Martin Flodén: My view of monetary policy and household debt
Speech by Mr Martin Flodén, Deputy Governor of the Sveriges Riksbank, at Swedbank,
Stockholm, 24 September 2013.
* * *
This is my first speech since taking up the post of Deputy Governor of the Riksbank. Since I
started in the spring I have taken part in two monetary policy meetings. On both occasions I
have entered a reservation against the majority decision and advocated a lower repo rate. It
therefore seems natural for me to devote my speech today to explaining my view of
monetary policy and the reasons for my reservations.
Should monetary policy take into account households' high and rising indebtedness? This is
a question that has been central for monetary policy in recent years and also at my first
monetary policy decisions. I consider it clear that the Riksbank has a responsibility to
safeguard financial stability and prevent crises linked to credit granting. However, it is not so
clear what consequences this responsibility has with regard to conducting monetary policy in
practice. I shall explain my reasoning at the recent monetary policy meetings. I also intend to
comment on how the new framework for macroprudential policy may affect my view of
monetary policy. However, I shall begin with a brief description of my view, and the
Riksbank's view, of the economic situation.
Positive signs but risks remain
In recent months we have been able to see some positive signs in the Swedish economy,
and also abroad. Confidence has risen in both the household and corporate sectors in
Sweden, and there are some signs that unemployment is falling. In the euro area, GDP
increased in the second quarter, after six quarters in a row of falling GDP. Here, too, the
confidence indicators are giving more positive signals.
However, one must remember that the economies still have a long way to go to reach a
normal status. GDP growth and inflation are at low levels in both Sweden and the euro area.
And there are still large downside risks for economic developments. In the euro area, the
weak public sector finances and problems in the banks' balance sheets have scarcely
improved in recent months. In the United States, the full effects of the sequester have not yet
been realised, and there is also uncertainty over how the debt ceiling will be raised during the
autumn.
Growth rates in large emerging markets like China and India have fallen, albeit from very
high levels. Previously, international capital has tended to move towards emerging markets
as interest rates have been low in the more developed economies. However, as yields on US
government bonds have been rising since the spring, the capital flows have changed
direction. The outflow of capital means that exchange rates are weakening, which may
improve the countries' international competitiveness and contribute to maintaining their high
level of economic activity. But the large fluctuations in growth rates, capital flows and
exchange rates are in themselves problematic and create uncertainty regarding economic
developments in the emerging markets.
A divided Swedish economy
The Swedish economy is dependent on developments abroad, and of course has been
affected by the financial crisis and economic downturn in recent years. In an international
comparison, overall quantities such as GDP and employment have nevertheless developed
well since the financial crisis.
However, behind the overall picture is a divide, where household finances in particular have
been strong. Their disposable incomes have increased every year during and since the crisis
(see Figure 1). Growth in consumption has also been good. Housing prices and loans to
households have increased rapidly, probably partly due to strong households finances and
an expansionary monetary policy (see Figures 2 and 3). Developments in the corporate
sector have been weaker, which is reflected in weak growth in exports, low investment and
only modest growth in loans to companies (see Figure 4).
Figure 1
GDP and real disposable income
Index, 2007 =100
115 115
Real disposable income
GDP
110 110
105 105
100 100
95 95
90 90
07 08 09 10 11 12
Source: Statistics Sweden
Figure 2
Housing prices
Index, January 2005 = 100, seasonally-adjusted data
200 200
HOX Sweden (Single-family houses)
HOX Sweden (Tenant-owned apartment)
HOX Sweden
180 180
160 160
140 140
120 120
100 100
Figure 3
Lending to households and companies
Index, 2007 =100
160 160
Companies
Households
140 140
120 120
100 100
80 80
07 08 09 10 11 12 13
Source: Statistics Sweden
Figure 4
Exports, investment and consumption
Index 2007 = 100, seasonally adjusted data
110 110
Private consumption
Gross fixed capital formation
Export
100 100
90 90
80 80
07 08 09 10 11 12 13
Source: Statistics Sweden
The division in the economy is a problem for monetary policy. With only one tool, the repo
rate, we are trying to attain the inflation target and at the same time attain a balanced
development in economic activity. In practice, the repo rate is often adequate as a tool to
give both inflation and economic activity a push in the right direction.1 But in recent years, we
have also needed to manage the problem of economic activity being at different levels in
different parts of the economy. We cannot use the repo rate to stimulate the corporate sector
and limit the build-up of household debt all at the same time. In this situation, it is not evident
how monetary policy should manage the balance between inflation, economic activity and
the risk of an overly rapid increase in housing prices and household credit. Let me elaborate
on my thoughts a little further here.
Monetary policy must take financial risks into account
The concern over lending to households increasing too rapidly has led to a majority of the
members of the Riksbank's Executive Board voting to hold the repo rate at a higher level
than would otherwise have been justified. I have entered reservations against these
decisions and advocated a lower repo rate, for reasons I will return to later. Despite my
reservations, I share the majority's concern over the rapid increase in household debt. And I
consider that monetary policy should, in principle, take into account financial imbalances and
risks that may arise as a result of the monetary policy conducted.
In what way is this compatible with the Riksbank's mandate?
According to the Sveriges Riksbank Act, the objective of the Riksbank's activities is to
maintain price stability. Moreover, the Riksbank shall promote a safe and efficient payment
system. In addition, the preliminary works to the Act state that the Riksbank, without
prejudice to the price stability target, should support the goals of general economic policy
with a view to maintaining a sustainable level of growth and high rate of employment.
At the Riksbank we consider the task of promoting a safe and efficient payment system to
have a broad meaning and that it is, in practice, a matter of taking responsibility for
promoting the stability of the financial system.2 But it is not actually this task that justifies
monetary policy taking into account a rapid expansion in household borrowing. It is namely
the case that the preliminary works to the Sveriges Riksbank Act emphasise that the
monetary policy instruments shall only be used to maintain price stability, and thus not to
promote a safe and efficient payment system.3
We sometimes say that monetary policy shall take financial risks into account, as it can be
difficult to stabilise inflation around the target if households are forced to rapidly reduce their
debts.4 Such difficulties could arise, of course, but for me it is not consideration of the
inflation target that mainly justifies letting monetary policy take financial risks into account.
Instead I perceive taking financial risks into account to follow on from the task of "supporting
the objectives of general economic policy with the aim of achieving sustainable growth". A
monetary policy that leads to an unhealthy build-up of credit or other financial imbalances is
scarcely compatible with sustainable growth.
But this task, like the task of stabilising economic activity, is subordinate to the inflation
target. Monetary policy's consideration of financial risks must therefore be weighed against
the inflation target and economic developments.
From principle to practice
The question is then how the principle of consideration of financial risks and imbalances
should be put into practice in monetary policy. How should the balance between the different
tasks be managed?
When determining this we must consider whether other tools than monetary policy are more
suitable for managing financial risks, whether our concerns regarding household debt are
justified and what effects monetary policy has on the imbalances and risks that concern us.
I do not intend to conduct any deep discussion of the links between monetary policy and
other tools today. As expressed by the Riksbank (2010), I note that it is not primarily
monetary policy, but an efficient regulatory framework and supervision that is important to
prevent financial imbalances. The way in which monetary policy should take into account
financial risks may therefore depend on the formulation of the regulatory framework and the
supervision. I shall return to this question when I discuss the new framework for
macroprudential policy.
Household indebtedness is worryingly high
Also, I do not wish to get into a detailed discussion now as to whether the concern over rising
house prices and household debt in recent decades is justified.5 It is clear to me that we do
not fully understand what the underlying factors are. We therefore do not know whether the
upturn is largely explained by fundamental factors or whether it reflects imbalances that have
built up in the economy.
Fundamentals that we are not able to disregard include the fact that housing construction is
low and has been so for a number of years. A low level of construction, combined with a
growing population and a move to metropolitan areas also contribute to a rise in housing
prices, and ultimately to an increase in debt. And the conversion of rental properties to
tenant-owned properties also contributes to increased debt. A further aspect is that
household savings are high and have increased at the same time as debt has increased.
But high indebtedness probably means that the economy will be more sensitive to shocks,
even if it can be explained by fundamentals. An economic downturn could then be reinforced
by households with large debts trying to increase their saving by reducing their consumption.
Moreover, we can hardly rule out the possibility that households' increased indebtedness in
recent years has at least partly been caused by unrealistically low expectations of future
mortgage rates. In my opinion, it is therefore in principle justified for monetary policy to now
take into account the rapid increase in household indebtedness.
Risks with a low repo rate
A further question is thus in what way monetary policy can lead to financial imbalances
building up. International academic research discusses several potential problems that can
arise if a central bank holds its policy rate at a low level for a long period of time. Perhaps the
most common problem mentioned is that investors will then seek assets with a higher yield,
which also have a higher risk. One of many reasons for such behaviour could be that some
portfolio managers are required to attain a minimum return on their portfolios. This behaviour
risks causing an unwarranted rise in asset prices when interest rates are low.6
Another possible problem with low interest rates is that the monetary policy stimulus can help
weak companies to get along without having to deal with their problems. In this way, a
necessary structural transformation in the economy may be postponed. There is also a risk
that the stimulus will help the banks to struggle along with weak balance sheets, which will
inhibit credit granting in the economy.7
The problems I have just mentioned nevertheless appear less relevant to current
developments in Sweden. But I would like to mention two other potential problems linked to
low interest rates, which I think justify the concern over the Swedish economy.
My first source of concern is perhaps a little far-fetched.8 Let us say that for some reason we
find ourselves in a situation where the repo rate is low and many households are heavily
indebted. In this situation a repo-rate increase could have large negative consequences for
the indebted households and consequently for the economy as a whole. Then households
might believe that future economic policy will be formulated so that such negative
consequences are avoided or alleviated. They may then choose to take on even higher debts
if they believe - with or without justification - that economic policy will take this into
consideration. And these problems risk increasing the longer the repo rate is kept at a low
level.
Figure 5
Households' mortgage-rate expectations one, two and three
years ahead
Per cent
7 7
6 6
5 5
4 4
3 3
2 2
Households' mortgage-rate expectations
Repo-rate + 2 percentage points
1 1
Repo-rate + 1.5 percentage points
0 0
13 14 15 16 17 18
Note. Repo-rate forecast from the September MPU. The households'
mortgagerate expectations refer to expectations regarding the variable mortgage rate.
The broken lines show an interval based partly on an interval for the long-term
repo rate of 3.5-4.5 per cent and partly on an interval for the difference between
a three-month mortgage rate and the repo rate of 1.5-2 percentage points.
Sources: The National Institute of Economic Research and the Riksbank.
A more tangible source of concern is households' expectations of future interest rates.
Surveys show that households (and market agents, for that matter) are expecting much lower
interest rates in the longer run than we at the Riksbank are expecting (see Figures 5 and 6).9
Figure 6
Expectations of the repo rate
Per cent
5 5
4 4
3 3
2 2
Survey, Prospera average, 28 August 2013
1 1
Forward rate, 10 September 2013
The Riksbank's repo-rate path
0 0
13 14 15 16 17 18
Note. Repo-rate forecast from the September MPU. Repo-rate expectations
among money market participants 1, 2 and 5 years ahead. The broken lines
show an interval for the long-term level of the repo rate of 3.5 to 4.5 per cent.
Sources: The National Institute of Economic Research, TNS SIFO Prospera and
the Riksbank
One possible interpretation of these expectations is that households place too much
emphasis on the low interest rates in recent years when they are looking ahead. In this case,
further repo-rate cuts risk reinforcing the difference between households' expectations and
the Riksbank's expectations of future interest rates. And such incorrect expectations may
then lead to unwarranted increases in housing prices and household indebtedness.
But I would like to point out that it is genuinely difficult to know what will be a "normal" or
average level for future mortgage rates. It is not at all certain that the Riksbank's long-run
assessments of the repo rate are more correct than those of households or other market
agents.
A low repo rate is necessary, despite the risks
I have observed that there are risks linked to holding a low repo rate over a long period of
time, and that monetary policy should in principle take these risks into account. But at the
most recent monetary policy meetings I have nevertheless advocated cutting the repo rate
even lower.
There are several factors behind this stance. Firstly, a lower repo rate would mean that CPIF
inflation returns to 2 per cent even faster and that resource utilisation is more balanced than
in our forecasts (see Figure 7).
Figure 7
More expansionary monetary policy
Effects according to the Riksbank's macro model Ramses
Repo rate CPIF
4 4 3 3
3 3
2 2
2 2
1
1
1 1
0 0 0 0
12 13 14 15 16 12 13 14 15 16
Unemployment Real interest rate, 1 year
9 9 2 2
8 8 1 1
7 7 0 0
6 6 -1 -1
5 5 -2 -2
12 13 14 15 16 12 13 14 15 16
Main scenario Lower interest rate
Sources: Statistics Sweden and the Riksbank
Secondly, I have seen an incipient credibility problem and wanted to formulate monetary
policy so that it appears well-balanced even when combined with assessments made outside
of the Riksbank. The problems I have seen are based on a combination of inflation having
clearly undershot the target, the Riksbank's inflation forecasts having been more optimistic
than those of other analysts, the Executive Board's repo-rate paths having indicated a tighter
monetary policy than the market and analysts have expected and the repo-rate paths having
been revised down time after time. I have said that in such a situation it is better to cut the rate
immediately rather than continuing to present a repo-rate path that is not perceived by
outsiders as entirely credible. However, these problems have become a little less important in
recent months as other analysts' forecasts of inflation and the repo rate have been revised up.
Thirdly, it is not self-evident that taking into account household debt means setting a higher
repo rate than we would otherwise have done. The current repo rate, 1 per cent, is
undeniably low. In the long run, the repo rate will be raised to much higher levels. But we
cannot raise the repo rate until we see that inflation has clearly begun to move towards the
target of 2 per cent. And when this happens will of course depend on monetary policy. If we
cut the repo rate now, inflation will rise faster towards the target. If the repo rate is left
unchanged it will take longer before inflation begins to rise, and this in turn means that it will
take a long time before the repo rate can be raised. It is not even self-evident that inflation
will return to the target level in the long run if monetary policy is too tight.
If we are worried that a long period with a low repo rate will give rise to an unjustified upturn
in housing prices and indebtedness, we should perhaps ensure we conduct a monetary
policy that means we quickly move towards the inflation target, and that still works even if
economic developments are less favourable than forecast in our main scenario. Such a
monetary policy could entail cutting the repo rate now to increase inflation and then raising
the repo rate slightly faster in the coming period when inflation accelerates (see Figure 7).
Admittedly, preliminary assessments within the Riksbank, based on model calculations
combined with empirical relationships, indicate that a large repo-rate cut now, followed by
faster increases in the future would entail slightly higher risks linked to household
indebtedness than if the repo-rate path advocated by the majority is followed. However, the
difference in the risk outlook for these two alternatives is almost negligible. A lower repo rate
now and faster increases in the coming period seems to me a better monetary policy, when
weighing the risks against the opportunity to return to the inflation target sooner and to have
a more balanced resource utilisation (see Figure 7).10
The assessments and calculations I refer to here are based on the general framework
presented in our Monetary Policy Report published in July.11 It is not entirely clear how this
reasoning should be translated into recommendations for practical monetary policy. We are
working on this issue within the bank. It scarcely needs to be said that the assessments and
calculations I have implied today are uncertain, and that they will remain uncertain even
when work on these issues has progressed further.12
Further measures are needed to strengthen financial stability
In conclusion, I would like to discuss how the new framework for macroprudential policy
affects my view of how monetary policy should be conducted.
It is good that one single authority, Finansinspektionen (the Swedish Financial Supervisory
Authority), is given a clear responsibility for decisions on supervisory measures. In this way,
we avoid the problem that different authorities may try to put responsibility on others, which
could have arisen if the responsibility was shared between several authorities.
At the same time, it is positive that several authorities, including the Riksbank, are given a
role to play in the work on macroprudential policy through the new financial stability council.
Identifying and analysing factors that can give rise to financial imbalances is and will remain
an important part of the Riksbank's work. The Riksbank needs this analysis for several
reasons. As I mentioned earlier, the Riksbank has responsibility for promoting a safe and
efficient payment system. We must also understand if monetary policy risks contributing to
financial imbalances arising. Moreover, a development of the economy that proves to be
unsustainable will affect the way in which inflation develops and what type of monetary policy
it is appropriate to conduct. The financial stability council will give us a forum where we can
and shall openly present our analyses of financial risks and recommendations for supervisory
measures.
In the recent Monetary Policy Update our forecasts was based on no new macroprudential
policy measures being introduced. But how will my view of a suitable monetary policy be
affected if such measures are implemented?
The answer depends entirely on the measures implemented and their effects.
Supervisory measures can have direct effects on financial risks and imbalances by limiting
the possibilities of particularly vulnerable households, companies or banks to take certain
decisions. However, the measures may also have indirect effects on risks and imbalances, or
side effects on the economy by affecting the cost of capital or the general demand situation.
An example of a measure that probably first and foremost has direct effects is the mortgage
cap. This affects primarily a small group of highly-indebted households and can be expected
to contribute substantially to preventing financial imbalances arising. But the mortgage cap
scarcely has any major effects on the general demand in the economy, or on the cost of
capital for a typical household.
An example of a measure that can affect the cost of capital is higher risk weights on
mortgages. Such a measure would probably lead to an increase in mortgage rates in relation
to other lending rates. And higher risk weights would probably also push up average lending
rates at a given repo rate, at least in the short run.
As I in practice have not let concern for households' rapid build-up of debt affect my view of
how the repo rate should be set today, measures of the first type, that is, measures that
directly limit vulnerable households' opportunities to become or remain heavily indebted,
would probably also have little effect on my choice of repo rate and repo-rate path. On the
other hand, measures that entail an increase in the average lending rates or a weakening of
general demand would justify cutting the repo rate. The purpose would then be to counteract
the effects of the supervisory measure on total economic developments. However, the
supervision measures could nevertheless affect financial imbalances, for instance, by
changing the level of household mortgage rates in relation to companies' borrowing rates.
Further macroprudential policy measures thus need not change my view of which monetary
policy is most appropriate now. However, such measures are nevertheless important to
monetary policy as they can reduce risks and uncertainties. It is easier to conduct monetary
policy if financial stability is good.
References
Blanchard, Olivier and Galí, Jordi (2007), Real Wage Rigidities and the New Keynesian
Model. Journal of Money, Credit, and Banking 39(p1), pp. 35-62.
Farhi, Emmanuel and Tirole, Jean (2012), Collective Moral Hazard, Maturity Mismatch and
Systemic Bailouts. 102(1), pp. 60-93.
American Economic Review
National Institute of Economic Research (2013), Are households borrowing too much? Article
in Swedish Economy June 2013 [NB! only a summary of the report is published in English].
Rajan, Raghuram (2005), Has Financial Development Made the World Riskier? NBER
Working Paper No. 11728. National Bureau of Economic Research.
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Costs of Highly Expansionary Monetary Policy. OECD Economics Department Working
Paper No. 1082. OECD.
The Riksbank (2010), Monetary policy in Sweden.
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The Riksbank (2013a), The Riksbank and financial stability.
The Riksbank (2013b), Repo rate unchanged at 1 per cent. Press release, 5 September 2013.
The Riksbank (2013c), Financial imbalances in the monetary policy assessment. Article in
Monetary Policy Report, July 2013.
Svensson, Lars (2013a), Skuldhysteri I: Att bara titta på skulderna duger inte. [Debt hysteria
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economists, only in Swedish]
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Household Debt-to-GDP Ratio, manuscript, Stockholm University.