SPEECH
DATE:
9 December 2022
SPEAKER:
Deputy Governor Per Jansson
VENUE:
Swedbank
Monetary policy when inflation is too
high - prerequisites and challenges*
"There are decades when nothing happens; and there are weeks when decades
happen."
The words are said to be Vladimir Lenin's, but it is disputed whether that really is
the case. Nevertheless, the quotation is very well suited to what I intend to talk
about today.
Once a year, I usually make a longer speech, which is also published on the
Riksbank's website. The most recent was in December 2021.1 My speech then was
about the division of roles in macroeconomic policy, and my main message was
that in the future fiscal policy needs to be more active than has been the case in
recent decades.2
I emphasised in my speech that the inflation target needs to be symmetrical, that
is, it is as important to counteract too low inflation as it is to counteract too high
inflation. But at that time, too high inflation was not regarded as a particularly
pressing threat, nor was it something I specifically mentioned in the speech.
The situation has changed rapidly
To recall how the situation looked at the end of January this year, one can look up
the inflation forecasts of Swedish forecasters at that time. As energy prices had
begun to rise, all forecasters believed that inflation in 2022 would be higher than
the target of 2 per cent. But they all also expected that this effect would be
temporary and that inflation in 2023 would again be below the target on average
(Figure 1).3 The forecasters judged that these developments would be compatible
with a policy rate maintained at zero per cent in 2022. And only a few expected
modest increases in 2023.
Today, inflation is 9.3 per cent and the Riksbank, like other central banks around
the world, has raised the policy rate in rather large steps. This is as good an
illustration as any of how quickly and unexpectedly things have happened or, to refer
to my initial quotation, that decades have happened within a few weeks.
A natural conclusion is that this development was genuinely difficult to predict.
There are, of course, things that we could have predicted better, such as the
boost to inflation that came from the rapid recovery after the pandemic.
However, it would also have been necessary to foresee, for example, that Russia
would invade Ukraine in February 2022, that Russia would throttle its exports of
natural gas to Europe and that this would bring electricity prices up to
exceptionally high levels.
Two opposing types of criticism of monetary policy
There will always be those who claim, after the event, that things should have
been anticipated - and not rarely that they themselves actually did so. One
argument in the Swedish debate is that today's high inflation is an obvious result of
the expansionary policy previously pursued by the Riksbank and many other
central banks, during the rather long period when the problem was the reverse; that
is, it was difficult to bring inflation up to the target level.
It is certainly reasonable to assume that inflationary impulses from, for example,
rising energy prices will more easily take hold if demand in the economy has been
kept up by an expansionary policy than if it has not. But I find it difficult to push
the argument further than that. Apart from the fact that there are already
convincing explanations for the high inflation, it would require that a monetary policy
that has had difficulty for years in bringing inflation up to the target would
suddenly result in some kind of all-at-once effect, making inflation instead severely
overshoot the target. Even though monetary policy works with long and variable
lags, this would be an extreme example, with a very odd monetary policy
transmission mechanism.4
In the Swedish debate there is also an almost opposite argument. This states that
the high inflation is entirely due to the fact that the supply of commodities and
production inputs has been affected by the pandemic and the war in Ukraine, and
that it is therefore pointless and counterproductive for the Riksbank to try to
bring inflation down again by raising the interest rate. If you only wait for a while,
the effects on inflation will subside, and then it will fall back to the target by itself.
But that is also a questionable argument. Inflation is not only due to supply-driven
price rises, but has spread more widely in the economy. This has been partly due
to an unexpectedly rapid increase in demand during the recovery after the
pandemic. Various measures of underlying inflation, which capture such broader,
trend movements, have risen sharply during the year. That price increases are
broad-based is also underlined by the fact that they are visible in both goods
prices and service prices (Figure 2). Inflation is therefore not transitory, in the
sense that it falls back without monetary policy needing to react at all.
Sometimes, one adds an argument based on the fact that when the Riksbank
raises the interest rate, households' interest costs increase. This in turn means
that the demands for wage increases will be higher, which eventually will lead to
an even greater increase in inflation. This argument reverses the conventional
reasoning: Monetary policy would then no longer affect inflation by influencing
demand and inflation expectations, but by affecting interest expenditure - the
higher the interest rate and interest costs, the higher the inflation rate. I find this
way of reasoning unconvincing. It would mean that central banks would in future
have to act in a completely new way, which is not supported in either economic
theory or practical experience. It can also be noted that this argument was not put
forward during the period when inflation was low - that is, that the Riksbank
would then have needed to raise the interest rate in order to raise household
interest costs and ultimately inflation.
Temporary break from the low-inflation environment
rather than lasting change?
Before continuing, I would like to stress that, although much has happened in a
short space of time, this does not change the conclusion in my speech a year ago
- that fiscal policy and monetary policy need to interact in a better way than has
been the case in recent decades. My reasoning then was based on the fact that
the policy rate had for a long time been at, or very close to, its effective lower
bound - a bound below which it is not possible to reduce the rate further or
where the negative side-effects of doing so risk being very large. This
development was due to the fact that the global real equilibrium interest rate had fallen
for a couple of decades to a historically low level. This interest rate cannot be
influenced by the central banks, but neither can it be ignored when setting policy
rates - this is so as it is the distance between the policy rate and this normal
interest rate that determines how expansionary or restrictive monetary policy is. As
the real interest rate has fallen, the policy rate has had to be cut to ever-lower
levels for each business cycle. When the policy rate has hit the lower bound, there
are limited possibilities to use monetary policy to influence demand and inflation,
and my point was that fiscal policy therefore needs to take on a more active role.
The situation now is different, at least for the moment. Inflation is high and the
lower bound for the policy rate is no longer a restriction on monetary policy.
However, there may be other complications where fiscal policy can contribute to a
better economic outcome. I shall return to this.
It is also important to point out here that it is doubtful whether the global
economic playing field has been substantially altered in the longer run by what has
happened over the past year. In particular, it is difficult to see that the global real
equilibrium rate would have been significantly affected. According to most
estimates, it is expected to remain at a historically low level for the foreseeable
future. Since it determines what policy rates the central banks can set in the longer
term, this means that in a few years' time, when we have overcome today's high
inflation, we may well be back in a situation where monetary policy once again
has to deal with policy rates at the lower bound and inflation that is too low
(Figure 3).5
One possible caveat here is linked to the fact that the West has for a long time
been dependent on Russian energy and Chinese markets. Not least the pandemic
and the war in Ukraine have shown that this dependence has made many
companies and business operations vulnerable. It has therefore become increasingly
common to think about how the dependence can be reduced and production
made more robust. One way of doing this is through so-called reshoring, that is,
moving businesses closer to home again. In that case, the globalisation that has
contributed to dampening inflation over the last few decades would begin to roll
back.
This could mean that the 'headwind' that inflation has had for a long time is
turned into a 'tailwind'. Although the global real equilibrium rate would remain
low in the future, it does not need to become as common as it has been so far
that central banks' policy rates are at the lower bound. However, it is difficult at
present, when the geopolitical landscape is very uncertain and constantly
changing, to say what the significance of reshoring will be for central banks' monetary
policy and for the world economy more generally.
Similarities with the 1970s
But let us focus on the current situation. Inflation is now higher than at any point
during the whole period we have had an inflation target. In that sense, it can be
said that this is the first time that inflation targeting is put to the test in earnest
'on the upside'.6 In Sweden, inflation today is about the same as in the 1970s and
1980s, when average annual inflation was above 8 per cent (Figure 4).
This is not the only similarity to that period. The high inflation at that time was
triggered by similar factors to the high rate of inflation today. During the 1970s
energy prices increased as a result of geopolitical unease and production
disruptions in the Middle East, in a similar way as energy and commodity prices have
now been pushed up in the wake of the pandemic and the war in Ukraine.
An important explanation for the lastingly high inflation during the 1970s and
1980s was the expectations that economic agents had of future inflation. If
households and companies expect inflation to be high going forward, this will affect the
way that companies set their prices and the wage demands that households put
forward. The inflation that results from the inflationary price-setting and wage
formation confirms expectations and in turn affects the new expectations of
future inflation. This gives a new round of effects on price-setting and wage
formation, and the high inflation thus becomes a self-generating process.
One reason why the high inflation was built into expectations among households
and companies was that it was not sufficiently counteracted by the overall
economic policy. Instead, this policy became systematically too expansionary.
At that time, Sweden had a fixed exchange rate. The idea was that this would
have a disciplinary effect on price-setting and wage formation: If Swedish prices
and wages increased faster than prices and wages abroad, our competitiveness
would weaken, exports would decline and unemployment would increase.
However, the domestic inflation trend was nevertheless too strong. When prices and
wages in Sweden rose faster than those abroad, it created expectations among
economic agents that the resulting cost crises and unemployment would be
mitigated by writing down the value of the krona, that is, through devaluation. The
recurring devaluations then fulfilled the high inflation expectations. In addition,
wage formation in itself was not functioning well because of shortcomings in
coordination between the social partners.
As the aim was to hold a fixed exchange rate, there was no real possibility to
dampen the inflation trend through interest rate increases. Monetary policy
needed to be focused on maintaining the chosen exchange rate relationship. Nor
was fiscal policy sufficiently tight. This economic environment was a good
breeding ground for lastingly high inflation. While the inflation trend in the United
States, for example, was broken in the early 1980s in connection with a
reorientation of monetary policy under the then head of the Federal Reserve, Paul Volcker,
it was not broken in Sweden until the crisis in the early 1990s.
Better designed frameworks provide good
prerequisites
The challenge faced by the world's central banks today can be described,
somewhat simplified, as preventing a repeat of the inflation experienced in the 1970s
and 1980s by the current high inflation becoming entrenched in economic agents'
expectations. As many things are different today compared to then, the
conditions for meeting that challenge are quite favourable.
After the crisis in the 1990s, major changes were made to the Swedish economic
policy frameworks. Instead of defending a fixed exchange rate, the task of
monetary policy would be to keep inflation low and stable. In January 1993, the
Riksbank announced that an inflation target of 2 per cent would enter into force as of
1 January 1995. Gradually, the new order was confirmed through changes in the
monetary policy framework. The price stability target was written into the law in
1999 and monetary policy decisions were delegated to an independent Executive
Board. The Riksbank is therefore now in a much better position to take forceful
action to counteract high inflation. Another facilitating factor is, of course, that
the period of inflation targeting has meant that long-term inflation expectations
are initially much better anchored than they were in the 1970s and 1980s.
Fiscal policy, for its part, would focus considerably more than before on keeping
public finances in good condition so as to maintain market confidence. The budget
process was changed so that it would be easier to gain control over expenditure
developments, while public net lending would, on average, be positive through
the so-called surplus target. These changes have meant that fiscal policy no longer
contributes in itself to persistently high inflation, as was the case in the 1970s and
1980s.
Swedish wage formation was also changed and now works in a completely
different way than in the 1970s and 1980s. One important reform was the so-called
Industrial Agreement in 1997, which has meant that the manufacturing industry
sets the benchmark for wage negotiations and ultimately steers wage costs in the
entire economy. This functions as a brake in the system and reduces the risk of
price-wage spirals.
At the international level, the world's central banks have also reacted in a
different way than in the 1970s. This is also largely due to changes in the monetary
policy framework, which place more focus on keeping inflation low and stable. There
have been discussions that policy rate increases have been too slow in some
economies, and monetary policy has therefore fallen 'behind the curve'. However, the
reaction has been relatively swift and, perhaps more importantly, relatively
simultaneous (Figure 5). The fact that central banks have acted both relatively early and
in unison should mean that there are good prospects for dampening global
inflation.
Risk of central banks going too far?
However, there are those who argue that this more or less simultaneous and
powerful response from the world's central banks is not necessarily a good thing,
but that synchronisation could comprise a problem.7 The idea is this: Each
individual central bank tends to focus on inflation in its own country and raise the policy
rate to curb it. But inflation in each individual country is also affected by how high
inflation is abroad, for example via import prices. The extent to which
international inflation is affected by one's own increases in interest rates is not usually
taken into account, since the effect is assumed to be negligible. To use an
economic term, individual central banks do not internalise the effects of their own
actions on international inflation. However, as all central banks raise their rates
simultaneously, international inflation is dampened quite significantly. The results of
not taking this effect into account could be that all central banks go a little further
in their policy rate hikes than they need to. This in turn may lead to the whole
world economy becoming weaker than necessary.8
This is an interesting hypothesis worth considering, although it is not easy to see
how it could be taken into account in practical policy. Formal international
coordination of monetary policy is probably not on the cards, and without this it is
natural that each individual central bank continues to focus on inflation in its own
country. But a positive interpretation is that if this is something central banks
nevertheless have at the back of their minds, the risk of excessive interest rate hikes
in individual countries is reduced.
Easier communication when inflation is too high...
The conditions are also favourable in terms of communication. As I stated earlier,
it was not possible to use monetary policy for macro-stabilisation purposes in
Sweden in the 1970s and 1980s, because the interest rate was directed at
defending the fixed exchange rate. There was therefore, in principle, no monetary policy
communication either. However, compared with the period we have gone
through more recently, where it has been difficult to reach the inflation target
from below, communication about monetary policy has in a way become easier.
Everyone agrees that high inflation is a bad thing. You simply get fewer goods for
the same amount of money when you go shopping and in that way you become
poorer. This is something that is evident in everyone's day-to-day life.
The fact that it is quite easy to explain that high inflation is problematic does not
mean that everyone will be in favour of the interest rate hikes that are necessary
to deal with the problem. In addition, if a period of weak economic development
is required for inflation to return to the target, a specific challenge arises: One
needs to explain that this is preferable to a development in which the high
inflation rate will instead be lasting. Of course, this is not so easy as the public is aware
of what has happened, but not of what could have happened.
However, on the whole, I think most people have quite a lot of understanding that
a central bank with an inflation target of 2 per cent cannot simply sit and wait for
an inflation rate of around 10 per cent to fall back, without doing something
about it. It was, of course, largely through this type of policy that high inflation
could gain hold in the 1970s. That said, it is of course a question of judgement as
to exactly how much the interest rate needs to be raised. I will come back to what
the return to the inflation target might look like in different scenarios.
... than when it is too low
I feel that it has been more difficult to convey that it is equally problematic if
inflation is persistently too low. During the period of low inflation, the Riksbank has
been criticised from some quarters for trying to bring inflation up to the target of
2 per cent and therefore keeping the policy rate low, despite the fact that
developments in the economy have otherwise been relatively good.
Examples of arguments put forward are that the Riksbank should "apply the
target more flexibly" and not "chase tenths of a per cent" of inflation. But this
reflects a misunderstanding of what the Riksbank's motives have been as well as the
purpose of the inflation target. It has never been a question of inflation having to
be 2 per cent just for the sake of it, but because this is a way of ensuring that 2
per cent remains the long-term anchor for price-setting and wage formation in
the economy. In the same way that high inflation risks affecting economic agents'
long-term inflation expectations, too low inflation also risks doing so.
Since nominal interest rates include compensation for inflation, these rates will on
average be lower, the lower the average and expected rate of inflation is.
Moreover, there is an effective lower bound for the policy rate, where the positive
effects of further cuts cease and the negative ones begin to dominate. The
combination of a low average interest rate and a lower bound for the policy rate means
that the scope for cutting the interest rate will be limited.9
Monetary policy's ability to stimulate the economy in serious economic
downturns, when this is really needed, will thus be reduced. The fact that monetary
policy has sufficient scope to do this is of course important, but it is perhaps not
something that people notice in their everyday lives, in the same way that they
notice if prices rise in the shops.
It is worth pointing out here, which I often and willingly do, that if one thinks that
it does not matter that inflation on average is below 2 per cent and at the same
time dislikes a zero or negative policy rate - which seems to be a fairly common
combination of views - then these are two arguments that contradict one
another. If average inflation is below 2 per cent, then a zero or negative interest rate
will inevitably become even more common.
As inflation today is far too high, this discussion has for the moment disappeared
from the agenda. However, as I said earlier, it is not impossible that we might
return to a situation in a couple of years where it will reappear.
A good and a bad scenario
The present economic policy frameworks thus provide favourable conditions for
returning to the inflation target within a reasonable time perspective. And there is
no doubt that the Riksbank has the tools required to achieve this. When it comes
to raising the policy rate, there is no upper bound in the same way as there is a
lower bound. Of course, interest rate hikes are associated with costs too, but the
difficulties of bringing inflation back to the target are not about binding
restrictions but about how quickly this can reasonably be achieved. Even if
considerable strains might be imposed on the real economy during the process, there is no
doubt that we will do what is necessary to meet the inflation target.
This has to do with the fact that the development of the Swedish economy further
ahead would be even worse if high inflation were allowed to become entrenched
- we know this from experiences both in Sweden and in other countries. The
question is not, therefore, whether inflation will return to the target, but how it
will happen, and how the Swedish economy will develop during this process. It
can be painful, but it can also be relatively smooth.
How well the Swedish economy in general develops depends on the interaction
between different agents. This is an insight that I think has become somewhat
neglected, and that was the reason for the speech I held a year ago on the division
of roles between fiscal and monetary policy. But it is not just a question of the
macroeconomic policy mix. It is about a broader interaction, involving many
economic agents.
Let me describe how inflation can be brought back to the target in a favourable
scenario. In principle, it is the Riksbank's current forecast that I am describing, but
without numbers and in more general terms.
The increases in the policy rate that the Riksbank has made, and expects to make,
contribute to the fact that inflation will start to decline in 2023. Also contributing
to this is that factors causing restrictions on supply, and temporarily pushing up
commodity prices, are fading away, and that international inflation is being
curbed by central banks raising their policy rates. The economic agents trust that
the high inflation rate is temporary and will return to the target fairly soon. The
longer-term inflation expectations will thus remain anchored at 2 per cent. Wage
increases and the Industrial agreement benchmark are based on the assumption
that the inflation target will continue to apply in the future, despite the temporary
rise in inflation. Companies are refraining from excessive price increases, which
risk giving rise to compensatory wage increases that increase their costs, and
which force the Riksbank to raise the policy rate further, which will drive their
costs up even more. In turn, fiscal policy focuses on targeted support to
households and companies that suffer particularly badly in the poorer times that can
hardly be avoided going forward. In such a scenario, the inflation target will be
able to continue to provide a basis for a long-term favourable development in the
Swedish economy, without very large policy rate hikes by the Riksbank (Figure 6).
In a bad scenario, the opposite happens. Interest rate hikes will be insufficient and
economic agents start to doubt that inflation can return to the target in the
foreseeable future. This leads to the longer-term inflation expectations in the
economy rising. Wage increases are based on inflation being more permanently high,
and in this situation companies do not see any major problems with continuing to
raise prices - a price-wage spiral like the ones in the 1970s and 1980s starts. Fiscal
policy focuses on broad-based support rather than on more targeted measures.
This drives up aggregate demand in the economy as a whole and contributes to
the high inflation rate becoming entrenched. Here, the interaction between fiscal
policy and monetary policy again becomes inadequate.10 To curb inflation, the
Riksbank must raise the policy rate considerably more than we now expect.11
Since households and companies are heavily indebted, this can have very
significant negative repercussions. Even in such a worse scenario, inflation will
eventually return to the target, but it will take longer and be considerably more painful
for everyone in Sweden. Of course, it is not necessary for all of this to go wrong to
cause a bad scenario with more permanently high inflation. It is enough that some
of it does.
Interaction important even when inflation is too high
Let me round off. I often point out that the inflation target is not just the
Riksbank's target but is a target for society as a whole. Of course, it is the Riksbank
that is appointed to attain it, but how well this succeeds is of great importance
from a much broader economic perspective. There is strong political support for
the inflation target, which, in turn, is based on the conviction that the economy
simply works better with a specific, low and stable inflation rate. The
development we have had since the introduction of the target also indicates that this is
indeed the case (Figure 7).
Over the past decade it has become clear that a system where responsibility for
the inflation target is seen as entirely resting with the Riksbank, and not as
something which agents in general should support, can be problematic. This was
evident during the long period when the Riksbank's policy rate was close to the
lower bound, and the Riksbank also supplemented its policy with other measures
such as asset purchases, but it was nevertheless difficult to bring inflation up to
the target. This was not a specifically Swedish phenomenon, but a problem that
many advanced countries wrestled with. Monetary policy in isolation was simply
not enough. It needed support from other policy areas and agents, who, whether
they like it or not, also play a role in the development of inflation. And although
we now have well-designed frameworks in place for different policy areas, this in
itself is not always sufficient to ensure a good economic outcome - the
frameworks must also work together and result in a meaningful whole.
A lot has certainly changed in a year. Inflation has risen substantially around the
world, and central banks have raised their policy rates quickly and quite a lot. The
problems with the lower bound for the policy rates and too low inflation have
therefore disappeared from the agenda at the moment. However, as I have noted,
it is far from clear that the global economic playing field has changed in any
profound way in the longer run. Above all, there is a great deal to suggest that the
global real equilibrium interest rate remains at a historically low level. It is
therefore possible, perhaps even likely, that these problems will reappear in a few
years' time.
But perhaps my most important message today is that there is a need for
interaction between different agents in the economy also when inflation is too high, as it
is today. It is true that the policy rate is not restricted upwards in the way that it is
downwards - it can be raised without it hitting any ceiling. But even if there is no
such restriction on raising the policy rate, the problems gradually increase the
higher the policy rate has to be raised to bring inflation back to the target. It is
therefore not a question of whether inflation will be able to reach the target at all,
but of how large the cost will be for the Swedish economy in the short term to
attain this. The better the interaction, the smoother the slowdown in inflation will
be.
If we really see the inflation target as a macroeconomic target that provides
favourable prerequisites for a good long-term economic development, such
interaction should be both possible and desirable to achieve.
References
Auclert, Adrien, Hannes Malmberg, Frederic Martenet and Matthew Rognlie
(2021), "Demographics, Wealth, and Global Imbalances in the Twenty-First
Century", NBER Working Paper 29161.
Calmfors, Lars, John Hassler and Anna Seim (2022), Samspel för stabilitet - en
ESO-rapport om rollfördelningen mellan finans- och penningpolitik, (Interaction for
stability - an ESO report on the division of roles between fiscal and monetary
policy), report to the Expert Group for Public Economic Studies.
Jansson, Per (2020) "Thoughts on the need for changes to inflation targeting",
speech at Handelsbanken, 16 December.
Jansson, Per (2021), "Is it time to review the division of roles in macroeconomic
policy?" speech at Sveriges Riksbank on 8 December.
Obstfeld, Maurice (2022), "Uncoordinated monetary policies risk a historic global
slowdown", blog post, Peterson Institute for International Economics,
https://www.piie.com/blogs/realtime-economic-issues-watch/uncoordinatedmonetary-policies-risk-historic-global-slowdown.
Figure 1. Different inflation developments than forecasters expected in January
Annual percentage change
12 12
Range of other forecasters'
estimates
10 10
MPR Feb
8 8
CPIF
6 6
4 4
2 2
0 0
-2 -2
Jan-20 Jul-20 Jan-21 Jul-21 Jan-22 Jul-22 Jan-23 Jul-23
Note. Refers to forecasts based on outcomes for the CPIF up to and including December
2021. The range shows the dispersion between highest and lowest estimates of other
forecasters.
Sources: Statistics Sweden, individual forecasters and the Riksbank.
Figure 2. A broad rise in inflation - not just rising energy prices
Sub-index in the CPIF Measures of underlying inflation
Note. Annual percentage change. The range in the figure on the right shows the highest
and lowest outcomes among seven different measures of underlying inflation.
Figure 3. Policy rates are eventually determined by the global real equilibrium
interest rate
Source: The Riksbank.
Figure 4. Inflation as high as in the 1970s and 1980s
Annual percentage change
16 16
1970-1992
14 14
Average: 8.2
CPIF
12 12
10 10
8 8
1995-2022 October
Average: 1.7
6 6
4 4
2 2
0 0
-2 -2
1970 1980 1990 2000 2010 2020 2030
Note. Inflation is measured as the CPIF and before 1987 as the CPI excluding interest rates.
Figure 5. Central banks have reacted relatively quickly and unison
Policy rates Increases so far this year
4
3
2
1
0
BoC FED BoE RB ECB NB
Note. Per cent and percentage points.
Sources: National central banks.
Figure 6. In a good scenario, the Riksbank does not need to make very large
interest rate hikes
Real policy rate Nominal policy rate
Note. Per cent. The real policy rate is the Riksbank's expected real interest rate, calculated
as a quarterly mean value of the Riksbank's policy rate forecast one year ahead minus the
inflation forecast (CPIF) for the corresponding period. As the real interest rate is a
forward-looking variable, the outcomes are also based on forecasts. The outcomes are
calculated on the basis of the most recently published forecasts at that point in time.
Source: The Riksbank.
Figure 7. Favourable development during the inflation-targeting period
Yield differential against Germ