Ms Hessius speaks about the monetary policy and growth conditions
for Sweden's economy
Speech given by Ms Kerstin Hessius, Deputy Governor of the Sveriges Riksbank at the Chairmens'
Conference of the Västmanland's Local Authorities Association on 27 August 1999.
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The whole speech
The bright picture of the Swedish economy that has been coming to the fore in recent years now seems
to be becoming increasingly distinct. Growth is stable and employment is rising, accompanied by price
increases that are moderate. It is important now that this bright picture can become permanent and that
the work of creating good conditions for long-term economic development continues. Today I shall be
considering the economic situation in Sweden and the rest of the world, with some discussion of the
conditions for consolidating the favourable trend.
Functions of the Riksbank
Ever since Sweden abandoned the fixed exchange rate regime in November 1992, monetary policy has
been conducted with its sights on inflation. Sweden was one of the first countries to adopt an inflation
targeting strategy. In many respects, the period with the inflation target has been characterised by good
results in the Swedish economy. Interest rates and inflation have fallen to levels that are historically
low and, after the crisis in the early 1990s, growth has been comparatively high and stable. The
general public's expectations of inflation two years ahead are below 2%, which suggests that the
inflation targeting policy has achieved credibility - a matter that is crucial for monetary policy's
ability to produce good results.
The foundation for monetary policy credibility has been strengthened in that the new legislation in
force from the beginning of this year has created a more independent central bank. Maintaining price
stability is now the Riksbank's statutory function.
The Riksbank has defined its target as being to keep annual inflation, expressed as the change in the
consumer price index (CPI), at 2%. The ambition to keep inflation low stems from the insights about
inflation's harmful effects on the economy - that higher growth and employment cannot be generated
in the longer run by means of higher inflation. It is other matters, such as how the economy functions,
achievements in technology and the educational system, that determine those factors. The best way for
monetary policy to contribute to high growth and employment is therefore to improve the long-term
growth potential via low inflation.
To achieve its objective, the Riksbank uses its instrumental rate, the repo rate. If the Riksbank's
monetary stance is unduly expansionary, that is, if the repo rate is too low to ensure macroeconomic
balance, in time the economy will be liable to overheat. Demand then grows more rapidly than
production capacity and this generates inflationary pressures. If, instead, the Riksbank's monetary
stance is unduly restrictive, that is, if the repo rate is set too high, the result may be declining demand,
a weaker price trend and unsatisfactory growth.
The full effect of an interest rate adjustment takes between twelve and twenty-four months to
materialise. This means that the interest rate has to be set on the basis of the Riksbank's assessment of
the macroeconomic trend and inflation prospects in that period. However, the inflation assessments are
subject to uncertainty and this risk spectrum has to be considered too. Since December 1997 the
Riksbank's inflation forecast includes what is known as an uncertainty interval. This interval
represents the Riksbank's assessment of the uncertainties in the forecast.
Targeting CPI inflation, however, has certain drawbacks. At the beginning of this year the Executive
Board of the Riksbank therefore clarified the inflation target in some respects, stating that, under
certain specific circumstances, the Riksbank may have grounds for interpreting the CPI target more
flexibly. Price formation in the past three years, for example, has been affected by some clearly
identifiable price movements that monetary policy neither can nor shall aim to counter in full. This
applies mainly to decreased indirect taxes and the direct effects that the Riksbank's own interest rate
adjustments exert on interest expenditure and thereby on CPI inflation.
The economic situation in Sweden
Labour market
As I mentioned earlier, monetary policy's primary contribution to the development of employment lies
in creating conditions for a stable economic trend. A predictable monetary policy, focused on a clearly
defined inflation target, provides good guidance for wage negotiations. One of the main reasons why
wage formation did not function satisfactorily during most of the 1980s was probably that stabilisation
policy did not work. Inflation exceeded the official target on several occasions in that period and the
labour market organisations had difficulty in discerning the rules of the game. One example of this is
the government ambition of bringing inflation down in the mid-1980s: a crisis package was presented
in 1983, aimed at inflation rates of 4% in 1994 and 3% in 1995; when inflation exceeded these targets,
the employee organisations considered that a 5% ceiling on wage increases was no longer acceptable.
Today's confidence in the Riksbank's current inflation target facilitates wage negotiations. The 1997
wage round, for instance, took the 2% inflation target as a starting point.
The development of wages is always a central factor in inflation assessments, but the difficulties
involved in forecasting wages are considerable. The indicators used by the Riksbank include data on
wages and unit labour costs, shortage figures (bottlenecks) at industry level, wage drift and
unemployment relative to unfilled job vacancies. Another factor of importance for monetary policy is
the equilibrium level of unemployment, that is, the level of unemployment that is compatible with
stable inflation. Attempts to push unemployment down below the equilibrium level with the aid of
monetary stimuli are liable to just boost inflation. Maintaining an expansionary monetary stance
cannot therefore generate permanently higher employment.
During the past year the situation in the Swedish labour market has improved appreciably. Since the
beginning of 1999 the number in employment has risen by almost 100,000. A continued improvement
can be expected, but more employers are reporting difficulties in recruiting qualified labour even
though unemployment in Sweden is still historically high. There is still a need for measures of a
structural nature to improve the workings of the labour market and thereby the long-term conditions
for economic growth.
Consumption
The demand side of the Swedish economy, above all private sector demand, has picked up properly in
recent years. In 1997 private consumption rose 1.6% from the previous year, followed by 2.4% in
1998 and a preliminary rate of 3.4% between the first halves of 1998 and 1999. Major factors behind
the growth of private consumption are the better labour market situation, rising disposable income and
increments to household wealth.
The consumption trend is particularly dependent on future household income. Expectations of an
improvement will lead to increased spending on consumption at the expense of current saving.
At present, households' optimism about their own economy seems to have stabilised at a level that is
historically high. The Riksbank envisages that household expenditure on consumption will be
stimulated in the future by, for example, rising real wages, low interest costs and tax relief. Moreover,
international economic prospects have stabilised and employment in Sweden has risen. These
developments suggest that the consumption trend will remain favourable.
Public sector
The financial position of the public sector has been strengthened appreciably in recent years, partly as
a result of decreased unemployment, but also because interest expenditure on government debt has
been reduced as a consequence of lower interest rates and debt repayment. This has been accompanied
by comparatively high tax payments from households as well as the corporate sector. For 1998 the
financial surplus - measured as public sector revenue less expenditure - was almost SEK 40 billion,
which is equivalent to over 2% of GDP.
In recent years the central government budget process has been changed with a view to tightening the
control of government spending. The new budget process includes a spending ceiling that sets the
maximum level for central government expenditures. In addition to the new budget process, the goal
has been established of achieving a general government financial surplus equivalent to 2% of GDP
over the business cycle. Thus, the goal is formulated in terms of the average over the business cycle,
not as an annual target.
These rules do not owe their existence to happenstance. Both the expenditure ceiling and the goal of a
government financial surplus over the business cycle serve to promote greater confidence in economic
policy. The direction of budget policy, like the monetary stance, is highly important for economic
developments. The observance of these rules is important. Stable fundamental rules encourage
economic agents to make long-term decisions.
The international situation
Favourable conditions in the rest of the world are of course of major importance for economic growth
in Sweden.
In the euro area there are now also increasing signs that activity is picking up. Incoming statistics on
confidence indicators, for instance from Italy, France and Germany, show that households as well as
firms foresee a brighter future than before.
Moreover, the Japanese economy seems to be recovering from its poor performance in recent years.
Still, the latest statistics suggest that the trend for manufacturing output remains weak, making it
advisable to wait for further statistics before taking a Japanese upswing as given.
The US economy remains strong. GDP growth in the first quarter this year was over 4% and over 2%
in the second quarter. Household expenditure on consumption has gone on rising more rapidly than
current income, so saving has fallen and is now at a record low. This has been accompanied by a weak
price trend for a majority of goods. Nevertheless, the US Federal Reserve now considers that
inflationary pressure is building up. At the two most recent meetings the Federal Reserve has raised
interest rates in order to forestall an unduly rapid increase in consumer prices.
New economic relationships?
The prolonged strength displayed by the US economy has been unexpected. In the past five years US
economic growth has averaged an annual rate of over 3%. At the same time, the average rate of CPI
inflation has been little more than 2%.
Some observers consider that this performance represents a new economic era in which high economic
growth and falling unemployment can be achieved without generating increased inflationary pressure.
According to this view, potential output has risen in recent years, accompanied by a fall in equilibrium
unemployment. Explanations for this could be, for example, improved productivity as a result of new
technology and increased international competition. An alternative explanation is that transitory
factors, such as the loss of global demand in connection with the crisis in Southeast Asia, have caused
prices to fall or remain unchanged.
In Sweden, too, economic growth since the mid-1990s has been comparatively good without
inflationary pressure giving cause for concern. The monetary stance has been adjusted accordingly and
the repo rate is currently 2.9%. It is too early, however, to say whether or not this is a sign of some
farreaching change in the Swedish economy. The Riksbank will have to take a close look at the incoming
statistics and endeavour to arrive at a conclusion.
Conclusion
There are many signs that the Swedish economy is growing more rapidly. It is only now that we are
beginning to see growth rates above 3%. For the Riksbank - as well as for the economy in general - it
is important that this trend does not again land us in a situation where inflation is high and variable.
Provided the cards are played correctly, growth can be sustained and lead to a permanent increase in
employment.
This calls for an adjustment of demand to the economy's productive capacity. It is important that
structural measures which primarily improve the workings of the economy are implemented in good
time. The good consumption trend can then be met by rising output and high growth can be
maintained without this necessarily leading to unduly high inflation.
As I have already made clear on several occasions, I consider that tax cuts, in tune with the established
guidelines for budget policy, are motivated. The tax-to-GDP ratio has risen in recent years as a
consequence of the growth of private consumption and rising wage bills; today the ratio is above 50%.
The Swedish economy would probably function better with lower taxes.
The reforms that are needed in the tax system - as well as those I consider should occur in the labour
market - can be arranged, however, in such a way that they promote the aims of stabilisation policy.
Tax cuts in Sweden are probably needed that confer long-term benefits on both the supply and the
demand side of the economy; a long-term tax reform with those ambitions would be desirable. In the
present situation, however, with growth seemingly reaching around 3.5% this year and 3% in 2000,
tax cuts and labour market reforms that primarily favour the supply side would increase the
opportunities for good growth without contributing to increased inflationary pressure. That would
lessen the risk of overheating and facilitate the interaction of fiscal and monetary policies.
There is the problem, however, that evidence of good results - be they in the national economy or in
one's own enterprise - tend to weaken demands for changes which are needed for more sustainable
achievements. I would also say that the less one does in the good years, the tougher the going is likely
to be when times are worse. Not infrequently, necessary measures are not taken until a crisis is
actually looming. Today we are reaping the harvest from many important structural changes that were
implemented during the crisis in the first half of the 1990s. It is up to every decision-maker to consider
which measures we can now take in order to create robust long-term conditions for the economy.