SPEECH
SVERIGES RIKSBANK
DATE:
6 Dec 2017
SE-103 37 Stockholm
SPEAKER: (Brunkebergstorg 11)
Deputy Governor Per Jansson
VENUE:
Fores, Stockholm
Tel +46 8 787 00 00
Fax +46 8 21 05 31
registratorn@riksbank.se
www.riksbank.se
The ideological debate on monetary
policy - lessons from developments in
Sweden∗
These are unusually exciting times to be working at a central bank. Challenges
have always been present, of course, but I think that it could be claimed that
seldom have they been of such a fundamental nature as they are today. One
example is the debate on limiting central banks' independence that has arisen recently.
This has come about after several countries have found themselves unable to
conduct monetary policy using policy rate adjustments alone. Instead, they have had
to complement this with tools that some observers feel have blurred the
boundary between monetary policy and other economic policies. Another example is
that technological progress within the area of payments has led to the rapid
decline of cash usage in a number of countries, not least Sweden. Whether and how
this trend will affect the conditions for conducting monetary policy and whether it
provides reason for the central banks to issue electronic money as a complement
to physical cash will be the focus of intense discussions in the period ahead.
These are important and fundamental issues. Today, however, I would like to
focus on another discussion, one that I feel is at least as vital and, at the moment,
perhaps even more relevant. This concerns whether the conditions for monetary
policy have changed so much in recent years that central banks will be forced to
abandon, or at any rate considerably modify, the inflation-targeting policy that
has been the dominant monetary policy regime of recent decades.
International debate on whether inflation
targeting has become outdated
On one side of the discussion are economists and observers who argue that the
inflation process now is so different from before that it is very difficult, perhaps
even impossible, for central banks to conduct traditional inflation targeting, at any
rate with the targets of around 2 per cent prevailing today. More specifically, they
argue that inflation faces such strong 'headwinds' in the form, for example, of
globalisation and digitalisation that it is doubtful whether central banks can steer
inflation in any meaningful way. Instead, it is argued, monetary policy should be
focused on dampening financial cycles and maintaining financial stability.1
On the other side are most central banks, who argue that rumours of inflation
targeting's imminent demise are significantly exaggerated. They admit that it has
now become more difficult and more complicated to conduct monetary policy,
when global real interest rates have fallen for a long time and are currently very
low. This means that central banks' policy rates are likely to reach their lower
bounds more often and that monetary policy will occasionally have to be
conducted using other means than policy rate cuts. They also agree that digitalisation
and globalisation are making it more difficult to reach inflation targets. But, it is
argued, even if these complications must be managed, there is nothing to indicate
that the inflation process should have changed so much and so fundamentally
that inflation targets have become unobtainable and that inflation targeting as
such would have to be fundamentally reassessed.
Financial Times columnist Gavyn Davies has described this debate as an implicit
ideological struggle between Claudio Borio, chief economist at the Bank for
International Settlements (BIS), perhaps the leading advocate of the new ideas, and
the departing Chair of the Board of Governors of the US Federal Reserve System,
Janet Yellen, advocate of the traditional view.2
There are good reasons for looking more closely into this debate. One is that it
will probably be an important part of international monetary policy discussions in
the years ahead. Another is that the debate is not merely about practical
monetary policy but in fact also about fundamental issues within economic science.
The debate in Sweden is ahead of the
international debate
There is reason to believe that the experiences we have had in Sweden in recent
years mean that we can make useful contributions to the international debate.
For quite some time, we have had a discussion on the process of inflation and the
conditions for inflation targeting, while this is a relatively new phenomenon in
most other countries. Almost exactly one year ago, I held a speech where I noted
that the long period of below-target inflation had led to a debate in Sweden which
had few equivalents abroad. Analysts and observers argued that this
development, with inflation persistently below forecast and quite far below the inflation
target, indicated that the target was so hard to reach that the Riksbank should
abandon the attempt and instead conduct a less expansionary policy aimed at
dampening rising household debt and housing prices.3
While participating in international meetings recently, I have been struck by how
much the discussion reminds me of the one we had in Sweden a couple of years
ago. Countries that had not fallen below their inflation targets for very long at
that point have now increasingly started to ask themselves whether they have not
underestimated the difficulties of getting inflation to rise. One example is the
United States, where, even though the Federal Reserve's main argument is that
inflation will reach the target of 2 per cent in due course, Janet Yellen has also
noted that "many uncertainties attend this assessment, and downward pressures
on inflation could prove to be unexpectedly persistent".4 Her colleague on the
Board of Governors, Lael Brainard, has similarly expressed unease that "the recent
low readings for inflation may be driven by depressed underlying inflation, which
would imply a more persistent shortfall in inflation from our objective".5 The
European Central Bank (ECB) is grappling with similar problems. The President of the
ECB, Mario Draghi, recently stated that, even if inflation is expected to rise
gradually in the period ahead, "progress towards a durable and self-sustaining
convergence of inflation towards our objective is not yet sufficiently convincing".6
Of course, it remains to be seen how justified this unease is. But what can be said
so far is that we in Sweden have already been in the situation that other countries
may be about to enter and have had, for some time, the debate that may be on
the horizon there. In this respect, we are, in a sense, 'ahead of the cycle', both as
regards the development of inflation and the monetary policy debate. It could
therefore be worthwhile to summarise our experiences so far. Maybe there will
be a few lessons that other countries and central banks may find useful and that
have implications for the international debate.
So let me start there. When I discuss the lessons that I think we have learned, I
would like to divide the period after the global financial crisis into two different
sub-periods and discuss them separately: the period of falling inflation 2011-2014
and the period of rising inflation 2015-2017. I would like to emphasise that, as
usual, I am expressing my personal opinion. It is possible that my colleagues on
the Executive Board have come to the same conclusions as I do here, but it is also
conceivable that they have made a different interpretation.
The period 2011-2014 - inflation falls far
below target
In conjunction with the global financial crisis, Sweden's GDP fell heavily, but the
recovery was also surprisingly rapid. In 2010, Sweden's GDP increased by about 6
per cent, approximately as much as it had fallen in the year before. The increase
was mainly due to the recovery in world trade and strengthening in global activity,
which benefited Swedish exports and investment. Exports were also helped along
by the weak krona. In July 2010, the Riksbank started to raise its repo rate from
the level of 0.25 per cent to which it had been cut in conjunction with the crisis.
CPIF inflation in 2010 amounted to 2 per cent.7 The Swedish economy developed
strongly and resource utilisation increased rapidly. Until the summer of 2011, the
recovery seemed to be continuing at a fairly good pace. By this point, the
Riksbank had raised the repo rate in stages to 2 per cent.
However, during the summer and autumn of 2011, unease increased over
developments in public sector debt in the United States and several euro area
countries. Growth prospects abroad deteriorated. This also spilled over onto the
Swedish economy. Sweden's GDP slowed down sharply in 2011, fell slightly in 2012
and only showed modest growth in 2013. Inflation started to fall in 2011 and
basically fell until 2014, when CPIF inflation amounted to about 0.5 per cent and CPI
inflation to just below zero. This fall started earlier than in most other countries
(see Figure 1). To counteract this development, the Riksbank started to cut the
repo rate at the end of 2011.
One circumstance that has a certain significance for my discussion going forward
is that the Riksbank was already concerned about the rise in household debt and
housing prices by this point. With the aim of contributing, to some extent, to
dampening the build-up of debt and price increases, the repo rate was set slightly
higher than otherwise would have been the case.8 This is usually described as
monetary policy 'leaning against the wind', where the wind represents some kind
of financial imbalance that is deemed to be building up.
However, what is important to understand is that, at this time, monetary policy
was nevertheless largely governed by traditional monetary policy motives, that is,
the expected development of economic activity and inflation over the coming
years (see Figure 2). Risks linked to developments in household debt and housing
prices were included in the assessment but did not play a leading role. I discussed
this in detail in a speech a few years ago and, consequently, I shall not say much
about it now.9 But let me just emphasise that neither did other economic analysts
consider that the monetary policy conducted was mainly a matter of the Riksbank
leaning against the wind, even if there were, of course, different opinions on
exactly how high the policy rate should be.10
This was an educational period in many ways. Looking back on it with a few years'
perspective, there are two main conclusions, or lessons, that I would like to
emphasise:
(i) It is important not to lose sight of inflation and inflation expectations.
(ii) Fairly significant interest rate rises may be needed to brake the
buildup of financial imbalances.
I shall discuss these conclusions separately and explain what I mean in a little
more detail.
Conclusion (i): It is important not to lose sight of
inflation and inflation expectations
My conclusion that it is important not to lose sight of inflation and inflation
expectations may seem obvious and trivial to many people, but it is nevertheless worth
some reflection. Moreover, the international debate that has arisen recently
suggests that it may not be so obvious after all.
One apparent reason for keeping sight of inflation is that it has turned out to be
surprisingly difficult to bring it back on target once it has fallen, particularly if
inflation expectations have fallen too. I have to admit that I, for one,
underestimated these problems. One possible explanation is that I, probably along with
many others, had been lulled into a belief that the positive developments in the
years prior to the financial crisis confirmed that we had succeeded in tackling the
more significant problems and that the inflation target was completely credible
and more or less a natural element of the Swedish economy.
Of course, that it is important not to lose sight of inflation is easy to say, but it is
harder to live up to. Obviously, it was not the Riksbank's intention for inflation to
become as low as it did and for such a long time.11 We made the best forecasts we
could and implemented the policies we deemed to be the most appropriate. In
retrospect, of course, had we known that inflation would become as low as it did,
we would have cut the rate sooner and faster.
But it is not particularly meaningful to evaluate events with the benefit of
hindsight. For it to be meaningful, it has to be possible to identify things that could be
done differently in a similar situation in the future. For example, there is no real
point in observing that we would have acted differently if we had managed to
predict the debt crisis in Europe and its effects. It is highly likely that, in the future,
this type of event will be more or less just as difficult to predict.
However, one experience that I believe we should take with us concerns our
monetary policy communication. Much of our communication at this time was about
pointing out risks connected to the development of debts and housing prices, in
particular during the period in which we had again started to cut the repo rate.
Even if we still expected to reach the inflation target, it could well be that we
talked too little about the target and too much about financial imbalances. This
may have created uncertainty among economic agents regarding the status of the
inflation target, which may, in turn, have contributed towards inflation
expectations falling. This is something worth bearing in mind going forward. The problem
was possibly also exacerbated by the Riksbank's critics often exaggerating the
significance to monetary policy of the development of debt and housing prices.
A deeper question concerning keeping inflation in sight is whether confidence in
the inflation target is really so important. Would it not be possible to conduct
monetary policy without there being confidence in the inflation target - or, for
that matter, without there being any inflation target at all? Why is it not possible
for monetary policy merely to stabilise the real economy or lean against the wind?
Such a monetary policy arrangement would be well in line with the new thinking
in the international debate that I presented in my introduction, in particular if this
were to be taken to its logical conclusion.12 I intend to return to this debate soon,
so let me put this issue to one side for a moment.
Conclusion (ii): Fairly significant interest rate rises may
be needed to brake the build-up of financial
imbalances
One issue in which I have gradually revised my opinion in recent years is that of
how much a central bank should and must lean against the wind to deal with the
build-up of a financial imbalance. Previously, I had a rather strong belief that
leaning against the wind relatively moderately could have a good effect, primarily by
sending a clear signal that the central bank is concerned over developments and
perceives them to be risky. Today, I am more doubtful about this. It certainly
seems reasonable that the effectiveness of such a strategy will vary over time and
from economy to economy, depending on the exact circumstances, for example
regarding market sentiment and debt levels, but overall I am significantly more
sceptical than before. I still believe that a certain degree of leaning against the
wind, combined with clear communication of the risks, could increase awareness
of the problems among the general public, market participants and economic
policy decision-makers. But it is, of course, necessary that this raised awareness
results in concrete measures or changed behaviour that counteracts the financial
imbalance. It is doubtful, as far as Sweden is concerned, whether it can be said
that this has been the case, at any rate not to such an extent or at such an early
stage as could have been hoped for.
The fairly modest leaning against the wind that we practised was thus insufficient
to halt the build-up of debts and housing prices. Nevertheless, I myself was not
prepared to keep the rate any higher than we did in an attempt to achieve this.
This was also apparently true of the Executive Board as a whole. If we had set the
repo rate significantly higher, the increase in indebtedness would perhaps have
stopped more permanently, but, at the same time, there is a severe risk that the
development of the economy would also have been significantly worsened.
Perhaps even more importantly, the development of inflation would have been even
weaker than it actually was and it would have been even more difficult to bring it
up and maintain confidence in the inflation target.
One further conclusion, or lesson, is that a policy that leans against the wind
requires that there is confidence in the inflation target. When we felt that this
confidence was in the process of becoming undermined in 2014 and early 2015, we
made the assessment that there was no other option than to increase the pace of
repo rate cuts to clarify that the focus was entirely on inflation. Accordingly there
was no longer any scope to use the repo rate to attempt to influence debts and
housing prices. In this respect too, the Riksbank has been a forerunner in the
world of central banking, albeit unintentionally. As far as I know, no other central
bank applying a policy that uses its interest rate to counteract the build-up of
financial imbalances, such as Norges Bank, has had to make such a clear and
important choice.
Having said this, I now also see more fundamental problems with a monetary
policy that leans against the wind, even when there is confidence in the inflation
target. I will return to this at the end of this speech.
Consequently, my interpretation of Sweden's experiences so far is that a policy
that leans against the wind has its limitations. For example, it seems, at least
under certain circumstances, that the policy rate would have to be set quite a lot
higher to effectively dampen the increase of debt. But such a policy could slow
down the economy as a whole quite seriously and risk leading to inflation falling
significantly below target for a long period. It is effects of this type that are
referred to in the international debate when arguing that the policy rate is far too
blunt an instrument to counter financial imbalances. Sweden's experiences also
suggest that the policy rate cannot always be expected to be available for this
purpose. Even when a central bank is leaning quite moderately against the wind, such
a policy could be in conflict with the task of maintaining confidence in the inflation
target.
Here too, of course, the question arises of whether it is really so important to
maintain confidence in the inflation target. Would it not be possible for monetary
policy instead to just lean against the wind and let inflation develop as it will?
Once again, I will return to this shortly.
Before continuing, I would like to add that there is a growing amount of research
that explicitly attempts to calculate the costs and benefits of using the policy rate
to attempt to counteract financial imbalances. The debate is ongoing and the jury
is still out.13 Of course, in this context, the view I present here should only be seen
as a country-specific case study. But considering that practical experience of this
type of policy is very limited, reflections from someone who has been involved in
taking decisions in a country that is 'ahead in the cycle' may perhaps be of some
value.
The period 2015-2017 - inflation rises
towards target again
In 2014, monetary policy came to focus on rapidly returning inflation to target and
anchoring inflation expectations. The repo rate was cut by 0.5 percentage points
to 0.25 per cent in July and further to zero per cent in October. At the beginning
of 2015, inflation was still very low and inflation expectations were developing in
a worrying manner (see Figure 3). The repo rate was cut further in 2015 and early
2016 to -0.5 per cent. In addition, the Riksbank started purchasing government
bonds on a large scale.
The expansionary policy gradually started to have effect. Growth rose and
employment increased. Inflation started to show a more-or-less rising trend in 2015
and again reached the inflation target in 2017. Inflation expectations also turned
upwards and long-term expectations are now again anchored around the target
(Figure 4).
The conclusion from the period 2015-2017 that I would particularly like to
emphasise is the following:
(iii) It may take a long time with a highly expansionary policy to bring
inflation up - but it is possible.
It could be claimed that neither is this conclusion particularly remarkable. It is the
conclusion that comes to mind first, having observed monetary policy and the
development of inflation in Sweden in recent years. But, in light of the current
international debate, it is nevertheless important and worth bringing up.
Conclusion (iii): It may take a long time with a highly
expansionary policy to bring inflation up - but it is
possible
As I have already mentioned, the first part of this lesson provides an important
reason for not losing sight of inflation and inflation expectations. If this is allowed
to happen, the way back may be difficult and arduous. In Sweden's case, CPIF
inflation was systematically below target for about six years, 2011-2016,
occasionally by a considerable margin. To halt and then reverse the fall in inflation, we cut
the repo rate to levels it had never previously approached and, in addition, the
Riksbank purchased large amounts of government securities. Significant
communication interventions were also required, for example when it came to describing
which development of the krona the Riksbank deemed to be compatible with
rising inflation. Unlike what had possibly been the case earlier, there can, from a
communication point of view, hardly have been any doubt of the Riksbank's
determination to reach the target.
This policy has thus contributed towards inflation rising and currently being in line
with the target. The situation is reminiscent of that in the mid-1990s, when the
Riksbank, despite widespread scepticism, managed to establish confidence in the
inflation target, even though the aim that time was to bring down inflation. There
are, of course, no guarantees that inflation will stay at around 2 per cent going
forward. Nevertheless, things look good so far, even though a lot of support from
monetary policy will still be necessary and further monetary policy easing cannot
be ruled out.
Links to the international debate
How, then, can Sweden's experiences be linked to the international debate - the
implicit ideological debate between the Yellen camp and the Borio camp? To
more easily understand this, it is useful to start by reviewing the debate in a little
more detail. There are, above all, two differences, which are closely related,
between the two camps: the view of the so-called Phillips curve and the view of the
possibilities central banks have to steer inflation.
The Phillips curve exists in different variations but, in one way or another, all of
these deal with the relationship between resource utilisation and the
development of prices or wages. The starting point is that, by adjusting its policy rate, the
central bank can influence resource utilisation in the economy. When resource
utilisation increases, prices and wages rise faster, and vice versa, via the Phillips
curve.
The Yellen camp's view is that the Phillips curve looks largely as it normally does
or, at any rate, has changed so little that it still works as an effective channel
through which central banks can influence inflation. According to the Borio camp,
the Phillips curve has instead almost broken down or, at any rate, changed so
much that it no longer forms a central part of the inflation process. More
specifically, high resource utilisation no longer results in higher inflation, according to
this view.
Instead, it is claimed, inflation is highly influenced by structural factors. Factors
often emphasised as exerting downward pressure on inflation are globalisation and,
looking forward, more and more digitalisation.14 These are arguments that those
who have followed the debate in Sweden in recent years will recognise. According
to this view, the central banks will find it difficult to steer inflation for a long time
to come. As I mentioned in my introduction, taken to its conclusion, this means
that it is pointless to set up targets for inflation, as this is mainly determined by
factors outside monetary policy. As I also noted earlier, the Yellen camp does not
share this view but believes that inflation targets are meaningful, important and
possible to attain.
Implications of the Swedish experiences
What view, then, should we take of the international debate in light of our
experiences here in Sweden? As I see it, our experiences overall are more in line with
the Yellen camp's view. One example is that it seems to be possible to reach the
target with a sufficiently powerful expansionary policy. One reservation here, of
course, is that we still cannot be certain that inflation will really remain around
the target, even if this is what the Riksbank expects.
Another reservation is that neither is it obvious what part the Phillips curve has
played in the rise of inflation in Sweden so far. Increased resource utilisation has
certainly gone hand in hand with rising inflation, but we have also seen that wage
increases have so far been surprisingly modest given the economic situation. In
that sense, it is too early to say whether Sweden's experiences suggest that the
Phillips curve is continuing to work like usual. But our experiences nevertheless
suggest that central banks' inflation targets are fully possible to reach. And the
recent, relatively rapid increases in service prices are, after all, a sign that some
form of Phillips curve is active (see Figure 5).
There has been quite a lively international debate on the Phillips curve recently -
about its slope and even about its existence.15 Personally, I take a fairly agnostic
view of it. I see it as a mostly qualitative relationship between resource utilisation
and inflation that does not say much more than that high resource utilisation
sooner or later tends to lead to prices and wages rising more rapidly and that low
resource utilisation leads to them rising more slowly. The effect on inflation of a
given level of resource utilisation can certainly vary over time, which is to say that
the slope of the Phillips curve is not necessarily always the same. The time
dynamics may also vary, that is the time lag of the impact of resource utilisation on
inflation is not always the same. In addition, inflation is, of course, affected all the
time by a series of other factors - various shocks, in the vocabulary of economics.
These can be highly temporary, but also relatively persistent. However, I find it
very hard to swallow, not to say completely unlikely, that, other things being
equal, there should be no relationship between resource utilisation and inflation.
My conclusion that it is important not to lose sight of inflation and inflation
expectations is also quite well in line with the Yellen camp's view, in the sense that the
inflation target and confidence in the target are seen as vital. It is worth noting
that there is a debate, not least in the United States, which has come the furthest
with its policy rate rises, about how rapidly monetary policy should be made less
expansionary.16 The concern is precisely that excessively rapid changes will make
inflation and inflation expectations fall below target again - something that there
thus is reason to avoid.
The conclusion that it could take quite significant interest rate rises to halt the
accumulation of financial imbalances is also more in line with the Yellen camp's
view. It points to the limitations of the policy that the Borio camp argues should
be given a greater influence, or possibly even be the main aim of monetary policy.
Inflation targets are necessary
However, as I have discussed, in this respect it is necessary to go a little deeper
into the analysis. More specifically, the issue of whether it is really necessary to
have a target for inflation at all needs to be addressed. Would it not be possible
for monetary policy instead to focus on attempting to counteract the
accumulation of financial imbalances and allow inflation to develop as it will?
As I see it, this would not be an appropriate set-up. In my view, it is extremely
important that there is an inflation target in which there is confidence, and that that
target is set at a sufficient distance from zero. It is quite common that debaters
who advocate a new type of monetary policy omit to discuss the problems that
could arise if the central banks were to abandon their inflation targets. This is also
the case in the Swedish debate.
If the central banks were to abandon their inflation targets in the current
situation, inflation would almost certainly fall and there would be a large risk that
inflation and inflation expectations would become permanently stuck on a very low
level. This would make it more difficult for monetary policy to counteract
recessions in the future. If average inflation is low, the nominal average interest rate
will also be low. And the lower the interest rate is in normal conditions, the less
scope there is to lower it before it reaches its lower bound.
A more general problem is that the inflation target acts as a benchmark for price
and wage formation - it forms what is usually called a nominal anchor in the
economy. When economic agents have a collective picture of how prices will develop
in the future, it becomes easier to plan for the long term. The absence of a
nominal anchor could also lead to not just inflation varying more, but also output and
employment. Assume that a negative shock impacts demand in the economy,
causing inflation to fall. If there is uncertainty about the inflation target, inflation
expectations may also fall in the slightly longer term. This will cause a rise in the
real interest rate, i.e. the interest rate corrected for inflation expectations, if the
nominal interest rate remains unchanged. The higher real interest rate amplifies
the effect of the original negative shock on demand and weakens the economy
even more, as it is the real interest rate that affects companies' and households'
investment and consumption decisions. In a corresponding way, a positive shock
to demand can make inflation and inflation expectations rise. It lowers the real
interest rate and contributes towards further increasing demand. When confidence
in the inflation target is weak and inflation expectations are not well anchored,
the result thus becomes larger fluctuations in the economy. We went through
such a development in Sweden in the 1970s and 1980s, when the fixed exchange
rate did not act as a sufficiently strong nominal anchor, which in turn resulted in
recurrent cost crises and devaluations.
The reason that debaters do not address the problems of abandoning the inflation
target could, of course, be that they consider that the process of inflation has
changed so much that central banks simply no longer can reach their inflation
targets. This seems after all to be quite a common view in the debate. This would
imply that it is not meaningful to set up targets for inflation, as it is determined by
factors outside monetary policy. However, this is an assumption that, were it
correct, would actually turn much of what is considered accepted within economic
science on its head. Economic paradigms do change every now and again, of
course. But, at a minimum, one may argue that quite a heavy burden of proof lies
on those claiming it is no longer possible to choose an inflation target. Among
other things, they would have to disprove Milton Friedman's thesis that inflation
is basically a monetary phenomenon.17
Having said this, in practice, it is probably more of a gradual scale than a binary
zero-one solution. Structural factors can push inflation down in a way that can be
difficult to counteract for a relatively long time, even if not permanently. It is
therefore quite an important discussion that the Borio camp has initiated.18 How
should a central bank act in a situation in which, despite conducting the most
expansionary policy it deems possible, it does not expect to be able to reach the
target in a foreseeable time frame? As I see it, the reasonable decision in such a
situation is to hold fast to the inflation target and continue with the expansionary
policy.19 If the central bank instead were to change its policy in a less expansiona