Urban Bäckström: The current situation for monetary policy
Speech by Mr Urban Bäckström, Governor of the Sveriges Riksbank and Chairman of the Board of
Directors and President of the Bank for International Settlements, before the Standing Committee on
Finance, Stockholm, on 10 October 2000.
* * *
It is gratifying to be able to note, as on so many of my previous appearances here, that economic
developments in Sweden are impressive. Having achieved a growth rate in the past six years that
averages 3%, it seems that our economy is now expanding at an annual rate of around 3 to 4%.
Employment has really taken off. To date this year the number of people in work is 70,000 higher than
in the same period of 1999. I can also note, once again, that notwithstanding the rapid economic
growth, the rate of inflation has remained moderate.
But these favourable developments do not mean that the Riksbank can sit back and relax. The path
ahead contains a number of risks to which we must be alert.
What lies behind the favourable economic trend?
A basic factor behind the Swedish economy's favourable path is, in my opinion, the economic policy
realignment that has been carried out in the past decade and a half. Credit and currency markets have
been deregulated, the tax system has been reformed, components of the transfers system have been
modified and competitive pressure has increased. All this has helped improve the workings of our
economy. Then there is economic policy's commitment to stability, with price stability as a statutory
objective, as well as a successful consolidation of the government finances.
In the inflation forecast we are presenting today, productivity growth is judged to be marginally higher
than we foresaw in the June forecast. That in itself is a sign that the economy is functioning better.
The Riksbank's assessment of productivity has been revised gradually over the past few years. Higher
productivity means that more can be produced with the same input of resources. So a lasting
improvement raises the economy's potential long-term output. The higher productivity growth does
not seem to be solely connected with the economy's upward phase. Whereas productivity growth in
the period from 1974 to 1993, for example, averaged less than 1.5% a year, the average rate since
1994 has been almost 2%.
At the same time I want to underscore that there are not yet any clear signs of the kind of accelerating
productivity growth which has occurred in the United States. One explanation for the discrepancy
between our economies may lie in the different ways in which productivity is measured in the United
States and in Europe. There are also some indications that productivity growth may accelerate in the
future but they are still too uncertain to support any more far-reaching conclusions in the formation of
monetary policy.
It is accordingly conceivable that the Swedish economy will move into a process with accelerating
productivity growth but let us wait until that happens before incorporating it in our expectations and
policy decisions. Our economy is developing favourably enough as it is.
A growth process driven by rising investment and productivity can result in good circles. To some
extent, that can be said to have been the case in recent years. It accordingly helps to explain the
favourable economic developments in Sweden. Another cause lies in the various deregulations that
have been implemented.
Inflation this year improved by deregulation and competition
Thus, it is other positive supply side effects that have helped to achieve the rapid output growth
without generating inflationary impulses. The effects have come from the deregulation of electricity
and telecom markets, as well as from the EU's agricultural reform. Meanwhile, the temporarily lower
rate of inflation has meant that real wage growth has exceeded expectations and thereby acted as a
general demand stimulus.
On the whole, however, the effects are of the one-off kind that lower the price level and stimulate
demand for just a limited period. But if these effects have a gradual impact on different segments of
the economy, their overall impact on inflation may be spread over many years.
Another explanation for the favourable overall price trend is the generally stronger competition. It is
now more difficult for firms to raise prices in order to improve profit margins, as usually happens at
this stage in a business cycle. To some extent this may also be because firms know that price impulses
from that quarter will inevitably cause the Riksbank to raise the instrumental rate. To achieve a
reasonable return on capital, firms are obliged instead to make production more efficient. That tends to
result in better productivity.
The increased oil prices can be cited correspondingly as an example of a negative supply shock. That
is not an entirely adequate description, however, because to a certain extent, rising oil prices have to
do with the better global activity, which normally leads to a general increase in commodity prices. The
oil price increases tend to push prices up and curb output. But so far, the combined impact of all the
supply shocks seems to be positive, that is, lower inflation and high demand growth.
Larger amount of unutilised resources
Yet another explanation for the moderate path of inflation could be that the amount of unutilised
resources is larger than we - and many others - counted on earlier. Last autumn, for example, many
observers believed, along with the Riksbank, that labour shortages would lead to increased price
pressure via higher wages. But our fears have not yet been confirmed. Wage increases have been
moderate even though the increase in employment is the highest for 40 years and unemployment has
dropped to a level that few believed would be feasible after the profound crisis in the early 1990s.
Moreover, the labour shortage figures in the Swedish economy have continued to be moderate.
More people have joined the labour market. Many of those who were full-time students earlier and
thus not classified as participating in the labour force have now found work. The number of persons on
labour market programmes has also fallen, thereby making a further contribution to the increased
labour supply and helping to meet demand.
These are some signs that the extent of the unutilised resources has been somewhat larger than allowed
for earlier. We have therefore gradually altered our appraisal of resource utilisation in the Swedish
economy in recent years.
There are, accordingly, a number of factors that have contributed to such a good economic
development in recent years. A combination of favourable circumstances has so far made it possible to
combine high total demand with price stability.
But if the strong demand continues, sooner or later there will be labour shortage situations. Shortages
of labour with certain qualifications already exist in some regions. As the labour market becomes
increasingly tight and shortages arise more generally, the risk of accelerating wage and price increases
will grow. Then, if not before, the repo rate will have to be raised.
The present assessment
Today the Riksbank is presenting a new economic assessment of the coming one to two years. The
general features of the picture are the same as in our June report. Although the economy has moved
further along the upward phase, we continue to believe in a main scenario that combines a strong
economic trend with no unduly alarming inflationary tendencies. It is important to note, however, that
there are also a number of clear risks that we must keep an eye on in the future.
Monetary policy is currently formulated on the basis of an assessment of inflation excluding transitory
effects from indirect taxes, subsidies and house mortgage interest expenditure (UND1X). In the main
scenario in the Inflation Report, UND1X inflation with an unchanged repo rate of 3.75% is forecast to
be 1.5% one year ahead and 1.9% after two years. When various alternative paths are taken into
account - above all the risks of a higher oil price, a weaker exchange rate and more rapid wage
increases - the rates of inflation are judged to be somewhat higher, namely 1.6% and 2.1%,
respectively.
The inflation assessment starts from a continuation of strong international economic activity. Together
with rising consumption and a favourable development of investment, this provides conditions for
further rapid growth in Sweden, too. GDP growth in the main scenario is forecast to be 4% this year,
3.7% in 2001 and 3% in 2002. Compared with the June Report, only minor revisions have been made
to GDP growth in Sweden up to 2002. Neither has the inflation forecast been altered more than
marginally. That future inflation is not higher, even though the economic upswing is continuing and
the forecast horizon has been shifted ahead, is partly a consequence of the amount of unutilised
resources now being considered to be somewhat larger. Wage increases are judged to be somewhat
lower, accompanied by marginally higher productivity growth. In the short run, however, inflation is
expected to be somewhat higher than forecast in June, mainly because the oil price is higher and the
exchange rate somewhat weaker.
While the oil price and exchange rate assessments have been revised in the light of developments in
the summer and early autumn, the forecast of inflation one to two years ahead still counts on a
successive appreciation of the krona and a gradual fall in the price of oil. However, the uncertainty is
considerable. A higher oil price and a weaker exchange rate could lead to inflation rising more rapidly
than assumed in the main scenario.
The assumption of a somewhat lower rate of wage increases is supported by, for example, wage
outcomes to date this year as well as inflation expectations that are relatively low and stable. Still,
there is considered to be some risk, albeit relatively small, of a development of wages that is
considerably stronger, for example as a result of negotiators' demands for parity and compensation.
Together with confidence in the low-inflation policy, the situation in the labour market and the coming
wage negotiations will be of crucial importance for the future formation of monetary policy.
The present decision to leave the repo rate unchanged for yet another while is to be seen in the light of
the assessment that for virtually the whole of the time horizon the Riksbank currently appraises,
inflation is calculated to be below 2%. When various alternative paths are incorporated in the
assessment, however, inflation two years ahead is marginally above the target. The picture of a strong
upswing in the Swedish economy still holds, with rising resource utilisation in the labour market, for
example. That suggests that the repo rate may need to be raised in the future.