SPEECH
SVERIGES RIKSBANK
DATE:
10 June 2020
SE-103 37 Stockholm
SPEAKER: (Brunkebergstorg 11)
Governor Stefan Ingves
VENUE:
Swedish Economics Association
Tel +46 8 787 00 00
Fax +46 8 21 05 31
registratorn@riksbank.se
www.riksbank.se
The monetary policy toolbox*
The spread of the coronavirus came as an unpleasant surprise to us all. It is now
clear that the economic consequences of the pandemic threaten to be both
serious and protracted. Most analysts have very weak forecasts for economic
developments in the coming quarters, and in some scenarios also for a longer
period to come. We are in the midst of an unforeseen economic development
that needs to be met with various macroeconomic tools, and the Riksbank has an
important role to play here, together with the Government, the Riksdag (Swedish
parliament) and other authorities.
During the initial phase of the crisis, we Executive Board members have already
taken a large number of decisions to support the Swedish economy, and thus
contribute to meeting the targets for economic policy, and I will comment on
what we have done in more detail later on. We can note that many of the
measures have major consequences for the Riksbank's balance sheet - something
that will be a recurring theme in today's speech.
Today I intend to focus primarily on how the "monetary policy toolbox" needs to
look to be able to manage future challenges. I will take a longer perspective and
discuss which tools the Riksbank may need to use, especially if the low interest
rate scenario that has characterised the past 10 years becomes even more
prolonged.
The fact that monetary policy measures affect a central bank's balance sheet has
become increasingly common in large parts of the world. This development has
been driven by the very low interest rates and the need to make monetary policy
even more expansionary. Essentially, it is nothing new - if we go back in time,
there are many examples of central banks that have used variation in their asset
portfolios as a means of conducting monetary policy. The monetary policy toolbox
also needs to take into account changes in the financial system; for instance, we in
Sweden have, in recent years, seen a development towards a higher share of
market financing for Swedish companies.
As things look now, there is considerable probability that global interest rates will
remain low over a long period of time, and then monetary policy will have to find
other ways of working to attain the inflation target than those we are used to, and
many of the measures will have consequences for the balance sheet. We need to
endeavour to attain a better analysis of how measures that have an effect
through the balance sheet affect the economy and become as clear and
systematic when we talk about these as we have tried to be with regard to
steering interest rates.
I intend to begin with a historical retrospective - focusing on the past 30 years -
and to describe how monetary policy has developed over time. Then I will move
on to the challenges that monetary policy has faced and that have led to the use
of new tools. This takes me to the international discussions about the monetary
policy toolbox, and, in conclusion, I would like to discuss what opportunities and
limitations the Riksbank Inquiry's proposed new act entails.
The development of monetary policy - a
retrospective
Ever since central banks in the modern sense were created, their objective has
been clear: to provide the economy with a payment system and with a means of
payment and to ensure that the value of these funds remains stable over time.
Central banks have been able to conduct monetary policy to attain their
objectives - price stability and a smoothly functioning payment system - by
varying the volume of the means of payment or adjusting terms and conditions in
their payment systems. The central banks provide liquidity that enables us to
make payments smoothly.
Gold standard and redeemable money create
credibility
During the second half of the 19th century, the gold standard was introduced. The
meant that the value of a banknote, the means of payment at the time, was
directly linked to something real in that the banknotes could be redeemed for
gold in the central bank.1 However, fiscal policy tensions as a result of world wars
and the economic depression in the United States in the 1930s led to the abolition
of the gold standard. In addition, payments markets were developed so that other
means of payment than cash gained importance. When the link to gold no longer
existed, a new 'nominal anchor' was needed. The answer became the central
bank's credibility: a responsible monetary policy aimed at price stability. Over a
long period, the gold standard was replaced by a regime with fixed exchange
rates, where a small number of central banks in practice conducted monetary
policy for the entire world and thus 'lent' their credibility.2 In Sweden, this system
of fixed exchange rates did not function so well and this led to several major
devaluations. The larger central banks also lost credibility for various reasons and
the global economy underwent a period of high inflation in the 1970s and 1980s.
Independent central bank with inflation target replaces
gold
The global developments over the past 30 years have entailed major changes to
the monetary policy landscape, not least in Sweden. During the 1980s, work
began in the leading countries of the world economy on rebuilding the confidence
in monetary policy that had been lost in the 1970s.3
At the beginning of the 1990s, Sweden experienced a severe financial crisis
following the rapid winding up of several decades of hard regulation of the
financial markets. During the crisis, there was strong pressure to devaluate and
the defence of the fixed exchange rate finally became untenable. When the
Riksbank abandoned the fixed exchange rate, monetary policy sought a new way
to promote price stability, and Sweden joined the global trend of reinforcing the
credibility of monetary policy. The answer became a more independent Riksbank
with an explicit inflation target, and Sweden became one of the first countries in
the world to try this new path. After a few years of getting used to this new way
of conducting monetary policy, there was a long period of relative calm in large
parts of the world. Many countries introduced a similar policy that had the more
or less explicit target of holding inflation close to 2 per cent. From the middle of
the 1990s until 2008, inflation was on average fairly close to the target and
developments in the real economy were more stable than before. Blanchard and
Simon (2001) were among the first to document this phenomenon, which came to
be called the 'Great Moderation'. But even then, there were discussions of
whether the phenomenon was due to structural changes, skilful macroeconomic
policy, including monetary policy, or quite simply luck.
At the beginning of the 1990s, the Riksbank's balance sheet grew in connection
with the foreign currency reserves being reinforced through loans (see Figures 1
and 2). When the fixed exchange rate was abolished, it was decided that there
was less need to hold foreign currency reserves for monetary policy purposes and
the size of the balance sheet declined fairly rapidly. Between 1994 and 1998,
domestic bond positions were sold off and foreign currency loans were repaid.4
Instead, the Riksbank conducted monetary policy with a minimal toolbox in this
new environment. The repo rate, which is the base for the lending and deposit
rates the Riksbank applies with regard to the commercial banks, was adjusted to
ensure monetary policy was well balanced. Weak inflationary pressures and low
resource utilisation led to interest rate cuts and vice versa. Even the reserve
requirements that many other central banks around the world still use were set at
zero way back in 1994, and have remained unchanged since then.
Figure 1: Assets on the Riksbank's balance sheet 1980-2019
Note. SEK billion. Annual data where the final observation is 2019. The broken line indicates corona-related
measures.
Source: The Riksbank
Figure 2: Liabilities on the Riksbank's balance sheet 1980-2019
Note. SEK billion. Annual data where the final observation is 2019. The broken line indicates corona-related
measures.
Source: The Riksbank
The communication when the inflation target was introduced was clear and
successful - inflation expectations were gradually adapted down to the target of 2
per cent and wage formation functioned well when both employer and employee
could assume that average inflation would be close to the target.
Steering the interest rates worked well during this period, despite the Riksbank
using a very small toolbox when conducting its monetary policy. We went from
doing to mostly talking about monetary policy. But the fact that this works is
based on the Riksbank having built up credibility on the market and that it is ready
to use its balance sheet if market rates were to deviate from the desired levels.
On Wall Street there is an expression "Don't fight the Fed" - which means it is not
a good idea to take positions based on the assumption that the central bank will
fail to attain the interest rates aimed for. Steering interest rates is also based on
the fundamental transmission mechanism functioning - that other interest rates
in the economy actually change when the shortest money market rates the
Riksbank affects are changed. How well this functions depends on different
conditions in the financial sector that can be state-dependent.
A similar development took place in many countries during this period - the
central bank's job conducting monetary policy was relatively simple.
But below the calm surface, two interlinked problems were bubbling up - a trend
fall in real interest rates and rising debts. I have talked about these problems on
several occasions.5
Falling interest rates
Over the past 30 years, interest rates around the world have fallen heavily. This is,
of course, partly due to the central banks conducting a monetary policy that has
succeeded in bringing down the average level of inflation from the high levels of
the 1980s, which has been good. But it is also due to a global development
towards lower real interest rates (see Figure 3), something that most say has not
had anything to do with monetary policy, but instead is explained by real
economic factors.6 Holston, Laubach and Williams (2017) have carried out
empirical research into how the 'equilibrium real interest rate' has developed in
some leading economies, and they find a clear downturn after the financial crisis
2008-2009.
Three of the several attempts to explain why real interest rates are now much
lower than before are particularly worth mentioning. The first explanation is
based on fundamental economic theory, according to which the real interest rate,
at least in a closed economy, will be in proportion to growth in the economy, and
the latter has slowed down in recent years. The second concerns the 'global
savings glut', that is that (primarily) the major economies in Asia and the Middle
East have generated large trade surpluses and thereby increased demand for
savings, which tended to push down interest rates as the supply of safe assets is
limited. The third explanation highlights demographic developments. The idea is
that an ageing population needs to save for its pension, which once again leads to
an increased tendency to save, which in turn pushes down the real interest rate.
With today's integrated capital markets, we will have a global trend with lower
real interest rates. An individual country with a floating exchange rate may
deviate from this trend in the short term, partly for cyclical reasons and partly
because global investors may demand a time-varying risk premium to invest
there, but in the longer run the real interest rate in a small open economy will
follow the global trend downwards.
The challenge for monetary policy is that the low real interest rate limits the
monetary policy scope to manage a severe recession by cutting the repo rate. The
nominal interest rate cannot continue to be cut indefinitely - a negative repo rate
makes it increasingly attractive to hold cash. Even if frictions in the banking
system make it possible to have a weakly negative repo rate, it is not possible in
practice to cut the repo rate indefinitely. The average repo rate is the total of the
average real interest rate and the inflation target - the lower the real interest rate
is, the lower the average repo rate is and thus there is less scope for interest rate
cuts in a recession.
Figure 3: Global real interest rates have fallen in the past 25 years
Note. Per cent.
Source: Lundvall (2020).
Increased indebtedness
Parallel with the fall in real interest rates, indebtedness has increased in Sweden
and in many other countries (see Figure 4). In some countries, citizens have
become indebted through the state - a national debt of more than 100 per cent
of GDP is beginning to be common. In other countries, such as Sweden, the
national debt is low, but instead private indebtedness is high. A large part of this
development can be explained by lower interest rates. Households' interest
expenditure as a share of their incomes is not so much higher now than before,
despite the large rise in debts. The debts have mainly been used to finance
housing purchases, and, as the supply of housing has been relatively sluggish
(although construction has been high in recent years), housing prices have risen
substantially.
But if we can explain part of the increase with low interest rates, does this mean it
is not a problem? No, I don't think so. A high level of indebtedness leads to large
risks - if interest rates rise, then households will have a much higher interest
burden.
Monetary policy is conducted to attain an inflation rate close to the target and
stable resource utilisation. The problem is that monetary policy has an impact
through several different channels, including households' consumption decisions,
the exchange rate and investment. Monetary policy that is well balanced on the
basis of inflation and resource utilisation in the economy as a whole can be
problematic for a group of households that is highly indebted. In this situation, it
is important that the banks and Finansinspektionen ensure that credit granting is
sustainable. Moreover, households' interest rates may rise without the Riksbank
raising the repo rate - if problems arise in the banking sector that mean the
banks' financing costs rise. If the global tendencies that have pushed down the
real interest rate are reversed, this would most probably push up interest rates in
Sweden too. And one should remember that it is easy to increase the debt when
the interest rate is low, but more difficult to reduce it when the interest rate is
high.
Figure 4: Indebtedness as a percentage of GDP
Note. Per cent of GDP.
Source: Statistics Sweden
Almost all major financial crises have been preceded by a large increase in credit
volumes.7 There is no consensus on why this is the case, but I believe that
increased leverage means increased risks. Moreover, if short market financing
becomes more common when credit grows rapidly, the risks linked to banks'
short-term liquidity management increase.
The global financial crisis concludes the
Great Moderation
The dream of a world where fine-tuning monetary policy eliminates cyclical
fluctuations and leads to an entirely stable economic development was definitely
burst by the financial crisis 2008-2009. In the United States, the foundation for the
crisis was created when borrowers with weak debt-servicing ability were given the
opportunity to take large loans with their homes as collateral. The loans were
often sold on to other financial institutions packaged together with other assets,
until it was finally difficult to know which financial institutions were exposed to
the impaired loans. When the uncertainty spread, it had unexpectedly large
effects and repercussions on the entire world economy. Financial crises took place
in several countries in the euro area and in the United Kingdom. The world's
central banks reacted by implementing powerful measures - a lesson learnt from
earlier crises is that the reactions of central banks are decisive for the sequence of
events. Many say, for instance, that one of the reasons why the 1930s crisis in the
United States became so serious was that the Federal Reserve's monetary policy
was too tight.
Although it is difficult to distinguish the purpose of different measures, we can say
that the financial crisis roughly entails three different types of problem for the
central banks: liquidity problems, problems with market functioning and
difficulties managing an unusually deep recession. In addition, a long line of
solvency problems arose. The fact that different central banks, to some extent,
chose different measures during the phases of the crisis reflects which problems
needed to be counteracted at different points in time.
Central banks offered liquidity during the crisis
The acute liquidity problems arose when unease spread and various actors began
to question their counterparts' creditworthiness. This led to many financial agents
having problems obtaining short-term market financing. Many of these agents had
a business model based on lending or investing money in the longer term and
regularly obtaining financing through different forms of short-term market funding.
When access to short-term funding was strangled, there was an overhanging threat
of suspension of payments. To counteract this problem, many central banks
established different types of 'facility, where a number of financial institutions
could borrow money against various forms of collateral - even those that could not
be sold at a reasonable price on the market.
Here we can see that the central bank has an important task to fulfil in a crisis: to
take on risk in a time when no one else is willing to do so. In a crisis, there is a risk
of a 'fire sale' dynamic arising. Institutions that cannot replace their funding are
forced to sell off assets, which leads to a fall in prices If the central bank, in this
situation, goes in and offers the actors loans with these assets as collateral, and
does not fully apply the prevailing market valuation, the market can stabilise. The
purpose of the measure is primarily to preserve financial stability by ensuring that
the liquidity supply functions. But if the central bank does not support the liquidity
supply, there is the threat of a credit crunch and bankruptcies, which will, of course,
in turn have macroeconomic effects that impact the monetary policy objectives. It
is often difficult to distinguish between what is monetary policy and what is
financial stability policy, both in purely practical terms in the current situation, and
on a more theoretical level.8
Central banks supported market functioning
The next group of problems is related to market functioning. Some markets for
important securities can become so uncertain during a severe crisis that no private
investor is prepared to buy these assets. Or else the uncertainty on the financial
markets can lead to severe fluctuations in the compensation the financial agents
require to invest in risky assets (risk premiums). This could in turn threaten the
monetary policy transmission mechanism. This type of problem affected the very
important US housing bonds during the financial crisis. To avoid a substantial credit
crunch for US households, this market needed to keep functioning. During one
period, therefore, the Federal Reserve purchased a very large share of the newly
issued housing bonds, which had the desired effect - the market stabilised.
Sometimes all it takes is for the central bank to make it clear that it will act if
problems arise. The actual signal may then be enough to calm the market.
Sometimes a facility will do the job. If the market is worried it will be difficult to
temporarily convert an asset into liquidity on private markets (for instance through
repos), the central bank's facility may be sufficient to calm the situation. If this is
not enough, the central bank can use direct purchases to compensate for the
market's unwillingness to take risk. We note that it is the possibility to expand a
central bank's balance sheet, indirectly or directly, that creates the capacity to calm
the situation.
Lower bound for repo rate motivated other monetary
policy measures
The severe recession that arose in many countries in the wake of the financial crisis
was initially managed through very large interest rate cuts. But these were not
sufficient - resource utilisation was assessed to still be very weak and inflation
prospects were low. In this situation, several central banks decided that further
measures were needed to make monetary policy more expansionary.
Both the current interest rates and expectations of future interest rates play a role
when households and companies make decisions on consumption and investment.
One of the first measures taken by many central banks was therefore to
communicate the probable development of their policy rate over the coming years,
what is known as 'forward guidance'. Different forms were discussed and tested in
different countries. Both unconditional promises ("the policy rate will not be raised
for a good 2 years") and conditional promises ("the policy rate will not be raised
until inflation again reaches 2 per cent") were tested. The Riksbank's own repo rate
path can be regarded as a form of forward guidance.
Many central banks assessed that policy rate cuts and communication of future
action were not sufficient when monetary policy needed to become even more
expansionary. They then resorted to a further type of measure, known as
'quantitative easing', which means pushing down long-term market rates on
various markets through direct purchases of financial assets.
A further measure introduced by both the Bank of England and the ECB was
'funding-for-lending' programmes. The idea behind these is that the banks can
borrow money at a low cost for the explicit purpose of increasing lending to
households and companies. These measures were introduced when a credit
crunch threatened to hamper growth.
Sweden, as a small open economy, was hit hard via trade with other countries,
despite the financial problems in our country being much milder than in many
other countries, although there was initial unease over the Swedish banks'
exposures in Estonia, Latvia and Lithuania. The repo rate was cut by more than
four percentage points to alleviate the effects on the Swedish economy. In
addition, several measures were implemented with the purpose of supporting the
Swedish financial system. The Riksbank lent SEK 400 billion to Swedish banks and
also lent the equivalent of almost SEK 200 billion in foreign currencies to help the
Swedish banks with short-term liquidity problems. During 2010, the Swedish
economy grew strongly and the Riksbank and many other analysts forecast a
global economic upturn and a rapid recovery in the Swedish economy. The
Riksbank therefore began its repo rate increases, but was force to back down
when it became clear that the global economy was weaker than anticipated.
Moreover, long-term inflation expectations fell. In 2015, the interest rate was cut
to -0.5 per cent. The Riksbank also bought a large amount of government bonds
to further stimulate economic development. The Riksbank has also reinforced the
foreign currency reserves to have a better preparedness to give Swedish banks
access to foreign currency in a crisis situation. Both of these measures led to the
Riksbank's balance sheet becoming much larger than it was before (see Figure 1).
The Riksbank's response to the coronavirus
At the beginning of 2020, the world once again suffered a global economic crisis,
this time in the form of the repercussions of the coronavirus outbreak. The
measures taken to reduce the spread of the virus have had very large economic
consequences and created a need for support measures from various authorities.
The Riksbank's role in the initial stage of the crisis has been to ensure that there is
no lack of liquidity so that lending can continue and we can conduct an
expansionary monetary policy to support the economy. We have therefore taken
a large number of measures to reduce the economic consequences of the
coronavirus pandemic. When it becomes clearer how lasting the crisis is likely to
be, it may be appropriate to further adjust the expansiveness of our monetary
policy.
In recent months, the Riksbank has decided on
• A lending programme to the banks of SEK 500 billion to facilitate lending
to companies
•
Purchases of covered bonds for SEK 145 billion
•
Purchases of municipal bonds for SEK 30 billion
• Purchases of government bonds, in addition to those decided in 2019, of
SEK 25 billion
9
• Purchases of commercial paper for SEK 32 billion
• Lending of USD 60 billion to the banks
• Easing of collateral requirements so the banks can borrow from the
Riksbank more easily
•
Lower interest rate on the lending facility, to 0.2 percentage points above
the repo rate (from 0.75 percentage points).
• Offering the banks unlimited loans against collateral with a three-month
maturity in weekly extraordinary market operations
Common to many of these measures is that they lead to significant changes on
the Riksbank's balance sheet.
It may also be necessary to adjust the repo rate, although there is not very much
scope for interest rate cuts at present. However, the major problem at the
moment is not that the interest rate is too high, the risk of a credit crunch is more
about the major difficulties faced by many Swedish companies and households.
When the banks are to decide to give loans, they must of course consider whether
the borrower will be able to repay the loan. But here it is important that we all
help to see the whole picture: if all agents just take into account their own
shortterm interests, there is a risk that the consequences for society as a whole, and
thus for all of us, will be unnecessarily large. To increase the incentives to give
loans, the Government has allocated several million to share the risk in new
lending with the banks. The terms and conditions in this programme will be more
decisive for how much the banks lend than those we at the Riksbank decide on.
We can offer the banks slightly cheaper financing, but if the unwillingness to lend
is based on an assessment that the risk is too high, then other measures are
needed. It is then a question of fiscal policy, not monetary policy.
The central issue here is that most of the crisis measures have an impact through
the Riksbank's balance sheet instead of the interest rate. Over the past ten years,
this type of measure has become increasingly common, both in Sweden and
abroad. An important question going forward is to what extent this type of
measure will be used to conduct monetary policy in more normal times.
The international discussion of the toolbox
An intensive international discussion was already under way before the
coronavirus pandemic broke out concerning how the monetary policy framework
and toolbox need to be adapted to meet the challenges of the future. Part of this
discussion has been marked by a desire or hope for a return to the situation
before the financial crisis. But another part focuses on the insight that we may
have to change how we work in the longer term too. The current situation
strengthens this already great need. Below, there follow a number of the
proposals raised. Some of them are intended to institutionalise the usage we have
already come across in my description of the crisis measures.
One key theme of the discussion is the need to have tools able to counteract
future recessions in a credible manner. It is also important to be systematic and to
describe clearly the conditions under which these tools may be used. With these
conditions met, we can achieve better automatic stabilisation of future economic
shocks, as the participants in the economy will understand how monetary policy
will act going forward and be able to adjust their expectations accordingly. If the
private sector instead perceives the scope for monetary policy as being limited or
the policy as being hard to grasp, credibility for the inflation target may be
jeopardised, particularly in a situation in which these limits are perceived as
longterm.
Proposals for tools that could be used to provide better possibilities for
counteracting a recession include:
• Raised inflation target
• Make up strategies for better automatic stabilisation of the economy
after shocks
•
Quantitative easing used systematically in the implementation of
monetary policy
• Forward guidance
• Coordination with fiscal policy under special circumstances
• Fiscal policy stimulation measures funded with central bank money,
socalled helicopter money
•
Acceptance of low inflation
We shall now examine the arguments behind these proposals.
Raised inflation target
Firstly, it must be said that the proponents of this idea do not usually mean raising
the inflation target in the current situation. Rather, if the inflation target is to be
raised, this should be from a normal level, when inflation has been close to the
target for some time and monetary policy has become somewhat normalised.
The argument for raising the inflation target is that this would increase the
average scope for monetary policy in future recessions, as the average nominal
interest rate is the sum of the real interest rate and inflation. If the real interest
rate falls, the inflation target can, in principle, be raised by as much to restore
scope.
Does it matter to the economy if the inflation target is two or, say, four per cent?
Empirical research has certainly identified a relationship between the level of
average inflation and growth, but this relationship is quite weak and primarily
seems to be relevant when inflation is relatively high. High inflation also seems to
coincide with greater variation around the average level. There is thus a certain
support for the view that the inflation target should be fairly low. However, the
inflation target's most important function is to provide the economy with a
nominal anchor, for example for wage formation activities to coordinate around.
There are practical aspects that must be considered if the inflation target is to be
changed. Establishing a new level may require a great deal of work, as it takes
time for the participants in the economy to get used to new targets and a change
may also lead to the private sector starting to expect further changes of the target
later on. There are also open economy aspects to this issue, as it is hardly a
coincidence that almost all countries applying some form of inflation targeting
policy have chosen an inflation target of almost two per cent. It seems likely that
any movement towards a higher inflation target should be the result of an
international discussion in which Sweden will hardly be the country to go first.
Make up strategies for better automatic stabilisation of shocks
Another idea discussed is that of changing the central bank's targets so that a
certain measure of history-dependency is built into the monetary policy strategy.
For example, the US central bank has initiated a review of its monetary policy
framework where one alternative being discussed intensively is a target for
average inflation.10 The idea is that the participants in the economy understand
that, if a shock to the economy pushes inflation down, the central bank will, in the
future, compensate (make up) for this by allowing slightly higher inflation later on.
If prices are sluggish, there will not be such great incentive to cut prices as a
response to the shock and inflation will therefore become higher. Such a
monetary policy strategy could, therefore, theoretically give better automatic
stabilisation of shocks and lead to less of a need to adjust the interest rate,
something that is particularly interesting when the policy rate is close to its lower
bound. Bernanke (2020) has an alternative proposal that is based on this kind of
target only being introduced temporarily when monetary policy is limited.
However, here too it is important that this is communicated in advance - the
measure will then have the maximum effect as it contributes to increasing the
central bank's ability to stabilise the economy and thereby affect the participants'
expectations.
One counterargument is that, if expectations are instead backward looking, the
make-up str