Villy Bergström: Monetary policy in an uncertain world
Speech by Mr Villy Bergström, Deputy Governor of the Sveriges Riksbank, to the Sparbanksstiftelsen
Nya, held at the Gävle concert hall, 14 May 2001.
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Following several years of very strong GDP growth, we are now seeing a slowing down in the Swedish
economy. It is necessary for the growth rate to slow down over the next few years to avoid a long-term
threat to price stability. While there was a plentiful supply of free resources, GDP could grow more
quickly than the long-term productivity growth and labour force supply allowed. Now, however, the
resources are running out and production needs to be adapted to a slower rate that is more
sustainable in the long term. When the Riksbank raised its repo rate by 25 points to 4 per cent in
December last year, the decision was based on assessments that demand would continue to increase
to such an extent that the shortage of resources would lead to the inflation target being exceeded. The
interest rate was raised despite the fact that the inflation rate was then only 1.4 per cent. This shows
the pedagogical and practical problems the Riksbank faces when making such decisions. Monetary
policy decisions are based on assessments of the inflation rate a couple of years ahead and are
aimed at achieving the inflation target in this time horizon. This means that we are often forced to raise
the rate, despite the fact that the inflation rate is below the target at the point in time when the decision
is made. Conversely, interest rate reductions may be motivated even when the inflation rate is above
the target level.
As we all know, since the end of last year, the unexpectedly severe slowdown in the US economy has
led to a downward revision in the assessment of Swedish production growth over the next two years.
However, according to the assessment published by the Riksbank earlier, the most serious
consequence of the slowdown will be that almost all of the resources within the Swedish economy will
be occupied. If this is realised, one could say that the USA-led economic slowdown is, in a way, a
welcome development in Sweden.
The information on the Swedish and international economies that has been received in recent months
does not give reason to change the assessment of the economic slowdown in Sweden. However, the
signals are rather mixed and there is still considerable uncertainty. The downside risks with regard to
international growth still remain. Despite the fact that growth has so far developed largely in line with
our earlier assessments, price increases have been slightly greater than we had estimated. The krona
has also continued to develop weakly. However, the wage agreements that have been signed so far
appear to be in line with the earlier assessments. In the light of these developments, the Executive
Board decided at its monetary policy meeting on 26 April to leave the repo rate unchanged at 4 per
cent.
I would like to spend the rest of my time here discussing the conditions for economic growth in the
near future - both here in Sweden and abroad.
The American economy is a decisive factor
There is still great uncertainty over how quickly confidence in the American economy will return and
what spread effects this will involve for the rest of the world.
The slowdown in the American economy was preceded, as we know, by a long and pronounced
economic boom. Great optimism over future growth prospects, based mainly on expectations of gains
in efficiency from IT, led to a substantial increase in investment, a strong growth in consumption and
rising share prices over several years. The growth in investment and rise in share prices were
particularly strong in IT-related sectors. The high level of domestic demand could not be met with
American goods and services, but spilled over to create a considerable deficit on the current account
over several years. At the same time, there was a strong expansion of credit. Both households and
companies have greatly increased their level of indebtedness, while rising asset prices have increased
household wealth. This development has been reflected in a considerable deficit in savings. The
deficit in savings in the private sector amounted to approximately 7 per cent of GDP at the end of last
year, with both households and companies contributing to this figure.
Despite the strong demand, inflationary pressure has been only moderate. The dollar exchange rate
was strengthened by widespread inflows of capital from foreign investors who bought American
shares and a strong growth in productivity has had the effect of subduing prices.
What characterises periods with a build-up of financial imbalances?
The development of the American economy bears some similarity to the development that has usually
preceded the financial crises that have affected many countries in recent decades. Characteristic for
the development of countries that have suffered financial crises has been than an optimism, which has
later proved to be unwarranted, has been reflected in rising asset prices, over-investment, excessively
high consumption and a strong expansion in credit. It has rarely or never been possible to determine
in advance when a realistic optimism has passed into over-optimism and in its turn pushed up asset
prices, investment, consumption and indebtedness. It has rarely been possible to judge, for instance,
whether a large build-up in indebtedness has expressed an adaptation to realistically based
expectations of future growth prospects or whether the build-up in debt is based on exaggerated
expectations.
In addition, the target that has been used to guide monetary policy has rarely been able to signal early
enough that imbalances were being built up, regardless of whether monetary policy was aimed at a
fixed exchange rate or towards a price stability target. To simplify, one can say that the result of an
exaggerated optimism in countries with a fixed exchange rate has been that the build-up of financial
imbalances was expressed in rising inflation without any depreciation pressure on the currency. It has
not been possible to subdue inflationary pressure through raising interest rates while optimism
regarding the country's economy and confidence in the fixed exchange rate regime have remained, as
a more stringent monetary policy would have reinforced the nominal exchange rate. At the same time,
increases in consumer prices have been kept down by the strong currency, temporary increases in
productivity, or by demand being aimed towards, property, shares and land - assets whose prices are
not included in the central bank's target function. There has thus been no reason for monetary policy
to counteract the emergence of financial imbalances.
When the financial bubble has actually burst, the country has often suffered a deep and long-lasting
recession caused by adaptations to the imbalances that have been built up. A high level of
indebtedness, falling asset prices and unprofitable investments have subdued demand for a long
period of time. Households have chosen to increase their savings to reduce their debts. Companies
have been unable or unwilling to invest as a result of earlier investment mistakes and poorer
prospects for the future. The banks have suffered severe credit losses, which has further intensified
the recession, as their capacity to provide new credit has been limited. The situation becomes
particularly serious when losses have led to acute bank crises, which has often been due to the banks
being greatly exposed to a particular sector. For instance, it was an overheated property market with
banks strongly exposed to this sector that was one of the main reasons behind the bank crises
afflicting several countries - including Sweden - at the beginning of the 1990s. Adaptations to large
financial imbalances have also put a burden on central government finances and increased
uncertainty. This has in itself prolonged and intensified the crisis. Japan is a well-known example of
what can follow in the tracks of a serious financial crisis if confidence cannot be recreated in economic
policy and future growth potential.
The consequences of financial imbalances have proved particularly serious in countries with a fixed
exchange rate, partly because interest rates need to be kept high when confidence in the fixed
exchange rate policy declines, and partly because there has often been a large foreign currency debt.
When the fixed exchange rate has to be abandoned and the country's own currency is weakened, the
burden of debt increases.
Should the central bank then concern itself with asset prices?
Following the dramatic 1990s in the USA (and Sweden), with soaring prices on shares and property,
many people began to think that perhaps the central banks should keep an eye on asset prices and
react to these, even if there were no sign of rising inflation.
Overrated share prices and/or property prices lead sooner or later to an adjustment in asset prices. If
this adjustment is dramatic, the effect could be an economic downturn, with rising unemployment and
a slowdown in prices. The extreme valuing of certain shares in the IT and telecom sectors on the
American stock exchange, Nasdaq, should perhaps have warranted more stringent monetary policy a
few years ago, according to the international debate on monetary policy.
One argument put forward as to why the central banks should not merely look to forecasts regarding
consumer prices when making decisions on monetary policy, but should also monitor the development
of asset prices, is that ownership of shares is much more widespread now. Thus, changes in asset
prices probably have much greater significance for household expenditure now than they did before.
Deregulation, liberalisation and globalisation have increased the importance of the capital markets for
economic developments and made them more volatile. Assets with market prices now comprise a
much greater share of households' balance sheets than before. This is thus claimed to be a good
reason for monetary policy to take into account developments in asset prices.
In the worst case, falls on the stock exchange that correct overvaluations can lead to financial
instability, if share prices have been driven by pledged shares and if the market participants are in
some cases unable to pay back their loans. This can result in panic sales, exaggerated falls in prices
and credit institutes facing difficulties as a result of exposure to households and institutions that have
become insolvent. This result risks leading to large fluctuations in the real economy.
Critics of the Federal Reserve in the USA claim that when Alan Greenspan coined the phrase
"irrational exuberance" in 1996, it was clear that prices on the stock exchange had risen too much and
that this development should have been counteracted. Nothing was done and the rise in share prices
continued until March 2000. Since then the stock exchanges have fallen, Nasdaq by 70 per cent, and
the fall on the stock exchange risks pulling the USA down into a recession that could have been
avoided.
However, comes the objection; is it really possible to realise when a stock exchange has risen too
much? The answer is that prices on the stock exchange must have some relation to the underlying
development of productivity in trade and industry, to company profits and to the market's pricing of
risks.
Of course, it is not possible to determine precisely when the stock market has risen too much or when
it is undervalued. However, it should not be too difficult to detect obvious deviations. The problem is
similar to the central banks' analyses of the output gap, which indicates whether there is an inflationary
risk in the economy as a result of an excessively high level of activity or a risk of deflation. The output
gap is calculated routinely by central banks around the world, and these calculations estimate the
sizes that would be included in a calculation of over-valuation or under-valuation on the share
markets. It can hardly be easier to calculate potential growth for the entire economy than the
fundamental value of the stock market, according to critics of US monetary policy.
It should be possible, at least in the case of major deviations from fundamental economic conditions,
to detect imbalances on the asset markets, exaggerated valuations that could potentially give rise to
monetary policy measures being necessary, even if the target for consumer prices is being followed
fairly well.
This is how the international discussion runs, caused by stock market developments, primarily those in
the USA, with the current fears that the large downturn on the stock exchange will be followed by a
deep recession.
For a small, open economy like Sweden's, the possibility of affecting share prices through monetary
policy restraint should be limited. The Swedish stock market is strongly correlated with that in the USA,
partly because many of the companies listed on the Swedish stock exchange are multinational. In
principle, however, there is good reason for taking action if we assess that large financial imbalances
are being built up. This is partly because these can cause instability in both the real economy and
prices when the bubble bursts and partly because the stability of the banking system could be
threatened. Measures to avoid financial imbalances being built up are thus motivated on the basis of
both of the Riksbank's objectives; to maintain price stability and to promote a safe and efficient
payment system. However, the question is how effective the interest rate is as a weapon - perhaps
other means can be utilised. Examples of such measures are monitoring the financial institutions and
making capital adequacy requirements of them. The analyses made by the Riksbank in its Financial
Stability Report are also aimed at drawing the attention of the banks and other authorities to any
problems and they thus play a role in this context.
How great are the problems created by the imbalances in the USA?
Is there a risk that the imbalances in the American economy are so great that the process of
adaptation back towards a balance will dramatically intensify and prolong the economic slowdown? It
can be noted that none of the ten major economic analysts of the American economy assesses that
the USA will suffer a recession during the next few years.
Firstly, it is probable that the growth potential that can be created by developments in technology is far
from exhausted. There should thus be good reason for at least some of the optimism that has
comprised a basis for earlier developments. When confidence in the American economy returns and
investment growth takes off, there is every indication that productivity will continue do develop
favourably. However, this does not mean that the long-term growth path indicated earlier by
developments in share prices and demand will be realised. Secondly, it seems that the
over-investment has mainly taken place in the IT sector, where financing has been largely via the risk
capital market. The depreciation period for IT investments is often short, which means that investment
mistakes do not affect the willingness to invest in the long term. The bank system does not appear to
be particularly strongly exposed to the IT sector and the risk spread among the banks' assets is
assessed as good. There would thus appear to be little risk of problems in the banking sector
reinforcing the slowdown to any great extent. Finally, there is scope to use fiscal and monetary policy
to stimulate the economy, if necessary. The American central bank has utilised part of this scope and
lowered interest rates by a total of 2 percentage points since the beginning of the year. The central
government finances are in good condition. For several years now the public sector - unlike earlier
periods of large American current account deficits - has shown a surplus in savings.
All in all, there are thus many factors indicating that confidence in the American economy can quickly
be recovered. If this is true, the economic decline will not last very long. The most likely situation is
therefore that although the high level of indebtedness, the large deficit in savings in both the
household and corporate sectors, combined with over-investment in certain sectors, will subdue
growth for a time, there will be no dramatic or prolonged economic recession.
However, in order to increase saving in the economy and thus correct the constant deficit on the
current account, it is necessary that growth is not primarily driven by increases in consumption. Net
export and investment should instead be the motors behind growth to a larger extent than before.
Bringing about this state of affairs requires a weaker dollar exchange rate. One can therefore look with
scepticism on the idea that tax cuts will bring the American economy out of its decline.
How will Sweden be affected?
The American economy affects developments in the rest of the world through many different channels,
with exports to the USA as the most direct channel and the one where the effects are easiest
measured. However, exports to the USA are only responsible for a couple of per cent of GDP in
Sweden and have a similar significance for the euro area. Spread effects via the expectations that
largely govern consumption, investments and the stock market are probably much greater, although
more difficult to measure. Nevertheless, there are numerous indications that the Swedish economy is
more sensitive to developments in the USA than the economies in the euro area. For instance,
shareholding is more widespread among Swedish households and many of the major "Swedish"
multinationals - in which Swedes have invested a substantial part of their shareholdings - are very
dependent, directly or indirectly, on developments in the USA.
Developments in the Swedish economy in recent years have shown many similarities to developments
in the USA. Rapidly rising share prices, a strong GDP growth driven by both investment and
consumption and an increase in indebtedness is a description that fits both the Swedish and American
economies in recent years. However, the increase in economic activity began later in Sweden and has
not really had the same speed as that in the USA. Moreover, the rise in Sweden was preceded by a
period where adjustments following the crisis at the beginning of the 1990s had forced down
investment and consumption considerably and where both the household and corporate sectors had
reduced their level of indebtedness. Saving in both of these sectors was therefore at a high level and
indebtedness fairly low when growth in the Swedish economy picked up. Now that economic activity is
slowing down, the private sector's indebtedness is not particularly high, from a historical perspective.
Furthermore, the lower interest rates will mean that interest expenditure comprises a much smaller
burden for borrowers now than previously. Although the surplus in saving in the private sector has
declined gradually in recent years, it only became a slight deficit towards the end of last year. This
applies to both the household sector and the corporate sector. There is thus a substantial difference
here from developments in the American economy, where saving in the private sector at the same
point in time amounted to almost 7 per cent of GDP. The risk of widespread financial imbalances
having built up here in Sweden is therefore slight. Growth in Sweden thus need not be hampered to
any large degree by indebtedness in the household and corporate sectors or by investment mistakes
in Swedish companies. At the same time, central government finances have been consolidated and
the central government's established ceiling for expenditure and its targets for the current account
balance have reduced uncertainty over central government finances in the near future. The support for
and confidence in the inflation target are yet another fundamental factor helping to create favourable
conditions for growth in the Swedish economy.
To summarise, the Swedish economy is in good condition. This speaks in favour of the slowdown in
GDP growth being moderate and production now entering a growth path that is at a level more easily
sustainable in the long term. The uncertainty stems mainly from the outside world and particularly from
the risks arising from financial imbalances in the American economy. However, there are also many
indicators there that confidence will return fairly soon and that the economic decline will not be
dramatic.