Karolina Ekholm: Why Swedish monetary policy needs to be more
expansionary
Speech by Ms Karolina Ekholm, Deputy Governor of the Sveriges Riksbank, at Almega
(employer and trade organisation for the Swedish service sector), Stockholm, 15 November
2013.
* * *
The views expressed in this speech are my own and are not necessarily shared by the other members of the
Executive Board of the Riksbank. I would like to thank Björn Andersson who has helped in writing the speech.
Accompanying charts can be found at the end of the speech.
Interest in central banks and monetary policy has been greater than normal since the
financial crisis. Here in Sweden, much of this interest has concerned the disagreement
among the Executive Board on the level of the interest rate, where I have been one of those
who has consistently voted for a more expansionary monetary policy. I have mostly voted for
a repo rate that is 0.25 percentage points lower and a repo-rate path that rises more slowly.
One might of course think that the difference between this and the repo rate and repo-rate
path decided on is so slight that it would not have any effect on the outcome. However,
behind this apparently marginal difference in the view of what the repo rate should be is a
fundamental difference in the view of the role of the central bank and the route monetary
policy should take in the new economic landscape emerging in the wake of the financial
crisis. It is this fundamental difference that I intend to talk about today.
On a general level one can say that the difference concerns the view of the risks linked to
financial imbalances and to what extent monetary policy should be used to counteract such
risks. It is primarily the latter that has come to be a recurring theme in the discussions on
Swedish monetary policy.
Here in Sweden, monetary policy has deliberately not accelerated more, despite the low
inflation and low resource utilisation, with reference to the claim that a more expansionary
monetary policy increases the risks linked to high household indebtedness. One justification
for this deliberation is that the financial crisis has shown how high costs can be if these risks
are allowed to increase and that it is therefore worth deviating from the inflation target and
allowing a somewhat poorer development of the real economy to avoid indebtedness soaring
too high and creating problems further ahead.
I can very well understand the wish to prevent new crises and I am not categorically against
conducting monetary in this way; leaning against the wind as it is usually called. But if one
weighs the advantages of conducting this policy against the disadvantages, I reach the
conclusion that there is no justification for it in Sweden today. As I see it, the advantages are
small. We do not have a general credit boom in the Swedish economy that needs
dampening. However, we do have problems with high housing prices that lead to high
household indebtedness and risks associated with this. But it is difficult to use monetary
policy to influence household indebtedness without this having very negative consequences
in the form of poorer target attainment for inflation and poorer stability in the real economy in
the coming years. Poorer target attainment over a long period of time also entails costs and
risks in itself which must be taken into account.
The framework in which monetary policy is conducted in Sweden and in many other
countries is based on the mandate of maintaining price stability, often specified as a target
for inflation, as we have in Sweden. And it is this mandate that is the reason why central
banks in general have been allocated a greater degree of independence than other public
authorities. Over the past two decades, the clear objectives for monetary policy and the
independent work by central banks to attain them, have proved effective in anchoring
inflation expectations and creating stability in the economy.
However, the framework is based on the central bank actually delivering. If inflation is
allowed to deviate from an established target over a long period of time it can affect the
general public's understanding of the policy conducted and their confidence in the inflation
target. The more the central bank stretches its task of delivering the set objective, the more
difficult it will be to understand and evaluate the policy conducted. And then the greater the
risk will be that the general public's attitude to the framework deteriorates.
I intend to try to describe my opinion on these questions today and on how they tie in with my
view of the role of the central bank and how monetary policy should be conducted within the
current framework. It may be useful to start by describing the framework we have lived with
for a good twenty years now. Why do we have an inflation target and an independent central
bank?
Why an inflation target and independence?
From credibility problems for the fixed exchange rate...
When the international monetary system of fixed exchange rates - what was known as the
Bretton Woods system - collapsed at the beginning of the 1970s, Sweden needed to find a
new nominal anchor for its economy. The predominant view was that a fixed exchange rate
was the best means for a small, open economy to attain stable prices and set a framework
for the stabilisation policy. This was one of the reasons why Sweden chose to continue with a
system where the krona was pegged to other currencies.
But when the economy suffered problems in the 1970s and 1980s it became clear that the
target for the fixed exchange rate was not regarded as credible. The target often came into
conflict with the aim of bringing down unemployment, which became an increasingly
important element of the stabilisation policy. This was resolved by means of recurring krona
devaluations. The result was a negative spiral, where expectations of continued high inflation
and new devaluations affected price-setting and wage formation. Wage increases in Sweden
therefore showed a higher trend increase than other countries. This in turn led to cost crises
in the manufacturing industry, which were resolved through devaluations of the krona. This
fulfilled the expectations of devaluations and thus sowed the seeds for the next round.1
In the middle of the 1980s, the Swedish credit market was deregulated, which was the
starting point for a rapid credit boom and sharply rising prices for financial assets and
property. The economic policy conducted could not withstand the pressure and the result
was a property market bubble and a very overheated economy. When the bubble burst in the
early 1990s, it triggered a financial crisis and a deep recession. Many were assuming that
the old pattern would be repeated and that the krona would be devalued. But the political
stance on this occasion was instead to once and for all disperse expectations of devaluations
and show that they were serious about the fixed exchange rate. As you all know, this proved
unsuccessful, despite a policy rate of 500 per cent and explicit support for the defence of the
krona. In November 1992 the Riksbank had to give up the fight and let the krona float freely,
which meant that it weakened significantly.2
... to a floating exchange rate, inflation target and independent Riksbank
When the krona fell, there were probably not many people who believed that Sweden would
change its monetary policy regime entirely. Most people probably expected that we would
eventually return to a fixed exchange rate. However, it was clear that such a return would
take time and during a transition period a new strategy would be necessary. At the end of the
1980s, the Reserve Bank of New Zealand had begun to aim its monetary policy at trying to
directly govern inflation and in 1990 they introduced an official inflation target as a means of
creating a nominal anchor in the economy. Canada and the United Kingdom soon followed
suit and Sweden joined the group in 1993. On 15 January, the Riksbank announced that its
monetary policy objective would be to hold inflation around a quantified target: 2 per cent,
measured as the change in the consumer price index. This target would begin to apply from
1995.
Twenty years have now passed. With hindsight, we know that it actually took a very short
time for the inflation target to become credible and for inflation expectations to become
anchored around 2 per cent. But in the beginning, it was not entirely clear that the inflation
target would be a success. Monetary policy was therefore mainly focused on creating
confidence in the target initially. The repo rate was kept at a high level to bring down inflation,
despite relatively high unemployment, which led to criticism from several areas.3 As inflation
expectations became anchored, however, there was scope to include developments in the
real economy in monetary policy. One could deliberately allow inflation to deviate from the
target for a period of time if this would give a better long-run development in employment and
unemployment. The inflation-targeting policy was thus flexible.
The framework for the inflation-targeting policy has of course developed considerably over
the past twenty years, much due to academic research. Research has also contributed
insights into the economic policy problems faced by Sweden and several other countries in
the 1970s and 1980s. It was difficult for decision-makers to inspire confidence in the long-run
aim to hold inflation low, as participants in the economy understood that there were
incentives to deviate from the target in the short run, for example, to reduce unemployment.
It could therefore be beneficial if monetary policy were conducted with a focus on a
clearlyformulated, long-run target for price stability and an arm's length away from the current party
politics. This was the starting point for the reforms implemented in many countries during the
1990s and which meant that monetary policy, in slightly different ways and to varying
degrees, was delegated to central banks along with a more independent status and with a
clear mandate to hold prices stable.
In practice, the Riksbank conducted its monetary policy independently from the mid-1990s,
but formally it was not given an independent status until 1999.4 The Instrument of
Government and the Sveriges Riksbank Act were then amended as part of the adjustment to
the requirements in the EU treaty, requirements that were of course affected by the insights
gained and by developments in the field of monetary policy. The changes in the regulatory
framework meant, for instance, that an Executive Board was appointed at the Riksbank,
consisting of six members and with the task of independently conducting monetary policy. At
the same time it was confirmed by law that the objective of the Riksbank's operations would
be to maintain price stability. The independence thus concerned which interest rate decisions
would attain the price stability target in the best way, not what objective the central bank
would have for its operations.
Better development with an anchor in place
As I mentioned earlier, the inflation target gained credibility relatively quickly and inflation
expectations were soon anchored around 2 per cent. The severe weakening of the krona
when it was allowed to float also stimulated exports, which made the consolidation of public
finances easier in the mid-1990s and helped the Swedish economy to climb out of the deep
recession. The new framework for both monetary policy and fiscal policy and more efficient
wage-bargaining rounds contributed to the rate of inflation declining and moreover fluctuating
much less from year to year in relation to the 1970s and 1980s.
The much calmer development of inflation was also supported by more stable inflation
abroad. It is important to remember that developments with lower inflation and reduced
volatility were not an isolated event in Sweden, but an international trend. From the
mid1980s there was a period when the fluctuations in many industrial nations' economies were
considerably dampened in relation to earlier decades. The reasons for this development, "the
Great Moderation" as it came to be called, have been the object of considerable analysis and
debate. It was probably the result of a number of interacting factors. But there are many
indications that the changes in the monetary policy field that took place on a broad front
during this period were an important reason why inflation began to fluctuate much less.5
Inflation-targeting policy after the crisis
As in the early 1990s, the most recent financial crisis has for natural reasons triggered a
discussion of to what extent and in what way the current framework for monetary policy
needs to be changed. Attitudes to change have varied, partly depending on what role one
believes monetary policy played in the crisis. Was inflation targeting one of the perpetrators,
contributing to interest rates being too low prior to the crisis; was it the bystander who could
only look on in horror, or was it the saviour who ensured that inflation expectations
nevertheless remained firmly anchored?6
Personally, I do not believe that the argument that the financial crisis stems from an overly
expansionary monetary policy is particularly convincing. As I see it, it was primarily a
combination of a lack of supervision and regulation of the financial markets.7 Two obvious
lessons are that there was over-confidence in the ability of these markets to regulate
themselves and that the distortions in incentives on the financial markets had been
underestimated.8
Given the enormous socio-economic costs the financial crisis entailed, there is of course a
strong will to correct what one perceived went wrong to ensure it cannot happen again - this
applies in particular to the central banks, who had to deal with quite a few of the problems.
There is thus an instinct to take on the task of ensuring that financial crises do not arise - not
merely through advocating better supervision and regulation of the financial markets, but also
through monetary policy. But there are a number of problems with this.
Risks linked to household debt have held back monetary policy
This leads me on to the situation in Sweden and how monetary policy has been conducted
recently. We have had low inflation and a low level of resource utilisation in the Swedish
economy for a long period of time. During my first year as a member of the Executive Board
from spring 2009 until some point in the middle of 2010, CPIF inflation was close to 2 per
cent.9 But then it began to gradually fall to its current level of around 1 per cent (see
Figure 1). The Riksbank's forecasts have shown, and still show, that it will take a couple of
years until underlying inflation begins to approach 2 per cent and resource utilisation
normalises. This means that for several years inflation has undershot the target, at the same
time as resource utilisation has been low.
In this type of situation, a more expansionary monetary policy could have been used to
reduce unemployment without creating a risk of inflation being too high (see Figure 2). Today
there is quite simply no conflict of interests between inflation and unemployment of the type
that was so common in the 1970s and 1980s, when the ambition to hold back unemployment
was what ultimately pushed up inflation to levels that were unsustainable for the fixed
exchange rate. On the contrary, inflation has now been so low for so long that I am
concerned that it risks becoming a problem in itself, as inflation expectations are adjusted to
a lower level.
For these reasons, I have considered a further cut in the repo rate to be justified. But a
majority of Executive Board members have assessed that this is not justified, because an
even lower repo rate is thought to increase household debt, which is in turn assumed to
increase their vulnerability and thus the risk of shocks leading to a deep recession.
It is, of course, important to consider how concerned one should be over household
indebtedness, not just the Executive Board of the Riksbank, but the Government and the
Riksdag (the Swedish parliament), as well as the banks that lend money to Swedish
households and Finansinspektionen (the Swedish Financial Supervisory Authority), which
supervises these banks. My own opinion is that the high housing prices probably mainly
reflect a shortage of housing and are thus not to be regarded as a price bubble. However, if
the supply and demand situation changes, this could very well lead to falls in house prices in
some situations. And even if such price falls are justified, they can entail problems for
macroeconomic developments. I believe that the high level of debt, combined with an
unwillingness to have higher debts than assets, could in such a situation have negative
effects on growth in consumption.10 I would therefore feel more secure if the level of debt was
lower, or at least was not increasing.
But if I would feel more secure with a lower level of debt, why not use monetary policy to try
to slow it down? The answer is simply that the disadvantages with using monetary policy in
this way outweigh the advantages.
A trade-off between target attainment at different horizons
One fundamental problem here is how to make the trade-offs clear to economic agents,
which is necessary if one wishes to convince them of the need to lean against the wind. The
policy the Riksbank has conducted for some time means that one deliberately allows longer
time for both inflation and the real economy to return to normal levels. At the same time, this
is justified by the Riksbank's mandate to stabilise inflation around the inflation target and
production and employment around long-run sustainable levels. It is probably not clear to
everyone how the actual aim of the policy is connected to the justification for it. The
tradeoffs therefore need to be made concrete and clear - partly so that the Riksbank's principal
can assess its monetary policy, and partly so the general public can understand the basis for
the policy the Riksbank conducts. What does one gain by conducting a policy that
deliberately allows it to take longer for inflation to return to the target and for resource
utilisation to return to a normal level? Is it worth the cost in terms of poorer target attainment?
This is not easily illustrated. It is a question of a "new" type of trade-off being included in the
material on which the analysis and decisions are based and it takes time to find good forms
for this. It also involves illustrating risks and uncertainty and making them more concrete, and
this is always a challenge. The Riksbank has been carrying out work on developing this for
some time, and an outline as to how financial imbalances can be included in the monetary
policy assessments has begun to take form. The July Monetary Policy Report included such
an outline that shows how one can approach this question.11
The reasoning concludes that one can regard recent monetary policy as a trade-off between
target attainment in the coming years, that is the period for which the Riksbank normally
makes forecasts, and target attainment in the long run, beyond the forecast horizon.12
The
idea is that a monetary policy that solely focuses on target attainment a couple of years
ahead could miss the fact that financial imbalances are building up that risk leading to very
poor macroeconomic outcomes in the longer run.
According to this outline, decision-makers need to balance target attainment in the short and
medium term against target attainment in the long term. Thus, there are two questions one
needs to take a stance on: How does indebtedness affect the risk that shocks will lead to a
really severe depression? And to what extent can monetary policy affect indebtedness and
thus the risk of this type of scenario? The latter question, in particular, is important in this
type of trade-off.
Unclear benefits but clear costs
Monetary policy is the most effective tool we have for influencing general price
developments. It has an impact through, for instance, credit growth in the economy.
Monetary policy can therefore be used to dampen credit growth when it appears alarmingly
high, even if this does not appear justified on the basis of the prospects for inflation.
However, it is not alarmingly high credit growth that is visible in the Swedish economy now,
but a high level of debt in the household sector that is primarily a consequence of high credit
growth prior to the financial crisis (see Figure 3). At present, growth in household credit is
only slightly higher than growth in disposable incomes. Growth in corporate credit is at the
same time low.13 The increase in lending by the major banks over the past five years has
consisted almost entirely of Swedish mortgages (see Figure 4).
My assessment is that it does not have any major impact on household debt to hold the repo
14
rate slightly higher for a limited period of time (see Figure 2). To have an effect that is more
than marginal, one would probably need to hold the repo rate so high that the costs in terms
of poorer macroeconomic growth would be very high. So what one gains by monetary policy
leaning against the wind in terms of dampening debt, reducing vulnerability in the economy
11
Sveriges Riksbank (2013).
12
This is, of course, a simplification. Actually, an unfavourable scenario could also occur within the normal
forecast period, that is, within the next three years. See also Sveriges Riksbank (2013).
13
Companies' market borrowing has increased in recent years, which to some extent compensates for the
downturn in growth in bank loans. However, even if one takes this market borrowing into account, credit
growth in the corporate sector appears relatively low.
14
Model estimates of the short-term relation between the repo rate and household indebtedness indicate that
the average effects may be relatively small: a 1 per cent lower repo rate over a period of one year, and which
gradually reverts, will give rise to an approximately 4 percentage points higher level of indebtedness as a
percentage of disposable income. Similar estimates of the relation between housing prices and the repo rate
also show small effects - see Sveriges Riksbank (2011) Chapter 2.1.However, estimates of short-term
relations might underestimate the total effects of the repo rate on household indebtedness.
and having a potentially better target attainment in the long run is thus very unclear. On the
other hand, the costs in terms of poorer target attainment a couple of years ahead are very
clear.
Other tools than the repo rate could moreover influence household debt more effectively.
Various types of tax tools are probably particularly potent, such as tax deduction regulations
and property taxation, but at the same time these are the most politically sensitive. So-called
macroprudential policy tools are probably more effective than monetary policy in influencing
debt in the household sector. Finansinspektionen, which has been given the main
responsibility for these tools, has already used several of them and has signalled that it will
remain vigilant with regard to risks linked to household indebtedness. This should reasonably
have an effect on the monetary policy trade-offs. Once macroprudential policy is in place,
monetary policy can focus on attaining the inflation target and stabilising resource utilisation
a couple of years ahead.
An analysis of the target versus the means thus does not advocate the repo rate as a tool for
dampening household debt. It would be costly to society as a whole to use monetary policy
for something it is not particularly well-adapted to influence.
The trade-offs must also include the risks of deviating from the inflation target
My final objection to the monetary policy conducted recently is that the trade-offs have not
sufficiently taken into account the costs and risks linked to deviating from the inflation target
over a long period of time. Flexible inflation-targeting means that the central bank can
deliberately allow inflation to deviate from the target out of consideration for developments in
the real economy. This is possible as long as the deviation is assessed as temporary, and
households and companies perceive that the central bank aims to bring inflation back to the
target level. However, a situation where monetary policy leans against the wind does not
really fit into this description. Here the central bank allows target attainment for both inflation
risk
and the real economy a couple of years ahead to stand back, out of consideration for the
of a really poor target attainment, probably far ahead in the future.
Such a trade-off needs to take into account possible costs linked to households and
companies having made decisions over a long period of time on the basis of what turn out to
be incorrect inflation expectations.15 Moreover, one must assess the risks that a low inflation
rate in itself entails. I consider it important to keep a respectful distance when prices are not
increasing at all, so that one avoids deflation, which could lead to major problems for the
economy. In addition, one must take a stance on how long inflation can be allowed to deviate
from the target, given the other trade-offs, without having consequences for inflation
expectations, for the credibility of monetary policy as a whole and ultimately for target
attainment in the long run.
As I said, the inflation target has been an anchor in many countries for a long period of time -
for twenty years in the Swedish economy - and we almost take for granted that long-run
inflation expectations will be around the target. They also still appear to be well-anchored
around the target of 2 per cent in Sweden, although expectations in the shorter run are lower
(see Figure 5). However, a monetary policy that explicitly leans against the wind is in many
ways untested as a strategy and it is not clear how the participants in the economy will
interpret inflation deviations in this context. One must therefore be careful. I see a risk in
allowing monetary policy to continue to lean against the wind until one sees tendencies for
inflation expectations in the long run to begin to adjust downwards. That is a situation that
might be hard to turn around.
Target attainment is important for credibility
One argument that is sometimes put forward is that the differences between what the
majority of Executive Board members and the minority advocate are so small and that in
practice it is not very important whether or not one cuts the repo rate a little more. And in a
strictly "mechanical" sense, it is perhaps true that a policy rate that was 0.25 percentage
points lower for a period of time would have a limited effect on the economy. But for the sake
of credibility and target attainment in the long run, it is also important how households and
companies perceive monetary policy. How seriously does the central bank view the inflation
target? The longer inflation is deliberately allowed to deviate from 2 per cent, the greater the
risk that one begins to question what target the bank really has. We have seen elements of
this in the recent debate on monetary policy in Sweden.
This could also have significance for how the central banks' principals perceive the way
monetary policy is conducted, which can ultimately affect the banks' mandate and position.
The Riksbank has a mandate to work independently to maintain price stability and, without
prejudice to this, to support the goals of general economic policy. On the one hand, this
means that it is up to the Riksbank to determine which risks are relevant for its decisions. But
on the other hand, the Riksbank is accountable to the Riksdag, which determines the
Riksbank's mandate. The Riksbank therefore needs to be able to show in a convincing
manner that the trade-offs it makes are anchored in its mandate. And given the current
mandate, it may be a problem if one accepts deviations from the inflation target over a long
period of time. If the trade-offs in monetary policy are not clear and concrete, it will be difficult
to assess whether it has been conducted in a reasonable manner and within the mandate.
The costs are clear, but what have we gained?
Of course, it may be the case that the principal understands the difficulty in making these
trade-offs concrete and considers it desirable that the central bank nevertheless takes the
risks into account in a way that reduces the degree of target attainment a couple of years
ahead. But in this case, it is desirable that the principal should make clear that the mandate
is worded too narrowly and therefore needs to be broadened. And one question that also
arises is to what extent such a broader mandate fits into the degree of independence granted
to many central banks. There is some tension between the breadth of the mandate and the
degree of independence. A high degree of independence assumes that it is fairly simple to
assess whether the mandate is fulfilled, which could be difficult if the mandate is worded so
broadly that it encompasses most potential outcomes.
"Let the cobbler stick to his last!"
Let me conclude by summarising my message today and perhaps unexpectedly I shall begin
in ancient Greece. It was said that the famous artist Apelles from Kos one day heard a
shoemaker pointing out a mistake the painter had made in his depiction of a sandal. Apelles
corrected the mistake, which encouraged the shoemaker, who then continued his criticism of
the way the leg of the person in the picture had been drawn. An indignant Apelles then
reminded him that a shoemaker should not criticise above the sandal.16 The expression we
use today in Sweden - Let the cobbler stick to his last! - may sound outdated and rather
negative as an attitude.17 But if one rewords it, and at the same time removes the critical
tone, it could be: "The best thing is for everyone to stick to what they do best." I think the
interpretation of the old expression summarises my point fairly well.
For around two decades we have had a framework for monetary policy that has proved
effective in anchoring inflation expectations and creating stability in the economy. This
framework has quite naturally developed and been refined over the years, but essentially it
means that the central bank has a clear task of maintaining stable prices in the economy and
the mandate to make decisions to attain this independently. Stable prices are something that
benefits everyone in the long run, but are difficult to attain because there can be such great
temptation to deviate from the target in the short run to attain other targets - such as lower
unemployment. This is why many countries have chosen to put monetary policy - which is
the most effective tool for influencing inflation - in the hands of independent central banks
and at the same time to give them clear mandates to hold prices stable. Well-anchored
inflation expectations also create scope for the central bank to stabilise the real economy.
For understandable reasons, focus following the financial crisis has honed in on risks linked
to financial imbalances and to preventing these imbalances. There is thus an instinct to also
include these trade-offs in monetary policy. As I have tried to explain, I believe there are a
number of problems with this. It is difficult to manage the new trade-offs, which in the case of
Sweden concern high household indebtedness, both strategically and in terms of
communication. And tensions may also arise between these trade-offs and the original
framework regarding price stability and the mandate the central banks currently have.
One solution to this would of course be to change the framework and give the central banks
an extended mandate. But then one would need to have a political discussion on what it
should actually include and on the possibility to assess the central banks and hold them to
account.
I understand and sympathise with the instinct to act to ensure that crises like the one we
recently experienced never arise again. But using monetary policy for this purpose creates
problems. Given the Riksbank's current mandate, it is difficult to accept large deviations from
the inflation target over a long period of time. The more the inflation target is stretched, the
more important the question of the general public's confidence in the target will be and our
principal's attitude to the framework. This worries me, as the framework with a focus on price
stability and an independent central bank has been successful as a nominal anchor in the
economy. I therefore consider it imp