Barbro Wickman-Parak: The economy and the labour market
Speech by Ms Barbro Wickman-Parak, Deputy Governor of the Sveriges Riksbank, at
Skandinaviska Enskilda Banken (SEB), Stockholm, 29 April 2010.
* * *
Sweden's GDP fell by almost five per cent in 2009, compared with the previous year. We
need to go back as far as the 1940s to find an individual year with a correspondingly large
fall in growth. The large demand shock that followed in the wake of the financial crisis had an
unavoidable and drastic impact on production and employment. It has been possible to
alleviate these effects, but not to prevent them, despite forceful monetary policy measures
and expansionary fiscal policy.
Normally, changes in employment and unemployment occur two quarters after changes in
production. This time, however, it appears as though the upturn in employment has already
begun and unemployment has stopped rising, which is surprisingly early given the large fall
in GDP. But unemployment is still high, and we are expecting a slow recovery in employment
in the coming period. During the past three months unemployment has been around 9 per
cent as a share of the labour force.
Today I intend to talk about developments in the labour market in Sweden. I will begin by
describing how employment usually varies over the business cycle and then discuss what is
different this time. I shall conclude by discussing how we Executive Board members viewed
developments in the labour market at our monetary policy meeting last week.
The relationship between economic activity and the labour market
Each economic cycle is unique, which became particularly clear during the most recent
economic downturn. However, there are some patterns that often recur in economic cycles
and forecasters have therefore often used them as a base in their forecasting work.
For example, it is normal that changes in activity in the labour market occur with some time
lag compared with changes in production. This is mainly because it is expensive for
companies to adjust production to a new demand situation and to employ and give notice to
staff. Firms may therefore initially choose to wait and see whether the change in demand is
temporary. This means that the first thing to happen in an economic downturn is that
productivity growth falls. Firms gradually adapt to the new situation by reducing the number
of hours worked without reducing the number of employees. However, if the downturn is
long-lived, the personnel force is also downsized over time. The time lag between GDP and
the number of hours worked is usually one quarter in Sweden, while the time lag between
GDP and employment is usually twice as long, that is, six months.
A well-known relationship between economic activity and activity in the labour market was
formulated by Arthur Okun in the early 1960s.1 This describes a negative relationship
between GDP growth and changes in unemployment, which has become known as "Okun's
law". He found, for instance, that the US economy needed to grow by at least 3 per cent to
avoid an increase in unemployment. Okun's law can thus be interpreted as a short-term
relationship that expresses the link between changes in economic activity and changes in
activity in the labour market. As the relationship between growth and employment is
dependent on factors such as labour market policy, productivity, social norms and
demography, the relationship varies between different countries and different periods in time.
A recently-published Economic Commentary on the Riksbank's website2 estimates this
relationship using Swedish data.3 The study shows that there is a relatively strong link
between GDP growth and unemployment, a link that has also varied over time. The
connection has increased over time and between 2004 and 2008 it was relatively high, which
indicates that unemployment was more sensitive to changes in GDP during this time.
However the relationship has weakened over the past year, when GDP fell heavily without
unemployment rising as much as one would have expected, given the historical relationship.
According to the study, a GDP growth of more than 2.8 per cent is now needed for
unemployment to decline, which can be compared with the historical average of 2.3 per cent.
At present a higher level of economic growth is thus required to change the level of
unemployment compared to the average historical relationship since 1980. The time lag
between GDP and unemployment also appears to have increased during the 2000s. Thus, it
now takes longer before the full impact of a change in growth has an effect on unemployment
in Sweden.
What is different this time?
Part of the explanation for unemployment not having risen as much as one might have
expected given the historical relationship could be that not all of the economy has suffered.
The main fall in employment has been in the manufacturing industry, while the services
sector, which is more labour intensive, has fared better. Last year exports fell by a good
13 per cent, while retail sales, for instance, only slowed down slightly. This is probably
because the Swedish export industry was hard hit by the large fall in world trade, while the
large economic policy stimulation helped hold up consumption.
Industrial production fell by around 25 per cent between the peak in November 2007 and the
trough in May 2009. However, the fall in the production of services was just over 10 per cent
between the peak in December 2007 and the trough in June 2009. In recent months
production in both sectors has stabilised. This has also had an effect on employment, which
fell much more in the manufacturing industry than in the services sector. The Riksbank's
calculations show that employment in the manufacturing industry has been slightly stronger
than the historical pattern implies during this economic downturn, given the large fall in
production, while employment in the services sector has been much stronger than one might
have expected given historical relationships.
As mentioned earlier, it appears as though the Okun coefficient has declined during 2009. I
mentioned earlier that GDP fell by almost 5 per cent last year. According to the estimated
Okun's law, unemployment in the economy as a whole should have risen by around 3 per
cent, but the increase was only around 2 per cent. Although cuts in staff have been made,
companies have not adjusted their workforce to the falling demand to the same extent as
they would have if the historical pattern had applied. Many companies have instead chosen
to retain existing personnel to a much greater extent than during earlier downturns. In some
cases, they have instead introduced measures such as freezing wages or shortening the
working week. One explanation might be that companies expect demand to be restored
quickly and that they want to be prepared to quickly increase their production again. Another
explanation as to why production has fallen more than employment, which is mentioned in
the IMF's latest World Economic Outlook4, could be that production has fallen most in those
sectors of the economy with the highest productivity level.
Studies have shown that unemployment may suffer long-lasting effects from a deep
recession. This is partly because a person who has been unemployed for a long time loses
part of his or her human capital and therefore becomes less attractive in the labour market,
and partly because some people, after job-seeking for a long time, quite simply give up and
leave the labour force. What is usually referred to as structural or "natural" unemployment
may thus increase during periods of high and protracted unemployment. Labour market
policy can counteract these effects to some extent, by for instance, offering further education
and retraining to the unemployed.
The situation today is in contrast to what we saw during the crisis in the 1990s. Then, GDP
fell for three years and the fall in employment was greater than the fall in GDP. That crisis
was domestically-generated and it was generally known that tough times lay ahead, as public
finances were to be consolidated. This time, the crisis has come from outside and there has
been scope for forceful fiscal policy and monetary policy measures.
It is always difficult to make forecasts. Moreover, I believe it is more difficult than normal in
the current situation. A crisis of the depth we have now passed through leaves behind
feelings of uncertainty regarding the future. Previously-observed relationships have not been
able to provide us with the same guidance as before, and moreover it is difficult to know what
these deviations from historical patterns will lead to further ahead.
The way this situation develops in the future will depend on many different things. If the world
economy returns after the recovery to a situation similar to that before the crisis, then
countries which have conducted a policy that has helped companies to retain their labour
force through the recession will be in a very good position. Companies in these countries will
then easily be able to increase production. However, if it turns out that the world demand is
for other goods and services than those prior to the crisis, these countries may instead find
themselves in a situation where they need to undergo a necessary structural transformation.
This could lead to a more protracted period of high unemployment and lower production. In
the future, countries like China may account for an increasingly large share of world
consumption. If consumption patterns differ in different countries, this could mean that
different types of product will be in demand in the future. A deep recession may also affect
the internal demand picture within a country permanently, for instance, by individuals
changing to more energy-saving and cheaper alternatives.
Monetary policy has a limited capacity to affect the real economy
When the Riksbank decides on the repo rate, we assume that it will take one to two years
before the decision has its full impact. Our monetary policy is therefore based on forecasts of
inflation and economic developments over the coming three years. However, as I have said,
it is particularly difficult to make forecasts right now as a result of the prevailing uncertainty.
When we make our decisions we take into account both the inflation outlook and the
prospects for the real economy. Depending on what type of shock the economy is exposed
to, we can allow it to take time for inflation to return to the target and in this way avoid overly
large fluctuations in employment and production.
However, it is now generally accepted that monetary policy cannot be used to attain a
permanently lower level of unemployment. Many people believed this was possible a while
ago when A. W. Phillips found a negative correlation between unemployment and inflation at
the end of the 1950s,5 a relationship usually called the Phillips curve. This shows that higher
employment can be achieved at the cost of higher inflation. It was thus long believed that one
could "buy" lasting lower unemployment by allowing inflation to rise. However, this
relationship was empirically proved not to hold in the long run. In the 1970s, for instance,
there were periods with both high unemployment and high inflation, what is known as
stagflation. Instead we now base our discussions on the assumption that there is in the long
run a "natural" unemployment level that depends on the functioning of the labour market.
This way of functioning can in turn improve or deteriorate as a result of economic policy
measures in a broader sense. The problems cannot be tackled with monetary policy. If
monetary policy tries to push down unemployment below this "natural" level, it will only result
in higher inflation.
This is because inflation expectations have great significance. Although there is a
short
relationship in the run between unemployment and inflation, the central bank cannot
make use of this in the long run, as companies and individuals will realise what policy is
being conducted and adapt their behaviour accordingly. For instance, wage-earners may
demand higher wages as compensation for expected inflation, which will have a negative
effect on employment, as the scope for new recruitment will decline. Monetary policy is thus
unable to lastingly affect real variables such as long-term lower unemployment. But it can
have a stabilising effect in the short run, particularly if inflation expectations are
wellanchored so that temporary changes in inflation are not perceived as permanent. If a central
bank succeeds in attaining credibility so that inflation expectations are stable, there is some
scope for also taking into account developments in the real economy.
The labour market: an important variable for monetary policy
We thus try to conduct our monetary policy so that the inflation target is attained within a
reasonable time horizon, at the same time as we emphasize that resource utilisation should
approach a "normal" level. However, there is no generally-accepted measure for resource
utilisation as there is for inflation. It is therefore necessary to use questionnaires or to try to
estimate it using some statistical method. At the Riksbank we use, for instance, "gap
analyses", where we try to relate the current situation and the forecasts for different
measures of resource utilisation to the trend for the respective variable. The gap shows how
far the variable is from its "normal" level. For instance, we use the deviation in GDP from its
trend to study the GDP gap. We have two ways of measuring the gap for the labour market;
employment measured as the number of hours worked and measured as the number of
persons employed. Developments in the labour market thus have considerable significance
for the analysis that precedes the monetary policy decision. However, all of the measures of
resource utilisation we present are very uncertain, and this is why we use several different
measures.6
Monetary policy decisions often concern complex deliberations. But now that the economy
has undergone a period of deep crisis and it is difficult to assess what structural changes the
crisis may lead to, the process becomes even more complex. One illustration of this is how
one should assess future developments in the labour market. So far employment has not
fallen as much as might be justified given the historical relationship between unemployment
and GDP, and the large fall in GDP. This has come as a surprise to us and to other
forecasters. But what conclusions should one draw with regard to the effects in the slightly
longer term when the economy recovers? Employment and the number of hours worked are
now beginning to increase. Normally, one might have expected a greater adjustment in the
number of hours worked than we have seen in this economic downturn. The fact that the
adjustment has not corresponded to the fall in production means that productivity has been
very weak. But as we observe in our most recent Monetary Policy Update, which was
published last week, we expect productivity to improve in the future, which also means that
the number of hours worked and the number of employed will grow slowly. Periods of low
productivity are normally followed by periods when productivity recovers quickly.
The labour market and current monetary policy
Last week the Executive Board of the Riksbank decided to hold the repo rate unchanged at
0.25 per cent. But at the same time we made it clear that the time for a repo rate increase
was not too far off. This could come in the summer or the early autumn. But even with the
increases in the repo rate included in our repo rate path, monetary policy will be
expansionary for a long period of time. The real repo rate is negative throughout the whole
year, and will be below one per cent for the whole of 2011.
The underlying CPIF inflation rate, that is, the CPI excluding the effect of changes in
mortgage rates, is now relatively high at 2.5 per cent. But our assessment is that inflation will
begin to fall, partly as a result of a stronger krona. In addition, slowly rising wages and
increasing productivity growth will together mean that companies can produce goods at low
cost. As economic activity strengthens the inflation rate will be pushed up and when we look
ahead to the end of the forecast period it is close to 2 per cent. The forecast for the CPIF is
therefore only marginally changed, compared with the assessment in the February Monetary
Policy Report.
Resource utilisation is an important variable for monetary policy as it is, for instance, an
important indicator of future inflationary pressures. When we made our most recent decision
on the repo rate we had received the GDP figures for the fourth quarter, which were much
lower than we and other analysts had expected. As I have already mentioned, this would
indicate lower resource utilisation. But when we take into account the stronger labour market
development, our conclusion in our most recent Monetary Policy Update is that resource
utilisation is slightly higher than it was in February. But it is still low and will remain so for a
large part of the forecast period.
When we cut the repo rate to its current extremely low level in July last year, the situation on
the financial markets was still critical, the economic cycle was in a much gloomier phase than
now and the forecasts were much more pessimistic. During the autumn the positive signs
increased and the forecasts were gradually revised up after numerous downward
adjustments. The Riksbank had offered loans at fixed-interest rates with a one-year maturity
in July, September and October. The purpose of these loans was to bring down general
interest rates in a situation where the repo rate was assessed as having come down to what
was in practice its lowest possible level. The fact that new loans were not offered in
December was a first sign that economic activity was beginning to stabilise and that this type
of unconventional measure was no longer necessary.
We are assuming in our most recent forecast that GDP in Sweden will increase by 2.2 per
cent this year and by 3.7 per cent next year. These are upward revisions of around one
percentage point and half a percentage point respectively, compared with July last year.
They are not very large changes in growth, but they are changes in the right direction and a
sign that economic activity is on firmer ground.
The largest change in our forecasts concerns the labour market, as I mentioned earlier. In
July we were assuming that employment would fall by just over 3 per cent a year and would
not begin to rise until 2011. Now we have already seen an upturn in employment and we are
instead forecasting a marginal increase in the number of persons employed. In July we were
assuming that unemployment would peak at 11 per cent in 2011. Following the large fall in
production this appeared to be a reasonable forecast in line with historical patterns, and it
was also shared by most other analysts. However, developments are now rather different
and our current forecast is that the current unemployment level of 9 per cent is a peak and
that unemployment will be 8 per cent at the end of our forecast period.
How has the stronger labour market affected the interest rate decisions? Firstly, it should be
said that it is not possible to point to any individual variable that will alone be a determining
factor in an interest rate decision. Prior to each interest rate decision we weigh together all of
the new information received since the previous decision. But employment is of course an
important element; when, for example, we said in February that economic activity was now
on firmer ground one of the things we were referring to was the stronger labour market. It
was a contributing factor to the marginal adjustment in the repo rate path we made then; with
a first repo rate increase coming slightly sooner than implied in the repo rate path from
December.
Our most recent repo rate decision entails both the repo rate and the repo rate path being
held unchanged. A weaker GDP outcome for the fourth quarter could on its own have been a
negative signal and made us more doubtful about the timing of the coming interest rate
increase. But we also had surprisingly positive information on the labour market, which
provided support for the assumption that the economy is moving in the right direction.
Our forecasts are based on employment only increasing at a slow rate in the future and on
resource utilisation being lower than normal for the greater part of the forecast period. But
the situation is that the crisis has hit the export industry particularly hard, while the services
sector has escaped relatively lightly. We have a "division" in the Swedish economy, which
complicates the situation for monetary policy. We are unable to distinguish between the
different sectors; our interest rate changes affect all sectors in the same direction. When we
deliberate on monetary policy in the coming period we must of course be observant of the
driving forces behind the different sectors and how these can affect inflationary pressures in
the economy.