of the policy rate, that is, the level that is to apply
until the next decision-making point.4 However, the monetary policy discussion and communication
differ slightly, depending on which interest rate assumption is used.
The first two approaches mean that a particular path for the development of the policy rate is taken for
granted by the central bank when making its inflation forecasts. The latter approach instead means
that the central bank makes its own assessment of what might be a reasonable future development in
the policy rate at the same time as it makes the inflation forecast.
The assumption of a constant policy rate has been the most common approach, although the trend at
present is for the central banks to be clearer as to how they envisage future interest rate
developments. Several central banks have changed over to basing their inflation forecasts on market
expectations of future developments in the policy rate. When the inflation forecasts are published,
there may also be a comment, phrased in general terms, on how the bank views market expectations.
So far, only a few central banks have taken the step of publishing their own forecasts for their policy
rates.
Arguments for and against own forecasts for the repo rate
There are currently discussions, both in academic research and in central bank circles, as to whether it
is appropriate for central banks to publish their own forecasts for the policy rate. In a moment, I shall
describe some advantages and disadvantages of such an approach. At the same time, one must
remember that there are a number of advantages and disadvantages to all of the approaches I
mentioned earlier, and these must be weighed against one another.
When we changed over from keeping the repo rate constant in our forecasting work to basing the
forecasts on market expectations, we had made the assessment that the advantages of this system
outweighed the disadvantages, compared with using a constant repo rate assumption. The
assumption of a constant repo rate worked well in as far as it made communication simple, which I
believe was particularly important when establishing the new monetary policy regime and building up
credibility for the inflation target. At the same time, it was of course usually an unrealistic assumption
that made it difficult for us to make good forecasts. This applied in particular in cases where there
were expectations of substantial repo rate adjustments. Normally, changes in the repo rate are
required to guide inflation towards the target. If we had kept to this assumption for the interest rate,
these difficulties would have been particularly prominent when we changed over to making forecasts in
a slightly longer time perspective. Of course, the assumption of a constant repo rate also made it
difficult to compare our forecasts with those of other forecasters and to evaluate our monetary policy.
But, perhaps even more importantly, it gave no clear guidance as to how we viewed interest rate
developments in the long term. The general public's and the markets' expectations of the future
interest path are at least as important for the way monetary policy influences the economy as the
expectations around the decision on the current interest rate.
We left most of these problems behind us when we began making forecasts based on market
expectations, as reflected in the so-called implied forward rates. This was because market
expectations in most cases provide a much more realistic forecast for the future development of the
repo rate. The changeover from a constant repo rate to the markets' expected interest rate path was
also a natural step on the route to publishing our own forecast for the repo rate. We then began talking
more systematically about future interest rate developments by commenting on the plausibility of the
interest rate path given by market expectations. In my opinion this was when we took the major step
towards increased clarity with regard to our view of future interest rate developments.
The method of basing forecasts on market expectations is not without its problems, either. One
problem concerns how expectations are measured. Other problems are related to communication
regarding the interest rate path. Let me explain what I mean here.
Changes in the policy rate have a direct effect on the shortest interest rates in the economy. Monetary
policy can therefore also affect financial market expectations of future short-term interest rates. It is
these expectations that the implied forward rates are meant to capture. The implied forward rates can
be interpreted as the financial markets' "average" forecast for the future repo rate. If, for instance, the
annual interest rate for government bonds is higher for long durations than for short ones, this could
be interpreted as the market expecting the repo rate to be raised.
One problem when interpreting implied forward rates in this way is that they do not solely measure
expectations of the repo rate. They may also contain premiums that can be regarded as compensation
for differences between securities with regard to duration, credit risk and degree of liquidity. Estimating
the size of these premiums can be complicated and can be done in different ways.5 It is therefore not
possible to calculate market expectations of repo rate developments in a clear-cut manner, which may
create confusion.
Another problem is that the implied forward rates may vary substantially in the short term. The
question is therefore when market expectations should be read.
A further problem that is sometimes highlighted is that there may be a risk of the central bank allowing
itself to be steered by financial market agents when inflation forecasts are based on implied forward
rates.6 Personally, I am convinced that this is not normally any great problem. When we have had a
different opinion from the market, we have said so. On these occasions we have also influenced
market pricing. This was the case, for instance, with the monetary policy decisions we made in
December 2005 and June 2006.
Another problem sometimes mentioned is that there may be difficulties in communication in the cases
where the central bank has a different view from the market as to what constitutes a reasonable future
development for the policy rate.7 The forecasts for developments in the real economy and inflation that
are published will under such circumstances not be the ones that the central bank believes to be the
most likely and the value of the published forecast is therefore diminished. This is the same type of
problem as with constant repo rate forecasts, although the problem is probably less on average over
time.
Most of these problems can be avoided if the central bank instead bases its inflation forecasts on its
own forecast for the development of the policy rate.8 However, the primary reason for publishing one's
own interest rate forecast is that it makes it easier for the central bank to steer expectations. With this
assumption for the interest rate, the central bank can explain more clearly to the general public and
the financial markets how it envisages future interest rate developments and how it reasons when
making monetary policy decisions. The interest rate development that follows on from market
expectations does not always give a good picture of all of the considerations a central bank must
make when discussing what provides a reasonable development in interest rates.9 At the same time, it
may be worth pointing out that our forecasts for the repo rate will not normally deviate very much from
market expectations.
This is essentially the background to why we are now choosing to go over to using our own interest
rate forecast when forecasting inflation and other macro variables. Although I am convinced that this
means increased openness and clarity in monetary policy, it has not been an entirely self-evident step
to take. This is because we have been forced to manage a number of practical problems. These are
primarily related to the fact that we are six persons on the Executive Board who together must agree
on what could be considered to be a reasonable repo rate development in the future, while
safeguarding our responsibility as individuals for how we vote.10
To make a forecast for the development in the repo rate, we Executive Board members must together
make an assessment of what would be a desirable path for the repo rate during the forecast period,
even though our interest rate decision only refers to the level of the repo rate applying until the next
monetary policy meeting. The different members of the Executive Board may have differing opinions
on, for instance, the current situation in the economy and at what pace inflation should be brought
back on target, giving consideration to the real economy and various risks. It goes without saying that
5
See, for instance, Alsterlind, J. and H. Dillén, (2005).
6
See, for instance, Giavazzi, F. and F.S. Mishkin (2006).
7
See, for instance, Giavazzi, F. and F.S. Mishkin (2006).
8
However, it is not possible to entirely rule out similar problems sometimes arising even when the central bank publishes its
own forecast for the policy rate. If new information is received in connection with making a decision on the interest rate and
this information changes the conditions for decision-making, the decision may be different from what might have been
expected on the basis of the inflation forecasts (which have to be completed before the interest rate decision is made).
9
The advantages of the central banks publishing their own interest rate forecasts are discussed in more detail in, for
instance, a number of essays presented at a conference organised by the Riksbank in June 2005. See in particular Archer,
D. (2005), Faust, J. and E., Leeper (2005), Svensson, L.E.O., (2005) and Woodford, M., (2005).
10
See Goodhart, C., (2001) and Mishkin, F. S., (2004) for a detailed argument against central banks publishing their own
interest rate forecasts.
BIS Review 6/2007
this is not a simple matter. However, we Executive Board members have made the assessment that
these problems are not in practice so great as to prevent us from agreeing on a path that a majority of
the Executive Board members can support. We have previously managed to agree on interest rate
messages with information on our future intentions when we have commented on the plausibility of the
interest rate path given by market expectations.
There are also some other problems that have been put forward as arguments against central banks
publishing their own interest rate forecasts. One such argument is that it makes communication with
the general public more difficult. If the central bank first announces a particular interest rate path and
then new information is received, which leads to a policy rate decision that differs from the path
published earlier, this could be perceived as a failure on the part of the central bank and it could
damage the bank's credibility.11
Personally, I do not believe that this will be a major problem. On the contrary, one of the main points of
publishing one's own interest rate path is that it should improve communication with the general public.
We have always carefully emphasised that there is considerable uncertainty in the assessments and
explained that new information may come in later which could radically change the conditions for our
monetary policy assessments.12 To emphasise this even more strongly, it is important to illustrate the
uncertainty in different ways, for instance by calculating the uncertainty interval around the interest
rate path. This we intend to do.13 Just as when we based our forecasts on market expectations,
publishing our own interest rate forecast does not involve any commitment from the Riksbank that the
repo rate will then actually follow this path. It is important to bear this in mind.
A further argument that has been put forward against publishing a forecast for the development of the
repo rate is that the financial markets, if given access to the central bank's views on the interest rate
level in the slightly longer term, would stop trying to find other information that is significant for
longterm interest rates. The central bank would then lose an important source of information, namely how
market prices reflect the markets' views on economic prospects in the longer term.
Neither do I find this argument particularly convincing. The financial market agents know that we live in
an uncertain world and will continue to look for other sources of information on long-term
developments via other channels than the central bank and make independent assessments.
What defines a good interest rate path?
When we make our forecasts of the repo rate, we must of course consider what would be a
wellbalanced monetary policy given the developments we foresee. What is meant by a well-balanced
monetary policy? Let me answer this by briefly summarising how we describe our monetary policy
strategy in the special document on monetary policy published in May 2006.14 Our new assumption for
the interest rate does not change the way we conduct monetary policy.
"A desirable monetary policy is characterised by inflation under normal circumstances being close to
the inflation target in a two-year time perspective while at the same time the paths for inflation and the
real economy do not exhibit excessively large fluctuations." Given this reasoning, I think it is possible
to identify some important characteristics of a good interest rate path.
Firstly, the interest rate should be set so that inflation remains close to the 2 per cent target. If inflation
were to deviate from target from the start, we should normally choose a path for the repo rate that
brings inflation back on target within two years. Moreover, this path should be chosen so that inflation
is close to target even beyond the two-year horizon. This way of conducting monetary policy helps
reduce uncertainty and anchor inflation expectations around the target.
The interest rate should also be set to achieve as far as possible a stable, sustainable development in
the real economy, as long as this is compatible with the price stability target. Let us say that the
economy was in a situation where inflation deviated from target. This would mean that when we
conduct our monetary policy we must assess how quickly it is appropriate to bring inflation back to 2
per cent. Several factors need to be taken into account; the reasons for the deviation from target, the
size of the deviation and how we expect real economy factors such as growth and employment to
develop. The two-year horizon should be regarded as a restriction as to how much consideration can
normally be given to real economic developments. Situations may arise where the deviations are
substantial and it is reasonable to allow longer than two years for inflation to return to target. In this
way we can avoid excessive fluctuations in real economic activity. However, I would like to emphasise
that this kind of strategy only comes into question when it will not jeopardise the credibility of monetary
policy.
A desirable monetary policy should also be predictable in order to make it easier for households and
companies to adapt to new economic conditions. Changes in the repo rate should therefore normally
be made gradually and not in large steps, as I see it. Of course, there may be other reasons to avoid
large changes in interest rates. Changing the interest rate gradually gives, for instance, some scope to
give consideration to the real economy, while enabling us to wait for and analyse new economic
information. The fact that no central bank knows exactly how the economy functions and the effects of
monetary policy also means that one normally proceeds cautiously in changing interest rates.
Finally, a desirable interest rate path should also be determined with consideration to an assessment
of different types of risks and the consequences for inflation and the real economy if they are realised.
Some risks may be difficult to quantify and capture in our normal forecasts. In my opinion, they should
nevertheless be included in the balance when shaping monetary policy. One recent example is the
risks linked to a rapid increase in property prices and household indebtedness as a result of a longer
period of expansionary monetary policy; a problem many central banks around the world have faced.
Let me also, for the sake of clarity, point out that when we publish our own forecast for the repo rate it
will indicate a smoother development in the repo rate than the policy that will be conducted. This is
because interest rate decisions must in practice be taken in stages and at particular points in time. It is
difficult to build this into the forecasting work.
Changes to the Inflation Report
Let me mention another new item, before I round off. Our inflation report will involve a change of
name, to "Monetary Policy Report". One reason for the name change and the most important change
is that the reports will from now on contain not merely inflation forecasts, but also a monetary policy
message. There will be a clear link between the forecasts and the monetary policy considerations
made directly in the report in that the forecasts are based on an interest rate path chosen by the
Executive Board. A more detailed account of the discussion held in connection with the decision on
the level of the interest rate that will apply until the next monetary policy meeting will be included in the
minutes of the meeting, which will be published as usual around two weeks after the meeting.
In addition, the arrangement of the report will be altered with the aim of becoming even clearer and
more efficient in our communication. The purpose is to make it easier for external parties to follow,
understand and assess our monetary policy. The report will also have a new, and hopefully more
readable, layout.
The routines for publishing the report will also be changed slightly. The report will be published, as
usual, on the Riksbank's website the day following the monetary policy meeting, at 9.30 a.m. However,
the printed version will be published slightly later, as the report will now contain information on the
monetary policy decision and must therefore go to print after the Executive Board meeting.
Concluding remarks
As I mentioned at the beginning, we at the Riksbank are constantly working on improving our
communication and the bases for making our monetary policy decisions. The fact that we are now
going to publish our own forecast for the repo rate is an important step in this process. I would like to
emphasise once again that this is a question of a forecast for the future development of the repo rate.
Forecasts are, as we know, always uncertain and new information and changed circumstances can
lead to assessments changing. The new interest rate assumption does not entail any commitment on
the part of the Riksbank that the repo rate will actually follow a particular path. Nor does this involve a
new way of conducting monetary policy.
When we chose to replace the assumption of a constant repo rate with an assumption based on
market expectations, we took a large step towards increased openness and clarity. Now we are taking
a further step in the same direction. I hope that this will enable us to become even better at explaining
to the general public how we reason when making our monetary policy decisions.
Thank you!
List of references
Alsterlind, J. and Dillén, H., "Monetary policy expectations and forward premia", Sveriges Riksbank
Economic Review 2, 2005.
Archer, D. (2005), "Central-bank communication and the publication of interest rate projections", article
presented at the Riksbank's conference "Inflation targeting: implementation, communication and
effectiveness", June 2005.
Blinder, A., (2006), "Monetary Policy Today: Sixteen Questions and about Twelve Answers", paper
presented at the Banco de España Conference on "Central Banks in the 21st Century, Madrid, June
8-9, 2006.
van der Cruijsen, C. and M., Demertzis (2005)."The impact of central bank transparency on inflation
expectations", Working Paper no. 031/2005, De Nederlandsche Bank, 2005.
Eijffinger, S. and P. Geerats, (2006), "How transparent are central banks?" European Journal of
Political Economy, vol. 22.
Faust, J. and E. Leeper (2005), "Forecasts and inflation reports: An evaluation", article presented at
the Riksbank's conference "Inflation targeting: implementation, communication and effectiveness",
June 2005.
Goodhart, C. (2001) "Monetary Transmission Lags and the Formulation of the Policy Decision on
Interest Rates", Federal Reserve Bank of St. Louis Review, July/August 2001.
Giavazzi, F. and F.S. Mishkin (2006), "An evaluation of Swedish monetary policy 1995-2005", Reports
from the Riksdag 2006/07:RFR 1, Committee on Finance.
Kontulainen, J., D. Mayes and J. Tarkka, (2004), "Monetary Policy Assumptions in Central Bank
Forecasts", Bank of Finland Bulletin 4, 2004.
Mishkin, F. S. (2004) "Can Central Bank Transparency Go Too Far?" NBER working paper no. 10829.
Rudebusch, G.D. and J.C. Williams (2006), "Revealing the Secrets of the Temple: The Value of
Publishing Central Bank Interest Rate Projections", NBER Working Paper, 12638.
Svensson, L.E.O. (2005),"Further Developments of Inflation Targeting", article presented at the
Riksbank's conference "Inflation targeting: implementation, communication and effectiveness", June
2005.
Woodford, M. (2005), "Central-Bank Communication and Policy Effectiveness", article presented at the
Riksbank's conference "Inflation targeting: implementation, communication and effectiveness", June
2005.