Eva Srejber: The role of monetary policy for growth in Sweden
Speech by Ms Eva Srejber, Second Deputy Governor of Sveriges Riksbank, at the
FöreningsSparbanken's Economics Day, held in Vellinge, on 6 June 2000.
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I would like to begin by thanking you for the invitation to speak here at FöreningsSparbanken's
Economics Day. In my speech today, I shall try to look beyond the day-to-day monetary policy where
the focus on interest rate points and minor differences in assessments of the consumer price index at
times entails a risk of a lack of perspective. It can therefore sometimes be justified to remind oneself
and others of the role that economic policy can and should play. For me as a decision-maker at the
Riksbank, this applies in particular of course to the role of monetary policy and the importance of the
stability of the payment system. I would also like to recall the successes achieved in the Swedish
economy during the past decade, where fiscal and monetary policy have both made important
contributions. The challenge now is to reinforce what has been achieved and at the same time be
strong enough to carry out the changes that remain. It is also important to continually evaluate and
discuss the design of economic policy as new experiences are obtained. This requires openness, which
has been a lodestar for the Riksbank in recent years.
To create understanding and support for the goal of price stability, it has been necessary to explain the
conceptual framework that guides monetary policy decisions in a simple, pedagogic way. This has
perhaps resulted in our creating an exaggerated idea that monetary policy decisions are arrived at with
the aid of very simple rules. A simple conceptual framework is a support in a complicated reality.
However, factors that cannot be captured in a simple rule for decision-making need to be taken into
account. Since the effects of monetary policy extend over a number of years, every decision must rest
on assessments of probability and individual valuations of the risks that are associated with alternative
developments in the macroeconomy in future. In conclusion, I draw attention to some of these risks in
the development of the Swedish economy in the present situation.
The three pillars of economic policy
A well-balanced economic policy contributes to creating good prerequisites for stable, high growth,
which is generally regarded as an important component of the welfare concept. For this, it is required
that all components of economic policy play their roles well. This applies to fiscal, structural and
monetary policy. Good conditions for growth are created when uncertainty about future income and
expenditure is minimised. If at the same time resources are used where they make the greatest
contribution to welfare, there are prerequisites for good development. Economic policy should be
designed so as to minimise uncertainty and so that the regulatory framework and tax system do not
distort the allocation of resources in the economy.
If fiscal policy is carried out so that the central government debt is stabilised at a reasonable long-term
level, certainty is established in the design of the transfer systems and coming tax burdens and
investment and consumption decisions are facilitated. Structural policy also has an important role with
regard to creating good conditions for growth. Structural policy is such a broad concept that I can only
point to some important components. The tax and transfer systems, for instance, should be designed so
that they do not create motives for citizens to act in a way that is harmful to long-term growth and
welfare. The task of the educational system is to provide access to relevant, high-quality education and
that of labour market policy to ensure that demand and supply of labour power match.
The tasks of the Riksbank
A monetary policy aiming at price stability reduces uncertainty about future real incomes. Agreements
on future payments and assessments of future income are thereby facilitated. Demands for
compensation for risk are reduced which, among other things, stimulates real investments. Price
stability also improves the ability of the price system to spread information about how resources are to
be distributed to areas where they most benefit citizens. In a market economy, it is the task of the price
system to communicate information about household preferences and, for instance, to provide signals
as to where productivity is to be best developed.
Besides the task of safeguarding price stability, the Riksbank is also responsible for the country's
payment system. It is a prerequisite for the functioning of a modern economy that payments can be
carried out in a safe, efficient way. In order for payment systems to function, it is important that
financial stability is maintained, which, for instance, means that bank crises shall be avoided. There
are close connections between the responsibility of the central bank for price stability and its
responsibility for financial stability. In order for the instrumental rate to have the desired effect on
interest rate formation, it is, for instance, important that the payment system functions efficiently and
securely, since monetary policy instruments operate via the payment systems. Price stability can
further be threatened by financial imbalances and by financial instability. At the same time a monetary
policy focused on price stability per se probably reduces the risk for financial instability. It is not
meaningful to draw a sharp boundary between what is regarded as the central bank's monetary policy
tasks and what is included in the responsibility for a secure, efficient payment system. I confine myself
here to stressing that price stability and financial stability are both required to create good growth
conditions in an economy. And the central bank plays an important role in achieving both these goals.
On 1 January 1999, a new Riksbank Act came into force. It states that the goal for the Riksbank's
activity is to maintain stable prices. The Riksbank shall also be responsible for a secure, efficient
payment system. In the preparatory legal material on the Act, it is also further stated that the Riksbank,
without setting aside the price stability target, shall also support the objectives of general economic
policy with a view to achieving sustainable growth and high employment.
The price stability goal has then been confirmed by law. The Riksbank's Executive Board is
responsible for making the price stability goal operational and designing the framework for monetary
policy. Among other things, this means that the Executive Board decides on how the price stability
goal is to be defined and over what period price stability is to be maintained.
The Executive Board of the Riksbank has decided that price stability shall be defined as an annual
increase in the consumer price index of 2% with a tolerance interval of plus/minus one percentage
point. If the consumer price index is affected by factors that are considered to only have a temporary
effect on CPI, the Executive Board has agreed that we shall be able to disregard this. The reason is that
monetary policy otherwise risks leading to unnecessary fluctuations in employment and production.
A lot has been achieved although some things remain to be done
Economic policy has been very successful in many areas during recent years. When central
government debt increased dramatically during the first half of the 1990s, when, at the same time,
unemployment increased to a very high level and large fluctuations in long interest rates and the
exchange rate indicated great uncertainty in inflation prospects in the mid-1990s, there were probably
not many who could imagine that we would so quickly have such a positive development as we are at
present experiencing. Central government finances have improved markedly and we are now one of
the best in the EU with regard to the size of central government debt and the central government
budget balance.
For some time now, growth has been strong and we expect unemployment to fall towards 4% during
the coming year. And despite this, inflation expectations remains at a stable level close to the target.
We can therefore note that the Riksbank has been very successful in creating support and credibility
around the price stability target. Without such a responsible fiscal policy, it would not have been
possible to reduce inflation expectations in the way that has happened, however. The prohibition
against financing the budget deficit at the central bank was a step in that direction. The rule that the
Government and Riksdag adopted and which means that fiscal policy is to strive towards a surplus of
an average of 2% over a business cycle furthermore supports the price stability target and creates good
conditions for growth. The expenditure ceiling for central government finances that sets limits for how
much public activity can expand has the same effect.
Many structural reforms that have improved the conditions for growth in the longer term have also
been carried out during the past decades. The financial markets are wholly deregulated and the tax
system is reformed so that it produces fewer distortions than before. During the 1990s, a process has
been initiated which has strengthened competition in many areas. Transport, communication and
energy have been deregulated. At the same time, EU membership and continued internationalisation
have exposed the business sector to increased competition.
However, there is still a great potential for deregulation. This applies, for instance, to many parts of
service production where moreover growth prospects look favourable. A study recently carried out by
the Competition Authority confirms that competition has improved during the 1990s, but also points to
considerable competition deficiencies in many industries. Besides many industries in the service
sector, this also applies, among others, to the construction industry where regulatory frameworks and
building norms contribute to excluding competitors from other countries. The study is a follow-up of a
study carried out in 1991. Its conclusion was that lack of competition and concomitant high prices was
a feature of a number of the industries investigated.
Exaggerated expectations about the growth path can create macroeconomic imbalance
Even though the growth prospects for the Swedish economy now appear very bright, it is too early to
write off the risk of old problems in our economy again making their presence felt. There is, for
instance, a risk for overheating when households and businesses now seem to make decisions on
consumption and investments based on expectations of strong future real income increases as a result
of higher productivity growth. This can lead to financial imbalances and exaggerated indebtedness
heightened by high share prices and increasing property prices. Earlier periods with strong credit
expansion and high demand in Swedish economy have been followed by rising inflation. Low
inflation expectations and price-dampening effects from deregulations can now for a time hold back
the inflationary pressure that builds up when resource use in the economy increases. Low inflation
combined with high growth can per se strengthen the concept that earlier patterns have been broken
away from in the long term and we have entered a period with long-term higher growth. If demand
increases so much that resources are put under pressure, however, inflation will sooner or later
accelerate. There is a risk that prices then will increase very quickly and that inflation expectations
will also increase. To get inflation in line with the target in that situation, it may be necessary to
conduct a stringent monetary policy for a longer period. If expectations of future growth prospects at
the same time are interrupted, a need for consolidation can arise in the household and business sector,
which will strongly dampen growth. The consequences of altogether too strong growth now could
therefore be instability in inflation and production later. If the financial imbalances have become
altogether too great, there is a risk that the consequences will not be limited to great variations in
growth and inflation but will even lead to lower overall production.
The same course of development as in the USA?
As we have said, it is incontestable that the Swedish economy has functioned better than before.
However, there is a risk that we will overshoot. The exceptionally long upswing in the USA has
contributed to strengthening expectations on faster long-term growth in Sweden as well. There are
certain developmental features in the Swedish economy that are reminiscent of the American economy
which could indicate that. An important basis for the favourable development in the USA is probably
the approach to budget consolidation and price stability that has guided economic policy there for a
long time. And in those areas we have had a similar development in Sweden although the process
started later here. At the same time, the strong penetration of information technology in the American
economy is considered to be a factor that has contributed to the productivity improvements recorded in
the USA. As regards information technology, we are well to the fore, although it is first recently that
statistics indicate some increase in productivity growth. Expectations for a continued strong increase
in productivity in the USA have also been a basis for the strong rise on the American stock exchange.
The high share prices and the positive expectations have stimulated demand and the debt ratio in the
private sector has increased. It is not possible to write off the risk of financial imbalances being built
up in the USA, which risks having negative effects on the macroeconomy. However, many analysts
consider that the long-term growth rate has in fact increased in the American economy and that the
expectations that have served as the basis for investments and increased indebtedness will therefore be
realised.
Even if there are some indications that point to the Swedish economy undergoing a similar
development to the American, the structural differences cannot be disregarded, which probably create
greater inertia in the Swedish economy than in the USA. The labour market is one such area. As I
mentioned earlier, considerable barriers to competition also remain in the Swedish economy. Another
difference is that the cyclical upswing we are now experiencing is taking place at the same time as
growth is increasing in the surrounding world and resource use is increasing. The American upswing
could benefit from a surrounding world with a lot of free resources and low price pressure and with
few competing investment alternatives for international investors.
Should monetary policy counteract financial imbalances?
How shall monetary policy be designed if there is a risk for exaggerated indebtedness and
overheating?
A decision-making rule the Riksbank sometimes uses to motivate its monetary policy decisions can in
simple terms be described as follows: when inflation exceeds the target in a one-to-two year horizon,
then the interest rate is increased. Interest rate increases reduce the demand for goods and services,
which in turn reduces inflationary pressure. In our simple conceptual framework, inflationary pressure
is then assumed to vary with the use of resources in the economy. When there is free capacity,
inflationary pressure is low in the absence of so-called shocks. When demand is so high that it exceeds
the level that is compatible with the long-term production path, inflation tends instead to exceed the
target. The line of reasoning is based on inflationary expectations being established close to the target
for monetary policy. Price increases when demand is strong may for instance depend on bottlenecks
being created in some part of the production chain. As the company in this situation, cannot improve
its profits by increasing its volume of sales, profit margins are increased by price increases. Shortage
of labour also increases the risk for excessively high wage increases. The result will be higher
inflation.
If we strictly apply such a simple rule for decision-making, we shall then disregard the risk of building
up of financial imbalances and overheating as long as inflation is not deemed to exceed the target
during the forecast period.
In the most recently published inflation assessments, it was assumed that the price stability target was
not threatened during the forecast period despite the growth of demand being so strong that use of
capacity was under strain at the end of the period. The majority view of the Executive Board was
therefore that there was no reason to increase the repo rate. This assessment was based on free
resources in the initial situation, good productivity growth, low price increases on certain recently
deregulated areas, low import prices and finally low inflation expectations. It is not per se strange that
GDP can increase as much as 3-4% for a couple of years without inflation sharply accelerating, if the
use of resources is low initially.
If the pattern from previous cyclical upswings was to be repeated, price pressure should now increase.
However, it has proven difficult to identify any exact and very stable correlation. As I mentioned
earlier great changes have taken place in the Swedish economy. While there are still considerable
deficiencies in competition in many areas, it is nevertheless not probable that inflation will accelerate
strongly in the next few years. An important reason for this is that the price stability target has now
obtained such strong support that inflation expectations are not increasing despite a cyclical upswing
that is stronger than for a very long time. I have, however, for the reasons I mentioned earlier in my
speech, been somewhat more pessimistic than the majority of the Executive Board as regards inflation
assessments at the forecast horizon. Fluctuations of consumer prices a few tenths of a percent up and
down around the target in an economy with a strongly accepted price stability regime are per se less
important than the mode of functioning of the economy.
I am more concerned about what can happen with inflation and growth after the forecast period if
demand increases at the rate we have anticipated. The simple rule that says that monetary policy shall
only react if the target for inflation is not met during the forecast period is a good help when
conducting monetary policy. However, it is not reasonable to mechanically apply this rule in every
situation. The consequences that the economic development can have for macroeconomic stability and
inflation beyond the forecast horizon must also be weighed in. The risk for financial imbalances now
being built up when indebtedness is increasing and of inflationary pressure accumulating at the same
time must in my view therefore be taken into account in the monetary policy decisions. A
development that I described earlier can be the consequence if the expansion of demand and credit
continue to increase at a high rate. The quantity of money and lending, especially to households, are
for instance increasing at present at a rate which is probably not sustainable in the long term.
The advantages of simple rules for decision-making are that they are easy to explain which can be
especially important when establishing credibility for a low-inflation regime. With simple rules for
action, it becomes clear what has guided monetary policy decisions. However, as I have shown, this
does not necessarily result in optimal policy in every situation in the sense that macroeconomic
stability and longer-term price stability are achieved. The difficulties in assessing when demand and
the increase in lending are too strong are certainly considerable although this applies by and large to
all the assessments we have to make.