Per Jansson: Time to improve the inflation target?
Speech by Mr Per Jansson, Deputy Governor of the Sveriges Riksbank, at Handelsbanken,
Stockholm, 3 December 2015.
* * *
I would like to thank Mikael Apel for helping me with this speech.
Since the global financial crisis, the world economy has entered an unusually uncertain and
turbulent period. The recovery following the crisis has progressed surprisingly slowly in many
countries, the European monetary union has been periodically exposed to major strains and
there are currently a great number of questions surrounding the developments in China and
several other emerging market economies, to name just a few examples.
When a storm is raging around you, it is a major advantage to be travelling in a reliable and
robust vessel. In terms of an economy, this often means having well-designed economic policy
frameworks and clear and credible ground rules which provide robustness and stability. I would
argue that the Swedish economy has been such a vessel for a long time now, and that this
has been highly beneficial to us, both from a longer-term perspective as well as during and
after the financial crisis.
It is evident that the Swedish economy is currently regarded as fairly stable when studying the
difference in long-term yields in relation to Germany. This difference has been small for almost
twenty years, and has occasionally even been negative (see Figure 1). When compared to
how the situation was previously, the difference is quite striking.
Fundamental reforms after the 1990s crisis provided stability
This is something which in many respects we can thank the crisis at the beginning of the 1990s
for. The Lindbeck Commission, appointed in December 1992, noted that the Swedish crisis of
the 1990s was not just a result of an unlucky combination of an international economic
downturn, overly generous lending and individual policy errors, but in fact had much deeper
roots.1 In their assessment it was to a large extent a "political and institutional crisis", which
exposed weaknesses in the way the political system worked. What they meant by this was that
there was an underlying "systemic error" in the Swedish economy - a built-in bias towards
systematically overly expansionary economic policy, which meant chronic problems with
excessively high inflation, recurring cost crises and growing national debt. The Lindbeck
Commission therefore advocated a policy which followed certain predetermined principles, or
a "rule-based" policy.2
Several important institutional and structural changes were implemented in connection with
the crisis and in the following years to create greater stability and sustainability in economic
policy. One of the more comprehensive reforms was that monetary policy was more directly
focused on keeping inflation low and stable, instead of, as previously, indirectly by maintaining
a fixed exchange rate. Sweden thereby became one of the first countries to adopt inflation
targeting. The price stability target was later written into the law and the interest rate decisions
were delegated to an independent Executive Board. Another very important change was the
creation of a fiscal policy framework with an amended budget process. This framework and
the new process aimed to get a grip on the evolution of public expenditures while also leading
to an average surplus in terms of net lending. The overall aim was to ensure that fiscal policy
would have the desired long-term orientation.
Flexible inflation targeting preferable - but improvements not ruled out
But even though these and other changes have made the Swedish economy more reliable and
resilient to shocks, we too have been affected by the events of the past few years. The global
financial crisis and surprisingly low inflation have meant that a number of previously accepted
truths have begun to be called into question, and led to a debate about whether the economic
policy framework developed prior to the financial crisis should be modified or potentially even
replaced.
My view here is completely clear: it is important for us to think very carefully before we make
any comprehensive changes to the Swedish economic policy frameworks. We know little about
what the world will look like in the future, and we should be careful not to casually abandon
something which has essentially worked well. It is easy to forget previous problems as time
passes, and to take for granted that certain things are simply working. This is a dangerous
approach, however, which can lead to setbacks. Dismantling a framework can be done quickly,
but building one up takes a long time and often involves major adjustment costs.
In terms of the monetary policy framework, I am convinced that the flexible inflation targeting
pursued by the Riksbank and most other central banks today will continue to be the most
effective approach for the foreseeable future. This does not mean, however, that I oppose all
forms of change and necessarily think that everything should remain exactly as it is today. If
we want something to endure, we must be prepared to change it. To continue with the
metaphor I used at the beginning: it is important to constantly maintain the vessel and make
any adjustments and improvements required for it to keep functioning well, even under new
circumstances.3
I would today like to highlight a few areas of the Swedish monetary policy framework about
which there are grounds to open up a discussion, based on the experiences we have gathered
over some twenty years of inflation targeting.4 It is perhaps mainly the experiences gained after
the financial crisis which have increased the need for a serious discussion. If this discussion
were to eventually conclude that it is appropriate to make certain changes within the areas I
raise, then this would not have drastic consequences for the monetary policy framework as
such. Rather, it would mean adjustments and improvements which could be accommodated
well within the existing framework of flexible inflation targeting.
Before I continue, I would like to underscore one important thing: the members of the Executive
Board always give their own views in their speeches. The ideas I express here are therefore
entirely my own. The issues I raise are issues we in the Executive Board have discussed off
and on, but it is an ongoing discussion and we have not yet drawn any conclusions. What I say
here should therefore not be interpreted as the Riksbank's official view on these issues.
I would like to highlight two aspects of the monetary policy framework - the target variable and
a potential interval, or band, surrounding the target.
Important to follow the international debate
One aspect which has been debated a great deal both in Sweden and internationally, and
which I do not intend to highlight here, is the level of the inflation target. That issue has recently
been discussed quite thoroughly by some of my colleagues, and I do not have much more to
add.5 I would just like to say briefly that if we are going to discuss a change in the target level,
then I, like my colleagues, have greater sympathy for the argument in the international debate
that central banks should raise their inflation targets than for the argument in the Swedish
debate that the inflation target should be lowered. The main reason for this is the motive usually
stated as the main justification for a rise - that if the target is too low, or if inflation expectations
are permanently too low for some other reason, then the policy rate will hit its lower limit more
often and for longer periods.6 This means that monetary policy in the future would find it harder
to counteract a recession. However, it is too early today to draw the conclusion that 2 per cent
is too low a level for the inflation target, and the discussion needs to continue.7
Nor do I intend to say anything about the issue debated both in Sweden and internationally as
to whether monetary policy should be used to actively attempt to counteract the accumulation
of financial imbalances. I also do not intend to comment on the principally international debate
as to whether inflation targeting really is the best monetary policy framework, or whether a
target for nominal GDP would be preferable, for example. As I have already mentioned, I think
that flexible inflation targeting is the preferable framework, both now and for the foreseeable
future.
In general, however, it is important for us to follow the fairly intense international discussion
about how monetary policy should best be conducted. We want to avoid ending up with rushed
and home-cooked solutions that we eventually regret and find it difficult to change. However,
the areas I will focus on here - the target variable and a potential interval - primarily refer to
the Swedish debate and are things that we ought to be able to change, should we wish to,
without a risk of major negative consequences.
The target variable
Let me therefore begin by discussing the target variable. Since the inflation target was
introduced in January 1993, it has been formulated in terms of the consumer price index, CPI.
The reason the CPI was chosen as the target variable was mainly due to the fact that it was,
and still is, the most well-known measure of price developments in Sweden. The CPI also has
the advantages that it includes a large part of household consumption, it is published regularly
and has well-known statistical properties.
However, using the CPI as a target variable has occasionally led to a number of pedagogical
difficulties, not least in recent times. The reason for this is that household mortgage rates are
included in the CPI. For example, when the Riksbank lowers the interest rate to bring inflation
up, mortgage rates will fall. The short-term effect on the CPI therefore heads in the "wrong
direction", that is, the interest rate cut makes inflation fall further (see Figure 2).
Major direct impact of interest rate changes makes Swedish CPI unique
This direct impact of interest rate changes on inflation is quite unique to Sweden. The reason
for the effect is that we include household mortgage costs in the CPI in a slightly different way
than most other countries with inflation targets. More specifically, we attempt to measure
households' costs for living in an owner-occupied property, where interest expenditure is an
important component.8 The CPI is calculated according to roughly the same principles in
Canada, for example, but in practice the interest rate changes have a much smaller impact on
the CPI there than here in Sweden.9 In Australia and New Zealand, interest rate changes also
previously had a major direct impact on the CPI, but the method for calculating CPI changed
in both countries at the end of the 1990s in a way that eliminated such effects.10 They now
apply a method which is principally based on following price developments of new housing, a
so-called net acquisition approach. In other countries, for example the United States and
Norway, costs for owner-occupied housing are approximated to the cost for renting a
comparable property - and this is far less affected by interest rate changes. In the euro area
and the United Kingdom, the target is formulated in terms of the HICP index (harmonised index
for consumer prices) which does not include costs for owner-occupied housing, only operating
costs.11
As Swedish CPI inflation has this characteristic, the Riksbank has, since the introduction of the
inflation target, calculated several different measures of inflation and has also regularly let
inflation indices other than the CPI guide interest rate decisions. The price index which has
played the biggest role in recent years is the CPIF, or the CPI with a fixed interest rate. Unlike
the CPI, the CPIF is not directly affected by changes in mortgage rates. CPIF inflation, with
energy prices also discounted at times, has functioned as a "steering" variable in such a way
that the Riksbank has normally aimed for it to be close to 2 per cent within the forecasting
horizon.
Major interest rate changes lead to substantial and long-term effects on the CPI
Despite this, the target has been formulated in terms of the CPI. As interest rates sometimes
go up and sometimes down, the idea has been that the differences in inflation according to the
CPI and the CPIF will level out over time. The long-run average of the two inflation measures
will be the same, and if the Riksbank aims to stabilise CPIF inflation around 2 per cent then
CPI inflation will on average also end up at the target. Deviations between both measures were
not expected to be too great or lasting, and if they were to occasionally differ and CPI inflation
were far below the target, then this could be dealt with by clear communication from the
Riksbank. So it was thought at least.
However, even though the "long term" in this case is not so long that we will all be dead, to
paraphrase Keynes, it is long enough for the difference between the CPI and CPIF to pose
problems. Interest rate developments over the past few years have led to major deviations
between the CPI and the CPIF, both upwards and downwards (see Figure 3). The period of
cuts which began in December 2011, and which is currently the longest continuous period of
interest-rate cuts since the inflation target was introduced, has contributed to CPI inflation
falling substantially below CPIF inflation and remaining near zero for three years.
Correspondingly, CPI inflation will be pushed upwards and exceed the target when the repo
rate approaches historically more normal levels in the future. An extremely low rate of increase
in CPI inflation therefore tends to be followed sooner or later by an unusually high rate of
increase, and these periods can sometimes be relatively protracted. This could look something
like Figure 4, for example. One could say that major, protracted interest rate movements lead
to substantial and long-term surges in CPI inflation - more substantial and long-term than we
previously believed would be the case.
Risk of misleading image and uncertainty about the inflation target
This has caused some difficulties, and will likely continue to do so in the future, not least in
terms of monetary policy communication. One problem is that the focus on CPI inflation -
which in itself is not entirely unnatural - has led to flashy headlines in the media from time to
time over the years about Sweden being in a state of deflation. When CPI inflation is negative,
this is obviously correct in a purely technical sense, but the story behind the headline often
fails to explain that it is to a large extent a result of the Riksbank lowering the interest rate, and
that CPIF inflation typically is considerably higher. Foreign commentators in particular have
therefore often come to the conclusion that the Swedish economy is in a highly critical situation
and that the state of the real economy is deflationist as well, with very weak growth in
production and employment. It cannot be ruled out either that this kind of media reporting can,
at least to some extent, affect economic sentiment. It is of course unfortunate if this kind of
misleading image takes hold simply because the Swedish CPI is calculated in the way it is.
A potentially more serious problem is that even if CPIF inflation were reasonably close to 2 per
cent, the formal target variable, CPI inflation, could be relatively far from the target for fairly
long periods of time. Even if upward and downward deviations were to level out in the really
long term, there could be long periods where CPI inflation deviates from the target - long
enough for there to be a risk of confidence in the inflation target being shaken. To put it
differently, participants in the economy could begin to question whether the Riksbank will truly
also stabilise CPI inflation around the target by stabilising CPIF inflation around 2 per cent.
And they would have fairly good grounds for doing so, not just based on past events but also
if we look ahead. If we assume in Figure 4 that CPIF inflation will continue to be around 2 per
cent after 2018, then CPI inflation would overshoot the target for a long time, based on
reasonable assumptions about the development of the repo rate. Even if the repo rate did not
continue to rise to levels considered normal before the crisis, but instead slowed to the average
of 2.3 per cent seen over the period 1998-2015, CPI inflation would overshoot the target for
around five years in total. If the repo rate did continue to rise, it would take even longer, all
things being equal, for CPI inflation to return to 2 per cent.12 Of course it is problematic if the
formal target variable deviates from the target for such long periods, even if this is a result of
a conscious policy.
Time to start a discussion about the target variable
Set against this background, it is my belief that it may again be time to open up a discussion
about the target variable. One option, which I personally find appealing and fairly natural, is to
face up to the consequences and allow an inflation measure upon which interest rate changes
do not have such a direct impact to not only be the "steering" variable but also the target
variable. The indices which come to mind first in that case are the CPIF and HICP. One
advantage of the latter index is that it is an internationally comparable measure, but the
differences compared with the CPIF are quantitatively not particularly large.
It is worth pointing out that this would not lead in practice to any particularly major change in
monetary policy. After all, the Riksbank already typically aims for a CPIF inflation rate of around
2 per cent within the forecasting horizon.
It is also worth emphasising that the purpose of changing the target variable would not be to
make it easier for the Riksbank to hit the inflation target. That would hopefully be a positive
side-effect, but the main purpose would be to rectify the problems with the CPI as a target
variable which have gradually become more and more evident.
Naturally, a change of target variable must be preceded by a thorough analysis of how and
when the replacement would take place and what consequences it could potentially have. My
aim here is simply to highlight the issue and initiate a discussion.
Of course, a new target variable would not solve every problem and be the only measure the
Riksbank would have to look at. We would need to continue to analyse different measures of
inflation to get as complete a picture as possible. For instance, as oil prices, and energy prices
in general, often vary greatly, there are reasons on many occasions to study inflation measures
where these prices are excluded. However, I believe the biggest problem would still be solved
if interest expenditure were excluded from the target variable once and for all.
Before I continue, I would like to make a comment about the target variable in relation to wage
formation. This is connected to my assertion that the significance of interest expenditure for
the CPI means that an extremely low rate of increase in CPI inflation tends to be followed
sooner or later by an unusually high rate of increase. As we have seen, these periods can also
be fairly protracted. If wage formation places a lot of focus on the current level of CPI inflation,
I see a risk that this could create instability in the wage formation system. A situation similar to
the one in the 1970s and 80s could then ultimately occur, whereby wage developments varied
substantially from year to year depending on the current inflation rate, which also varied
extensively. It would therefore be better if wage formation were based on a less volatile inflation
measure than CPI inflation.13 A new monetary policy target variable could hopefully take on
that role.
A band surrounding the target
When the General Council of the Riksbank decided to introduce an inflation target of 2 per cent
in January 1993, it also decided that there should be a tolerance band surrounding this target
of 1 percentage point both above and below.14 The aim was to clarify that the Riksbank does
not have the ability to control inflation exactly in the short term, but that it also aims to limit
deviations from the target - that it does not intend to "tolerate" deviations greater than
1 percentage point. The size of the interval was determined by what intuitively appeared to be
reasonable. It was not possible to rely on any past experience as the monetary policy regime
was entirely new and inflation had varied considerably during the old regime which had a fixed
exchange rate. The Riksbank expected that inflation would now vary less, but was unsure as
to how much.
The interval remained a part of the monetary policy framework for a long time, but was finally
abolished in 2010. The reason for this was that the Riksbank assessed at that time that it had
fulfilled its role and was not serving any practical function. In the memorandum published in
connection with the decision, it was noted that: "There is considerable understanding for the
fact that inflation commonly deviates from the target and that the deviations are sometimes
larger than 1 percentage point. Inflation can thus be outside the tolerance interval without
threatening the credibility of the inflation target. Such deviations have proved to be a natural
part of monetary policy."15
So as a few years now have passed, it may be justified to evaluate the period where there has
been no interval. Personally, I am not entirely sure that it has been as trouble-free as the
Riksbank expected, even though I too thought that the decision to remove the interval was
quite natural when it was taken.
Debate about the interval - but a different kind than before?
The question of whether the inflation target should be surrounded by an interval has recently
gained some attention again in the Swedish debate. There appears to be differing views on
what function an interval would fulfil, however. The previous tolerance band was first and
foremost a pedagogical tool intended to illustrate that we must accept certain, though not too
large, deviations from the inflation target of 2 per cent - the point target the Riksbank is always
aiming for.
The interval that a number of commentators have been advocating recently appears to be of
a different kind, however. They would prefer what could be called a target range, or in other
words the target itself is 2 percentage points wide and not an exact figure.16 A target range
implies that monetary policy is focused on inflation falling within the range of 1-3 per cent
within a couple of years, but there is no requirement for it to reach the midpoint of the interval.
Inflation of just over 1 per cent or marginally under 3 per cent is equivalent to inflation of 2 per
cent. If there were a tolerance band, inflation of just over 1 per cent, or below 3 per cent,
instead would be "tolerable" if unforeseen events meant that inflation ended up there, but it
would not be something to consciously aim for.
The idea that many commentators seem to have is that a target range would mean the
Riksbank would feel less forced to bring inflation up to 2 per cent, which in turn would mean
that monetary policy would not need to be as expansionary and the risks linked to such a policy
could be mitigated.
Difficult to pursue another policy even with an interval
I would like to point out here, without commenting on the pros and cons of a target range in
general terms, that this idea appears to be based in part on a misunderstanding of the motives
behind the Riksbank's policy. The reason the Riksbank is eager to get inflation to rise is not
that we have a rigid fixation with achieving exactly 2 per cent inflation all the time. It is due to
the fact that the period in which inflation has been below the target has gradually become
longer, and that long-term inflation expectations have shown a falling trend and still remain
below the target. For the reasons I noted a moment ago when discussing the level of the
inflation target - that the interest rate hits its lower limit more easily and it becomes difficult to
counteract a recession - it is important to avoid inflation and inflation expectations falling too
far and get stuck at a level that is too low.
This would be the case even if we had had a target range of 1-3 per cent. Inflation and inflation
expectations which creep downwards and get stuck near the lower limit of this range could be
as problematic as if the inflation target itself had been lowered. It is thus difficult to see that the
Riksbank would have pursued a notably different policy even if there had been a target range,
or that there would be grounds to adjust the current policy if a target range were to be
introduced tomorrow.17
This is probably also the reason why central banks in countries which have a formal target
range, such as Canada and New Zealand, usually aim for the midpoint of the range.18 After all,
the safest way to prevent inflation and inflation expectations beginning to slide out of the range
is to attempt to keep them in the middle of it. In this sense, there is no great practical difference
between a target range and a point target with a tolerance band.
Interval good for illustrating uncertainty
I believe there are still grounds for discussing whether the Swedish monetary policy framework
should be complemented once again by some kind of interval. As I see it, the main reason
would be to remind people that monetary policy is pursued under considerable uncertainty,
and that the Riksbank is not able to fine-tune the economy and inflation. It could be seen as
paradoxical that it is needed, as the justification for the interval being removed before was that
there was widespread understanding for this being the case. My impression, however, is that
there is a lingering perception that monetary policy is a tool with a relatively high level of
precision and that most things can be managed using well-calibrated policy rate changes. In
the discussion about monetary policy, many seem to assume that there are relatively precise
relations between the interest rate, inflation and unemployment, a perspective that does not
receive much empirical support.
This is something to which the Riksbank itself probably has contributed somewhat, as some
analyses in our reports could have given this impression. For example, we used to regularly
present different interest rate scenarios in the monetary policy reports which were based on
the effects of policy rate changes on the economy and inflation being calculated relatively
mechanically and with seemingly good precision. The fact that the effects of monetary policy
are surrounded by major uncertainty and cannot be calculated with good precision is
something we probably need to remind people of more or less constantly, and in that case an
interval can be useful.
The most obvious approach in this case would perhaps be to reintroduce a tolerance band
around the inflation target. If this route is chosen, it is important of course that it is given a
practical significance and fulfils some kind of function, in contrast to the interval removed in
2010. One possibility could be that the Riksbank undertakes to explain in a special report why
inflation has ended up outside the interval whenever this occurs - in roughly the same way as
the Bank of England writes an open letter to the Chancellor of the Exchequer. On the one
hand, this could lead to deviations outside the band being seen as slightly dramatic, but on the
other hand it could also make deviations within the interval less dramatic. I believe the latter
would be an advantage seen against the background of what I have just said about monetary
policy not being able to fine-tune inflation.
Naturally it is also important that the breadth of any band matches the variations in inflation in
a meaningful way. It could be questioned whether this was the case for the previous tolerance
band. It is worth emphasising that the choice of target variable is important when choosing the
breadth of the band. A reflection from Figure 3 is that the interval of 1-3 per cent would have
much better suited a target variable upon which interest rate changes do not have a direct
effect - that is to say CPIF or HICP inflation - than was the case for CPI inflation. The periods
outside the interval for these measures are more short-lived and the deviations are smaller. A
number of reports would still have needed to be written, but there would have been fewer than
with the CPI, and above all they would have contained more meaningful explanations as to
why inflation was outside the tolerance band than that households' interest expenditure in the
CPI has been influenced by the Riksbank's altered repo rate.
But once again - my aim here is mainly to contribute to the discussion. How an interval would
be designed, and whether we should have one, is something that we will of course need to
look further into. However, this is also a change I believe we could make without turning the
monetary policy framework as it is inside out.
The policy of inflation targeting does not need fixing, but can potentially be improved
Let me now briefly summarise what I have said here today. One of my most important
messages is: "if it's not broken, don't try to fix it!". In our eagerness to bring about change, we
can often do more damage than good. The aspect I believe is not broken and therefore does
not need fixing is the policy of flexible inflation targeting, which in recent decades has
developed into something of an international standard. This is not to say that I think it is without
problems and cannot be improved. I have highlighted a couple of areas for which I believe
there are grounds for consideration as far as Sweden is concerned. One is the target variable,
in which case I believe we should consider changing to an index upon which policy rate
changes do not have such a major direct impact as on the CPI. Another is an interval
surrounding the target. The main reason for considering a reintroduction of an interval is the
need to constantly remind people that monetary policy is pursued under significant uncertainty
and that the Riksbank is not able to fine-tune the economy and inflation. I look forward to
continued discussions about these issues.
9
BIS central bankers' speeches
References
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interest