Cecilia Skingsley: Inflation-targeting after the financial crisis
Speech by Ms Cecilia Skingsley, Deputy Governor of the Sveriges Riksbank, at Almega
(employer and trade organisation for the Swedish service sector), Stockholm, 22 May 2015.
* * *
Accompanying charts can be found at the end of the speech.
I would like to thank Björn Andersson and Mikael Apel for their help with this speech.
This coming Sunday is Pentecost, "the day of rejoicing", to quote Esaias Tegnér. And it is
certainly easy to rejoice at the season and see green shoots springing up, the result as
Tegnér writes, of "the friendly flames of the Spring-sun", even in the economic statistics. For
a long period of time now we have had a development where production and the labour
market have been improving, but inflation has been too low. This has also affected
expectations of inflation in the longer run. The Riksbank has cut the repo rate and its forecast
for the future repo rate to very low levels to bring up inflation, as well as purchasing
government bonds to make monetary policy even more expansionary.
It appears as though this policy has had an effect. But we are not home and dry yet, which is
shown, for instance in the unexpectedly low inflation outcomes in April. It takes time until
inflation is back at a level around the inflation target and there is still spare capacity in the
economy and scope to increase activity further. The risks of a setback in economic activity
should not be underestimated either. As we Executive Board members pointed out, we are
always prepared to make monetary policy even more expansionary if we assess that the
upturn in inflation is threatened.
But even if the focus of the debate in Sweden is now of necessity on current monetary policy,
we must not lose sight of the longer perspective. There is a lively international debate on
whether, and if so how, inflation targeting should be changed in the wake of the financial
crisis and the ensuing period of a long-drawn out economic recession, very low inflation and
very expansionary monetary policy. What do the past eight years mean for the functioning of
the economy and for monetary policy? Will we return to the way things looked before the
financial crisis? It is important that we also take time in the Swedish debate to focus on these
fundamental issues so that the discussions of our own monetary policy framework remain
well-informed and productive. This is important not least for the external evaluation of
monetary policy in Sweden now being carried out on behalf of the Riksdag Committee on
Finance.
There are many interesting question that are worth raising. One example that is of immediate
interest in the Swedish debate is the question of whether monetary policy should have an
explicit target for employment in addition to the target for inflation. This is one question that
will be taken up in the external evaluation.
Today I intend to take up a couple of questions that I consider relevant to both the debate in
Sweden and the international debate. The first question is what role monetary policy should
play with regard to promoting financial stability. This is a question that is still raised as one of
the most important ones in the international discussions on possible changes in the
inflationtargeting framework, although in many countries this has been overshadowed by the recent
low inflation figures. A second question that, for natural reasons, is always topical when
discussing whether the inflation-targeting policy needs to be modified is whether the level of
the central banks' current inflation targets - usually around 2 per cent - needs to be
changed. This is also something that has been discussed quite a lot by academics and in
various policy forums since the financial crisis. Internationally, the discussions have focused
on the question of whether the target should be raised, while in Sweden the focus has
instead been on whether the target has been set too high. I intend to address the arguments
for both points of view and to give my own views on the subject.
Should monetary policy take financial imbalances into account?
But let me begin with the question of monetary policy and financial stability. One lesson from
the financial crisis is that price stability is not sufficient to ensure financial stability in the
economy. More specifically, the origin of the financial crisis showed that even in a relatively
calm economic environment it is possible for financial imbalances and risks to build up and
lead to disruptions spreading throughout the financial system and causing substantial costs
to society.
After the financial crisis there has been intensive work around the world on producing tools
that can be used to prevent these systemic risks from arising. And a largely new policy area
has taken shape; macroprudential policy, which is responsible for these tools. In principle
everyone agrees that this policy area is needed and it has begun to be implemented around
the world with slightly different institutional set-ups. In Sweden, of course,
Finansinspektionen (the Swedish financial supervisory authority) has been given the
responsibility for the macroprudential policy tools.1 On the other hand, the responsibility for
the overall task of promoting a stable and smoothly-functioning financial system will be
divided between Finansinspektionen, the Riksbank, the Government and the Swedish
National Debt Office.
So macroprudential policy is intended to be the first line of defence in counteracting financial
imbalances that can affect macroeconomic and financial stability. There is broad agreement
on this. The issue now being discussed internationally, and on which the jury is still out, is
how strong this line of defence can be and whether other policy areas may at least
sometimes need to contribute to counteract this type of risk. A more specific question is
whether monetary policy should also take into account risks linked to financial imbalances.2
Financial stability has great significance for monetary policy
There is no doubt that financial stability has considerable significance for monetary policy.
Monetary policy largely acts via the financial markets and if these function poorly, monetary
policy will have less effect on the economy and on inflation. Problems in the banks can also
lead to problems in granting credit in general in the economy and thus to lower demand and
lower inflationary pressure. But the effects on unemployment, growth and other aspects of
the economy can be substantial, even if this does not extend to a full-scale financial crisis. If
imbalances linked to credit-granting and asset prices build up that are unsustainable in the
long run, there is a risk that the economic downswings will be deeper and more prolonged.3
Given the links between the areas, there are arguments in favour of monetary policy taking
into account risks linked to financial imbalances. This is actually nothing new. Such
arguments were put forward even before the financial crisis, although the debate then
concerned "bubbles" on the stock market or property market. Some said that monetary policy
should react to such sharp rises in asset prices, over and above the impact the upturns have
on the prospects for inflation and economic activity. But the predominant opinion was that
this is not something that monetary policy should do. One argument was that it is too difficult
to identify bubbles and that in practice it may make things even worse if one tries to
counteract them.4 The fact that the earlier consensus view is now up for discussion is of
course due to the experiences from the financial crisis that show that the economic costs to
society of financial imbalances can be substantial and that it is not so easy for monetary
policy to "clean up" afterwards when the economy has suffered.
The inflation target is still the foundation
There are different ways of justifying why monetary policy should take financial stability into
account. Different arguments lead to slightly different conclusions regarding exactly how
inflation-targeting should be adapted. Should, for instance, financial stability be included as a
new objective for monetary policy, together with price stability and macroeconomic stability?5
Or can the objectives, as before, apply to price stability and macroeconomic stability but with
consideration to financial stability included in the prospects for these two quantities in the
slightly longer run?6
Theoretically, there may thus be some differences between different ways of including
consideration of financial stability in inflation-targeting. In practice, I do not think the
differences are so large - regardless of the underlying reason, the results are in practice that
monetary policy is slightly adjusted to counteract potential imbalances on the financial side of
the economy.7 It may be worth pointing this out: a monetary policy that "leans against the
wind" in this way does not actually scrap the inflation target and swap it for a target for asset
prices or indebtedness. The inflation target is still the foundation. What this means is that in
some situations monetary policy can be adapted so that it takes slightly longer for inflation to
get back to the target that it would have done otherwise if one had not taken financial stability
into account.
A necessary condition for being able to give such consideration is that confidence in the
inflation target is firmly rooted and does not risk deteriorating because it takes somewhat
longer for inflation to attain the target. A monetary policy that leans against the wind thus
assumes that inflation expectations are firmly anchored around the target. It is probably also
easier if inflation is not too far from the target to start with, as inflation expectations are to
some extent affected by the current rate of inflation. Also, a deviation from the inflation target
is in itself more costly the larger the deviation is.
Lack of practical experience
So what is the current status of the debate? For natural reasons, an important dividing line
here is the view of macroprudential policy and how well it can function as a first line of
defence. Can it efficiently manage to counteract imbalances arising, or is it doubtful whether
it can do so alone? This is essentially an empirical question, so the route taken by the
international debate in the coming period will to a great extent be determined by the practical
experiences from macroprudential policy and the tools at its disposal. So far, these
experiences are relatively limited.
Another important dividing line in the debate is the view of monetary policy as a tool to
counteract financial imbalances. One argument that is often put forward against using
monetary policy as such a tool is that it is far too blunt for this purpose and has limited effects
on the risks one wishes to counteract. A monetary policy that leans against the wind
therefore gives little "benefit", while the "cost" in the form of poorer price stability and
macroeconomic stability is high. On the other side of the debate it has been pointed out that
it is not necessarily a disadvantage that monetary policy is blunt, in the sense that it has a
broad impact on the economy, as it then "gets in all of the cracks" and is difficult to
circumvent.8
What the benefits and costs of using monetary policy to counteract financial imbalances will
be is also an empirical question. Here, as well, the problem is that the practical experiences
of a monetary policy that leans against the wind are still limited.
Should the level of the inflation target be changed?
Another question being discussed is whether the level of the central banks' inflation targets
should be changed. The debate since the financial crisis has primarily concerned whether
the target should be raised, but most recently there have also been arguments for lowering
the target.
Should central banks lower their inflation targets?
It appears to be mainly in the debate in Sweden that arguments in favour of lowering the
target have been put forward recently.9 But they have also arisen in other countries to some
extent.10
A basic idea appears to be that underlying structural trends such as globalisation and
digitisation comprise such strong adverse winds with regard to bringing up inflation that it is
not worth trying. Instead of aiming to bring up inflation to 2 per cent, which will be difficult and
risks causing other problems, one should therefore lower the inflation target, the argument
goes.
Digitisation and globalisation can affect inflation...
It appears reasonable to assume that digitisation - defined as the digital technological
developments and its spread to various areas of usage in the economy - will on the whole
have a dampening effect on inflation, as it is usually measured.11 Perhaps the most obvious
and direct channel is price developments on certain products in the CPI's basket of goods,
which is affected by the production costs of these products showing a falling trend due to
technological advances making advanced electronic components increasingly cheap. This
applies, for instance, to mobile phones and computers. This is a development that has been
going on for a long time and it may well continue for some time to come.12
8
Stein (2013).
9
See, for instance, Mitelman (2013) and Schück (2015).
10
For instance, there appears to be a debate in New Zealand on whether the Reserve Bank of New Zealand's
attempts to attain the inflation target of 2 per cent risk overheating the economy, see the New Zealand Herald
(2015). The Governor of the Bank of England, Mark Carney, has claimed during a hearing in the House of
Lords that during long-term positive supply shocks there may be reason to adjust the inflation target
downwards, but he emphasised that this was currently only hypothetical reasoning, see House of Lords
(2015). The Bank of Canada investigated in 2011 whether the inflation target should be lowered, partly from
the view that the problems with incomplete indexing of nominal contracts could decline further, see Côté
(2014). However, this was dismissed on the grounds that the problems linked to the policy rate reaching its
lower bound more often would be too severe.
11
For a more detailed review of the effects of digitisation on inflation, see the article "Digitisation and inflation" in
Monetary Policy Report, February 2015.
12
Digitisation-related products have contributed for a long time to keeping down CPI inflation, but the effect has
been relatively smaller in recent years than before.
Another channel has an impact via the Internet and the matching and interplay between
producers and consumers. Increased competition via e-commerce and greater opportunities
for consumers to compare products make it more difficult for companies to raise their prices.
A third possible channel is linked to new technology being used to replace labour. Although
there have been fears that "technology will take away jobs" ever since the industrial
revolution in the 18th century, they have not been realised. However, it is not necessarily a
law of nature that technological advances always create at least as many jobs as they take
away. The digital technology developments have made it increasingly profitable, and to an
increasing degree possible, to replace human labour with machinery. It is probable that
"technological unemployment" resulting from automation will become a more common
phenomenon in the coming period than it has been so far, although this is of course
something that remains to be seen. If this were to be the case, a lot more groups in the
economy will experience downward pressure on their wages. This may, in turn, have a
restraining effect on inflation.
Globalisation, the acceleration of international trade and the integration of China and other
developing countries into the world economy, has been an important underlying trend in the
global economy and will probably remain so in the coming period. Like digitisation,
globalisation affects the economy through many different channels. Perhaps the one that has
been most in focus in the discussions on inflation is the downward pressure that results from
industrialised nations increasingly importing cheaper goods from, for instance, China.13 This
essentially concerns cutting the price of import goods relative to prices of
domesticallyproduced goods, while inflation is a change in the general price level that affects all prices.
However, cuts in the price of a certain product can have an impact on average consumer
prices during a period of time, in the same way as when the developments in digital
technology make some products cheaper. From this perspective, increased imports from
China and other Iow-wage countries can have a directly dampening effect on inflation in the
short and medium-terms.14
There are probably reasons why the idea of lowering the inflation target has been put forward
mainly in Sweden. Swedish inflation fell to low levels somewhat earlier than inflation in many
other countries. Another important piece of the puzzle is that the low inflation is not
considered to reflect a particularly poor development of the Swedish economy. It is therefore
likely that one begins looking for other explanations for the low inflation. And if one then
decides on the explanation that this is largely a matter of structural trends and that an
inflation rate that is persistently below 2 per cent is compatible with a reasonable
development of the real economy, it appears both possible and logical to lower the target.
This is roughly the way I believe the reasoning works.
...but they do not determine inflation
This method of reasoning may intuitively appear reasonable, but I think it disregards a couple
of important circumstances. Both globalisation and digitisation are underlying structural
trends that can have a dampening effect on inflation. But even if this effect may continue
over a long time, it is essentially temporary. One can say that these trends in principle
function as prolonged positive supply shocks that affect the economy over a long, but
nevertheless limited, period of time. However, the inflation rate does not depend on this type
of trend or shock on the long run, but on how expansionary monetary policy is, regarded as
an average over a long period of time. Inflation is, as they say, a monetary phenomenon. Let
us assume the hypothetical case of two countries - one that is fully digitised and the other
without any actual digital technology, let us say like Sweden in the middle of the last century.
If the central banks in both countries conduct the same policy, there is no reason to assume
that inflation would systematically be lower in the entirely digitised economy. On the other
hand, it may very well be the case that there is downward pressure on inflation during the
actual process when a country becomes increasingly digitised. But adjusting the level of the
inflation target to the structural underlying trends that for the moment are influencing the
economy does not seem like a good idea.
A related and equally important circumstance is that even if globalisation and digitisation can
subdue inflation, this does not mean that they determine inflation - and transform the central
banks into passive onlookers, without any opportunity to influence inflation over time. In
practice, the central bank has the possibility to try to estimate how much digitisation and
globalisation will dampen inflation and to compensate for this. This is what central banks with
an inflation target do now. It is not always an easy task, I will admit, as knowledge of the
quantitative effects of digitisation and globalisation is so far fairly limited. This also means
that a monetary policy that tries to compensate for the effects of these trends on inflation will
not always be right, but will sometimes compensate too much and sometimes too little.
However, digitisation and globalisation are not different in this aspect from other factors that
affect the economy and that the central bank must try to take into account.
My point is that structural trends that put downward pressure on inflation during a period of
time do not necessarily mean that actual inflation will be permanently lower than the national
authorities intend it to be on average. If one claims this, one is also implying that central
banks and governments do not have the possibility to choose the level of the inflation target,
but that this is something determined by structural conditions in the economy. Ultimately, one
thus also says that inflation is not a monetary phenomenon, which does not concur with what
is widely accepted today.
Important to maintain confidence in the target
A slightly milder interpretation is that one did not literally mean that the inflation target should
be lowered, but that the Riksbank, and all other participants in the Swedish economy should
accept that inflation will continue to undershoot the target over a long time to come - despite
the fact that it has already been below the target for several years. The main reason would
be that the expansionary monetary policy required to bring inflation up to the target would
also contribute to a further increase in house prices and household debt. I have some
understanding for these thoughts, but I consider that they disregard a number of important
circumstances as well. I believe that above all, one underestimates the importance of
maintaining confidence in the inflation target and the problems that can arise if this
confidence is lost.
We have lived with an inflation target of 2 per cent for more than twenty years and few would
claim anything other than that it has been a good system with good results for the Swedish
economy. The Riksbank is the only instance that has the express task of trying to ensure that
the inflation target is met. Of course, the Riksbank also has the task of "promoting a safe and
efficient payment system", which should be interpreted as acting to ensure the financial
system is stable and functions smoothly. But, as I have already pointed out, the latter is a
task that the Riksbank shares with the Government, Finansinspektionen and the Swedish
National Debt Office. Finansinspektionen has the responsibility for the macroprudential policy
tools, which comprise the first line of defence with regard to counteracting the emergence of
financial imbalances. As I have just mentioned, there is an international discussion on
whether monetary policy may need to support macroprudential policy in certain situations.
But I have also argued that one condition for this is that there is firmly-established confidence
in the inflation target. It is this confidence that creates the scope for monetary policy to take
other issues into consideration.
Confidence in the Riksbank's inflation target has long been fairly firmly rooted. But what has
happened in recent years is that inflation has fallen to very low levels, instead of beginning to
rise towards the target as the Riksbank and other analysts have expected. The period with
an inflation rate below the target has thus gradually become longer and longer. Parallel to
this development, the long-term inflation expectations among economic agents have fallen.
In other words, a risk began to gradually build up that the role of the inflation target as
benchmark for price-setting and wage formation would begin to weaken - that the nominal
anchor that has been an important part of the favourable developments in Sweden since the
1990s crisis would begin to slip.
Some say that the Riksbank should not attach any weight to this, but instead hold the repo
rate at a higher level. However, I find it difficult to see how the Riksbank could deliberately
ignore the risk that confidence in the inflation target, the linchpin of the inflation-targeting
policy, begins to be undermined - something the Riksbank alone has the explicit task of
preventing - to instead continue to try to counteract financial imbalances building up; a task
for which others share the responsibility and have more tools to manage.
Should central banks raise their inflation targets?
Most of the post-financial crisis debate on the level of the central banks' inflation targets has
been based on rather different trains of thought, as I mentioned earlier. Here the starting
points has instead been that problems can arise if inflation and inflation expectations fasten
at a too low level for too long. Many economists and debaters have therefore begun to ask
whether the central banks' current inflation targets should therefore be raised.15
The idea behind the proposal can be described as follows. When an economy falls into a
recession the central bank cuts its policy rate to boost demand and raise the too low inflation
rate. If the recession is really deep, as during the financial crisis, the policy rate may need to
be cut substantially. The average level of the policy rate largely depends on how high the
inflation target is. If the inflation target is low, the average nominal policy rate is also low. This
means that a low inflation target does not give very much scope to cut the policy rate before
it hits its lower bound. The lower the inflation target, the more often one can thus count on
the policy rate hitting this lower bound. Previously, it was assumed that the lower bound for
the nominal interest rate was zero, but recently it has become clear that it is possible to have
slightly negative policy rates.
Less risk of hitting the "near zero lower bound"
The higher the inflation target is, the greater the "buffer" monetary policy has if it is necessary
to stimulate the economy - the nominal "close to zero rate" corresponds to a lower real
interest rate. When the inflation-targeting policy was introduced in the early 1990s, a target of
2 per cent developed into something of a standard. The reason for the figure of 2 per cent
was not that research had determined that this was the absolutely most appropriate level; it
was probably more because this was the approximate level of inflation in most of the
countries that began to introduce inflation targets and it appeared to be a reasonable figure
in general. And until the financial crisis there was no real reason to question whether an
inflation target of 2 per cent entailed a sufficient buffer for monetary policy.
However, since the crisis, many countries have cut their policy rates to the "near zero lower
bound" and been forced to change over to other, more unconventional means of conducting
monetary policy, sometimes for several years. If the inflation target had been set higher from
the start, there would have been a greater possibility to stimulate the economy in the normal
way, through lower real interest rates. It is possible that the effects of the crisis would then
have been less and it would have been easier to emerge from it into a more normal situation,
some people argue.
Many say that the motives for a higher inflation target have recently been reinforced and are
not merely linked to the fact that it would be easier to extricate oneself from crises. They say
that it is not merely that the world has suffered an unusually large financial crisis and is now
having to deal with the repercussions. Moreover, there is an underlying structural
development that has meant that large parts of the world have entered a state of so-called
secular stagnation. What this normally means, expressed simply, is that the neutral, or
natural interest rate - the interest rate that has neither an expansionary nor a contractionary
effect on the economy - has fallen and become very low, perhaps even negative. It may be
difficult for monetary policy to stimulate the economy sufficiently in this type of situation, as it
requires that the real interest rate - the nominal interest rate minus inflation - to be lower
than the neutral one. Achieving this becomes more difficult when the nominal interest rate is
at the "near zero lower bound" and when inflation is low and falling, which keeps the real
interest rate up.16 If the neutral interest rate is persistently low, monetary policy will more
often hit the "near zero lower bound".17 However, it is an open question whether the world is
suffering from the prolonged but nevertheless transitory after-effects of an unusually
widespread crisis or is caught in a more lasting state of secular stagnation.18
The difference between introducing a target and changing it
The arguments in favour of raising the inflation target may appear fairly convincing on paper.
But there are considerable practical objections. The feeling one gets is that the starting point
for the analysis is often: "Assume that the world had looked different than it does now - that
is, the inflation targets had been higher". Then, one observes, developments would probably
have been more favourable than they actually were. But in this case the challenge mainly
concerns how the transition from one world to the other will be attained. Setting an inflation
target for the first time is one thing, but changing a target that has become established is
quite different.
If one is to change the level of an inflation target, I believe the easiest and most efficient way
would be to do so in a relatively normal situation - when inflation is not too far from the
original target and the economy is not in a crisis or otherwise in a difficult situation. If, for
example, one raises the inflation target in a situation where inflation is much higher than the
target, there is a risk that this will be perceived as giving in and taking the easy way out and
that one will be expected to continue doing this the next time there is a problem. There is a
corresponding risk if one lowers the target when inflation is undershooting the target by a
long way, even if there are of course limits as to how low one can set the target. Sooner or
later expectations would probably adjust to the new target, but the adjustment period could
prove costly.
I also believe that it may be difficult to raise the target in a situation where inflation
undershoots the target significantly, particularly if the central bank has cut the policy rate to
the "near zero lower bound", that is, the level at which may countries are now. Here there is
rather a risk that the increase will be perceived as a more or less desperate and in the worst
case not particularly credible measure to obtain a little additional help getting out of a difficult
situation. Apart from the best time to change the inflation target being in a relatively normal
situation, I would also think it would be easier if several central banks did it at the same time.
Financial crisis has affected the central banks' analysis and working methods
I have given some examples of questions that will probably continue to be argued in the
international discussion of how inflation-targeting may need to be adapted and modified. This
type of fundamental question of principle is central to monetary policy and, given that the
current framework for inflation-targeting has worked well over a long time, any changes
should be made slowly and cautiously - and are hardly in the pipeline in the near term. Quite
simply, we will have to see what takes shape after the international discussions. In the
Swedish debate we need to begin by taking a stance on the conclusions of the external
evaluation of the Riksbank's monetary policy that is published next year.19
But even if the experiences of the past eight years have had limited impact on monetary
policy strategies so far, the financial crisis has nevertheless had clear effects on the work of
the central banks. If I use the Riksbank as a starting point, for instance, the significance of
the financial conditions for macroeconomic developments and for monetary policy have
come under much greater focus than before, as have financial and banking questions in
general. One can see this in the research conducted in the bank, where these areas are
currently of central importance. The changes we recently made to our Monetary Policy
Report are also marked by the need to better highlight the links between financial conditions,
the macroeconomy and monetary policy. The low inflation in recent years has of course also
made its mark on our internal work and we have invested considerable resources in trying to
understand which factors lie behind it - both from a short-term perspective and in a more
structural perspective.
So, to conclude by returning to the question of whether everything will go back to the way it
was before the financial crisis, I think the answer depends on wh