Lars Heikensten: Introduction on monetary policy
Speech by Mr Lars Heikensten, Governor of the Sveriges Riksbank, at The Riksdag Committee on
Finance, Stockholm, 14 October 2004.
* * *
Let me begin as usual by thanking you for the opportunity to come here and give an account of the
Riksbank's monetary policy. It is ten years now since my predecessor Urban Bäckström was here for
the first time to attend a hearing under such transparent and public conditions. At that time the inflation
target had only recently been introduced. Given that this is the tenth anniversary of the hearings in
their current form, I think it is appropriate to begin by looking back on the past years. One conclusion is
that much has gone well; the inflation rate has been low and stable, and growth in both real wages
and the Swedish economy in general has been high. Employment growth has not been quite as
robust, however. Against this background, I will be focusing particular attention today on the issue of
monetary policy's ability to influence employment. By way of conclusion, I intend to touch upon the
Riksbank's outlook for economic developments and inflation in the years ahead and to comment on
the decision we made yesterday regarding the repo rate.
Ten years of low inflation
New policy
The crisis at the beginning of the 1990s was a dramatic, tragic conclusion to almost twenty years of
stabilisation policy problems in the Swedish economy. The 1970s and 1980s witnessed a succession
of cost crises. The fundamental problem was that economic policy had been unable to prevent
excessively fast rises in wages and prices from ending up time and again on a collision course with the
commitment to maintain a fixed exchange rate. As a result, the krona was devalued five times
altogether over the period 1976-82. When the fixed exchange rate was finally abandoned in November
1992, following extremely high interest rates and costly attempts to defend the krona, it was obvious
that something fairly drastic had to be done to enable the Swedish economy to develop more
favourably than during the previous twenty years.
The solution was what could be called a shift in stabilisation policy regime, whereby the framework
and rules for both monetary and fiscal policy were fundamentally changed. The shift in regime involved
the introduction of a distinct division of roles in Swedish economic policy. The exchange rate remained
variable and monetary policy was given the main task of trying to keep inflation at a low, stable level.
Fiscal policy, which had often resulted in large deficits under the previous regime of a fixed exchange
rate, would now instead be targeted at achieving long-term stability and sustainability in the public
finances.
Favourable results
Looking back at the ten or so years that have passed since the change of regime, I think that most
would agree with me that the shift in policy has turned out well and that the new stabilisation policy
regime has lived up to our hopes. Sweden has gone from having been a high-inflation economy with
recurring cost crises, high interest rates and unstable economic performance, to being an economy
with low, relatively stable price rises and wage increases that put real money in people's pockets, and
where the risk of overheating and subsequent recession has diminished markedly. In an international
perspective, too, the Swedish economy has performed well in the past decade, in stark contrast to the
1970s and 1980s.
The robust performance is evident if you compare developments in a number of central variables
during the 1970s and 1980s with their developments under the new stabilisation policy regime.
(Chart 1.)
In the 1970s and 1980s the rate of price increases stood at just over 8 per cent a year, while the
corresponding rate since 1995 has been just below 2 per cent. The lower inflation rate has not entailed
weaker growth in output. On the contrary, GDP growth has averaged around a half percentage point
higher a year under the new regime. Productivity growth has also been more robust. The higher
economic growth and productivity has contributed to healthy growth in real wages. This is one
considerable difference compared with the developments in the 1970s and 1980s. While real wages
have risen by about 2.5 per cent a year since 1995, the annual increase in real wages was no more
than around 1 per cent in 1970-89. So, even though nominal wages rose more than 9 per cent a year
during the 1970s and 1980s, purchasing power improved by only about 1 per cent; the high inflation
and devaluations eroded the rest.
In fairness, I should add that in addition to the shift in stabilisation policy regime there were a number
of significant changes in other areas too that may have contributed to the robust performance. For
example, the rapid advances in information technology are likely to have contributed to the improved
productivity. Another important factor underlying the stronger recorded productivity growth in the whole
economy is the relatively smaller role of the public sector today compared with ten years ago. Yet
another feature of the performance of the last ten years is deregulations and increased international
competition, the latter boosted by membership of the EU and the ongoing integration of the world
economy.
So, Sweden's economic performance after the crisis in the early 1990s has been healthy in many
respects. This does not mean that there are no problem areas. One of these is employment. There
was indeed a relatively fast upturn in employment after the crisis years. It has also proved possible to
combine low unemployment, compared with other European countries, with low inflation, contrary to
what many experts expected. But open unemployment has only come down towards 4 per cent in a
few occasional years, and stands today at 5.5 per cent. The number of employed now is lower than
before the crisis, and some 1.2 million people of working age (16-64 years) are not participating in the
labour force.
The regime shift and employment
Against this backdrop it's not surprising that a lively debate arises from time to time about
unemployment and what can be done about it. What is perhaps more surprising is that some people
still assert that the shift in stabilisation policy regime at the beginning of the 1990s is what has caused
unemployment to be higher today than it was during the 1970s and 1980s. Sometimes the argument
goes that Sweden has given up its previous objective of full employment in order instead, for some
more or less obscure reason, to introduce a target for inflation. If we only were prepared to return to
the high-inflation policies of the 1970s and 1980s, then everything would be better.
There is much to say about this. Firstly, it is difficult in a more general sense to imagine that the
markedly improved stability in economic policy that the shift in regime brought about in the long run
could be something negative for employment. Instead, there are many reasons to believe that more
stable economic performance over time also leads to conditions that foster high growth and
employment.
Moreover, a simple comparison of unemployment data between the periods before and after the shift
in regime proves rather misleading. This is because of the attempts in the 1970s and 1980s to meet
the target of full employment through a policy that was unsustainable in the long run - it was exactly
because of this that the change in regime was implemented. As I mentioned earlier, this policy
involved Sweden devaluing the krona as soon as we were hit by a cost crisis that resulted in weaker
developments in exports and employment in the private sector. The devaluation of the krona restored
competitiveness by lowering real wages for a number of years until excessive increases in prices and
wages compared with abroad once again eroded the scope that had been created. The other way in
which unemployment could be kept down was through a sharp increase in public sector employment.
From having comprised 15 per cent of the labour force in 1960, the proportion of the employed
accounted for by the public sector rose to just over 30 per cent by the end of the 1980s. So even
though jobs were being lost in the private sector, employment held up through increased employment
in the public sector.
However, neither the decreases in real wages due to the devaluations or the increased public sector
employment could solve the problems in the long run. As a result of the devaluation policy, it became
increasingly difficult to keep inflation in check. Wage earners tried to compensate themselves for the
reductions in real wages, and firms had little reason to resist; everyone believed that the krona would
be devalued if price and wage inflation became too high and competitiveness was threatened. The
expansion of the public sector contributed in turn to a rise in the tax burden that was unsustainable in
the long run. One way of putting it is that the devaluations and the increase in public sector
employment allowed us to put off dealing with our employment problems.
Monetary policy and employment in the long term
The crucial insight when discussing unemployment and jobs - an insight which has firmly rooted
support in decades of economic research and practical experience - is that loose monetary policy
cannot be used to bring about a lasting rise in employment. The best that monetary policy can do is to
reduce the fluctuations in the cyclically determined component of unemployment. Consequently, it's
not possible to create lasting jobs by systematically keeping interest rates low, weakening the
exchange rate and allowing inflation to rise.
In other words there is no opposition between a target for inflation at the levels pursued by most
central banks today and a policy of high employment. In order to reduce unemployment permanently,
attempts must be made to influence the structural component of unemployment, i.e. the component
that is not due to fluctuations in the demand for goods and services in the economy. And this requires
completely different measures than those of monetary policy. In particular, it is a question of
implementing measures that influence the functioning of the labour market.
One indication that the employment problems we are seeing today are largely structural is the big
differences in unemployment that exist between different regions and different occupational
categories. (Chart 2.) Unemployment figures are twice as high in some regions as in others, and the
percentage of people receiving benefit from their unemployment fund is twice as high in some
occupational groups as in others. The fact that these differences remain over long periods, even when
there is a shortage of skilled labour, suggests that the labour market doesn't function as well as might
be desired. The problems in the Swedish labour market are also underlined by the fact that open
unemployment barely came down to 4 per cent when economic activity was at its strongest a couple of
years ago.
Target deviations and employment
How the Riksbank works
So, even though monetary policy cannot be expected to have any tangible impact on employment in
the long term, short-term effects can arise. This is because a policy aimed at attaining the inflation
target may entail changes in interest rates, which temporarily affect demand so that employment rises
or falls. The limit for how long and how much monetary policy can raise employment is determined in
practice by the economy's long-term growth potential, which in turn depends partly on how well the
labour market functions. When we conduct monetary policy with an inflation target, this means under
normal circumstances that we can help stabilise actual output around its long-term potential. If the
Riksbank is to be able to take any account of employment in the short run, however, it is particularly
vital that economic agents have confidence in monetary policy and the inflation target; this is a clear
lesson from the situation in the 1970s and 1980s.
As you know, the principal instrument we use to try to meet the inflation target is the repo rate. We set
this rate with the aid of forecasts of inflation a couple of years ahead. Naturally, a lot can change in the
space of two years so that our forecasts do not prove accurate. We can make up for this to some
extent by being able to change the rate in the light of new information. But we can't compensate
entirely for such events, of course. Sometimes, developments affect inflation at very short notice: a
sharp hike in electricity prices, an equity price bubble that bursts, a war that heightens unease in the
world and curbs demand, etc. In such cases it's not possible to prevent inflation from deviating from
the target, and even if it was possible to lessen the deviations, it may require such sharp movements
in interest rates and such substantial effects on the economy that it would not seem desirable or
reasonable. When inflation deviates from the target, we normally try to bring it back gradually to the
target so as to avoid unnecessary fluctuations in the real economy and in interest rates.
When Sweden became one of the first countries to define its objective for monetary policy in terms of
a definite figure - even though we were very aware of the fact that it would be difficult to meet such a
target exactly - we did so for several reasons. One was to find an anchor for policy - a target around
which inflation expectations could be stabilised. But it was also done with a view to facilitating
evaluation of our activities and to make it easier to enforce accountability. Further steps were taken in
the same direction when we, once again among the first in the world, decided to publish the material
underpinning our decisions, mainly our inflation forecasts. This provided a more comprehensive basis
on which to analyse the background to our policy. Are deviations from the target a result of incorrect
assessments? If so, in what respects? Do we differ from other forecasters or not, etc? The conditions
for understanding and evaluating our actions were probably improved further when the Riksbank in
1999 began to publish the minutes from its monetary policy meetings. Now it is also possible to
examine the arguments put forward. Were they the right arguments or not in the light of what has
happened? On the whole, I believe that we have laid a solid foundation during these years for an
in-depth assessment of our decisions.
Inflation and inflation expectations
So how well has the Riksbank succeeded in achieving its target in the past ten years? (Chart 3.)
Looking at the average inflation rate since the target was introduced in 1993, CPI inflation has been
1.8 per cent, while the measure of underlying inflation that we in practice have used over a large part
of the period to explain our policy, UND1X, has been 2.1 per cent. If we instead make the comparison
from 1995, the year when policy began to have its full impact, the corresponding figures are 1.4 and
1.9 per cent, respectively. Even when average inflation has stood fairly close to the target, sharp
deviations can of course occur periodically. This has also been the case; during shorter or longer
continuous periods inflation has been above or below target. At the same time it is also evident that
the size of the deviations depends somewhat on the inflation measure in question. UND1X has
fluctuated less as it is not affected as much by changes in interest rates and taxes.
In this context it is also interesting to look at inflation expectations; have they been affected much by
the fact that we sometimes have missed the target or that we on average have been slightly below it?
(Chart 4.) Even though inflation expectations can be measured in different ways, the overall picture is
clear. From around 1996-97 expectations have been fairly well in line with the target a couple of years
ahead. Sometimes, of course, they have moved according to the actual inflation rate, but they have
not been much above or below the target for any appreciable length of time. This is a much better
performance than most expected when the monetary policy regime was changed in the early 1990s,
and many doubted that we would attain the low, stable inflation that we actually have achieved.
Allow me to make a comment in this context. Sometimes, it is claimed that the Riksbank acts
asymmetrically, being more focused on avoiding exceeding the target than falling short. However, this
view is not supported by measurements of inflation expectations: economic agents do not believe that
we have a "secret agenda". Instead, they believe that we try to do exactly what we are doing: trying
our best to achieve inflation of 2 per cent and a stable economic performance in Sweden.
Reasons for target deviations
So what has caused the target deviations in the past ten years? Four factors seem to have been
especially significant:
•
At the beginning of the period with an inflation target, particularly in 1996, the CPI was
affected considerably by the dramatic decline in interest rates that ensued when the
credibility of the new regime was established.
•
On a couple of occasions in the past years, rapid rises in energy prices in particular, but also
in food prices, have pushed up inflation. The rises were essentially related to supply factors,
such as water shortages in hydroelectric power companies' reservoirs. The effects were
judged to be temporary, which also proved to be the case.
•
During certain periods, not least recently but also in the latter part of the 1990s, imported
inflation has been unexpectedly low.
•
At the end of the 1990s and the beginning of this decade, productivity growth has been
unexpectedly robust.
It is interesting to note that during several periods when inflation was below target, monetary policy
was clearly loose at the same time as GDP growth was high. But in spite of this, inflation has been too
low. What has happened above all is that unexpected supply changes have dampened inflation. This
has been a global phenomenon to a large extent; in other words, a situation that we have shared with
other countries.
Developments in recent years
With hindsight, we can certainly see that the Riksbank has not always succeeded in predicting inflation
correctly and that monetary policy therefore could have been conducted somewhat differently on a
number of occasions in the past ten years. This applies, for example, to 1995 and perhaps also to
1999-2000, even though the latter period's probably too low interest rates did not have any
consequences since the upswing in the economy and inflation was broken when the equity price
bubble burst. This has also been the case in the past few years. Since the second half of 2003
inflation has been below target, and it is likely that it will continue to be so for at least another half year
or so. This suggests that interest rates could have been lower in primarily 2002 and 2003. One
conclusion from this is that we must deepen our understanding of factors such as productivity and of
the impact on international prices of tough global competition. In these respects we are essentially in
the same boat as other forecasters. As far as we can see, no Swedish forecasters have presented
forecasts that have differed markedly from our own. In discussions with colleagues abroad, moreover,
I have noted that all have been surprised by the low international inflation in the past year. When this
kind of shock occurs, whether it is a question of lower or higher inflation, it is reasonable to allow the
effects to dissipate gradually and not to act too strongly with the interest rate.
One feature of the debate on monetary policy in the past year has been more or less fanciful
assessments of how much higher employment could have been if only the Riksbank had acted more
prudently. The figures have varied from 20,000 up to 75,000 more jobs. It is certainly not easy to make
these kinds of counterfactual estimates; I admit that much. They require some rather bold
assumptions. They presuppose not only that the Riksbank would have been considerably more
successful than all other forecasters in assessing where the economy is headed. They also
presuppose that we would have succeeded in convincing external parties of this in advance, and
would have done so at least partly during a period when inflation in Sweden was clearly above the
2 per cent target.
In order to get an idea of what the effects on employment of a different interest rate policy could have
been, we have conducted a couple of experiments ourselves. They show that it would have been
difficult to achieve employment effects over 10,000 people even if the repo rate had been a whole
percentage point lower in the past year. In order to put this figure in perspective, it may be worth
remembering that around 200,000 people in Sweden today are openly unemployed and almost
400,000 people of working age are on sick leave. For safety's sake, I should perhaps also stress that it
is a question moreover of a shift in the timing of an employment upswing, and not a question of jobs
having been lost for good.
Allow me to round off this discussion. In my opinion, the shift to low inflation has worked well on the
whole, considerably better than most people thought. This does not mean of course that our policy at
various times does not deserve criticism, and recently the Riksbank has undeniably fallen short of the
2 per cent target. This spurs us to deepen our understanding of the inflation process even more.
Nevertheless, some of the criticism that has been levelled at the Riksbank has been out of proportion
and ill-founded. The unemployment problem is so serious that it deserves a better discussion.
The current assessment
By way of conclusion, I shall now comment on the Inflation Report that we published today and the
decision we made yesterday regarding the repo rate.
The main scenario
In brief, the main scenario described in the Inflation Report can be summarised as follows.
International economic activity is expected to continue to strengthen this year. Over the coming two
years, growth is expected to be robust, although it will probably be dampened somewhat. Thus far, the
underlying strength of the upturn has if anything surprised on the upside, largely thanks to
developments in a number of emerging economies in Asia, Latin America and eastern Europe. There
is therefore reason to be slightly more optimistic than we were in the May Inflation Report with regard
to short-term prospects for growth in the world economy, despite the signs of weaker developments in
the United States. Coupled with the unexpectedly large price increases for oil and other commodities,
this means that international price pressures are expected to be slightly higher than previously
forecast, particularly this year and next year.
Economic growth in Sweden is also forecast to be robust throughout the forecast period and has been
revised up in relation to the May forecast. The unexpectedly high international demand has
contributed to surprisingly rapid growth in exports over the summer. The increasingly evident recovery
in the IT and telecoms sector has also contributed to the favourable growth in exports. The Budget Bill
contained signals of more expansionary fiscal policy in the period ahead, which can be expected to
further boost demand in the economy through effects on both private and public consumption. New
National Accounts data also indicate that the pickup in investment long expected by the Riksbank and
other forecasters now appears to have begun. As in the May Report, gradually higher resource
utilisation and rising international prices are expected to lead to a gradual increase in inflationary
pressures. So, although inflation is expected to be slightly higher than previously anticipated, our
assessment is that it will be in line with the Riksbank's target towards the end of the forecast period.
Some questions
One could say that the Inflation Report revolves around some questions, which I intend to touch upon
briefly:
•
One question is to what extent the high oil price will significantly hamper international
economic activity. Although we, like most other forecasters, still assume that the oil price will
fall again over the coming years, our assessment is that the price will be higher during the
forecast period than we estimated in May. However, there are indications that the effects of
the high oil price on growth will be relatively limited. For instance, the rise in the oil price
appears to be largely a result of the fact that the world economy is expanding, although
concern over terrorist acts and other factors also appears to have played a role. In addition,
western world economies are today much less dependent on oil than they were in the 1970s,
while monetary policy is now conducted in a way that makes it difficult for inflationary
impulses from oil price rises to gain a foothold. Our current assessment is therefore that the
high oil price will dampen, but not derail, the international economic upswing and that the
effects on global inflation will be fairly modest.
• Another question is how inflation could be so low thus far this year, despite growth being
relatively high. One important explanation for the relatively low domestic inflation is, as I
mentioned earlier, the high productivity growth. Combined with low wage increases, the
favourable productivity growth has meant that cost pressures in the Swedish economy have
continued to be moderate. This has been the case despite electricity prices failing to fall as
sharply as we assumed in May. Imported inflation, which I also touched upon earlier, has
been weak as well. The high oil price has been countered by price falls for other imported
goods, including clothes and footwear. This question is in turn connected with another: how
is it that we expect inflation to remain relatively low during the forecast period when we have
revised up our growth forecast? One explanation is that we have allowed our assessment to
be affected by the new productivity figures, the lower wage outcomes and the continued
weak situation in the labour market. In our current assessment, inflation would probably have
been around a tenth of a percentage point higher if we had not taken into account the new
information received.
The balance of risks
To sum up, the forecast in the main scenario is that Swedish GDP growth will be 3.6 per cent this year
and 3.2 per cent a year in 2005 and 2006. Private consumption and investment are expected to take
over from exports as the main driving forces behind the pickup in demand in 2005 and 2006. UND1X
inflation is expected to be 1.4 per cent one year ahead and 2.0 per cent two years ahead, while the
corresponding figures for CPI inflation are forecast to be 1.6 per cent and 2.5 per cent, respectively.
This time, both the international and domestic inflation risks are judged to be balanced. On the
international front, the main upside risk is that the oil price will develop more unfavourably and have
greater contagion effects on other prices than is currently foreseen. The downside risks mainly consist
of a number of financial imbalances that could contribute both to lower inflation and weaker economic
activity. These include high house prices and an increase in household indebtedness in many
countries, as well as the large deficits in the US federal budget and current account. On the domestic
front, the risks are mainly related to productivity growth; more specifically to what extent the robust
productivity reflects a more permanent structural phenomenon and to what extent it is due to cyclical
factors. There is considerable uncertainty in this regard and there is a risk both of overestimating and
underestimating future productivity growth.
The balanced risk outlook means that the probability of inflation being higher than the forecast in the
main scenario is judged to be equal to the probability of it being lower. In other words, the
risk-adjusted inflation forecast is the same as the forecast in the main scenario.
Interest rate decision
Given the outlook for economic developments and inflation that I have outlined here, we decided
yesterday to leave the repo rate unchanged.
As the economic upturn progresses and resource utilisation increases further, it is reasonable to
assume that monetary policy will in future need to become gradually less expansionary. There is
nothing dramatic about this; rather, this is normally necessary in an economic upswing to ensure that
the inflation target is attained and that economic developments in the period ahead are stable. It is
also what most forecasters appear to be expecting. However, it is worth emphasising that it is not
possible at present to determine exactly when it may be appropriate to make a first adjustment of the
interest rate level. This will depend as usual on how the Riksbank assesses the inflation outlook and
on the new information received regarding economic developments.
Thank you.
1. Averages for the periods
1970-1989 and 1995-2003
9 9
8 8
7 7
6 6
1970-1989
1995-2003
5 5
4 4
3 3
2 2
1 1
0 0
Inflation GDP growth Real wage increase, whole Change in productivity,
economy whole economy
Source: Statistics Sweden
2. Proportion of open unemployed members
in different unemployment benefit funds
Per cent of members
10 10
2002
2003
9876543210 9876543210
SIF
HTF
SEKO
workers workers workers workers and workers
Teachers
officers
Graduates
employees
government Commercial
Government
officers
Hotel
Building
Local Industrial
Transport
Municipal restaurant
Note. HTF = The Salaried Employees' Union. SIF = The Swedish Union of Clerical and Technical Employees in Industry. SEKO = The Union of
Service and Communication Employees. The building workers' funds consist of The Building Union's and the Swedish Painters' Union's
unemployment benefit funds. The industrial workers' funds consist of the unemployment benefit funds of the Swedish Metal Workers' Union, the
Swedish Forest and Wood Trade Union, the Swedish Food Workers' Union, the Swedish Paper Workers' Union, the Swedish Graphic Workers'
Union and the Industrial Workers' Union. The number of members in the unemployment benefit funds included in the chart comprised in 2003 around
88 per cent of the total number of unemployment benefit fund members in Sweden.
Source: National Labour Market Board.
BIS Review 59/2004
3. Different measures of inflation
Annual percentage change
6 6
5 5
CPI
4 4
UND1X
3 3
2 2
1 1
0 0
-1 -1
1993 1995 1997 1999 2001 2003
Source: Statistics Sweden
4. Different agents' expectations
of inflation two years ahead
Per cent
4 4
3 3
2 2
1 1
0
0
Purchasing managers
Labour market organisations
Money market agents
-1 -1
1995 1996 1997 1998 1999 2000 2001 2002 2003
Source: Prospera
BIS Review 59/2004