Irma Rosenberg: Monetary policy and the Swedish economy
Speech by Ms Irma Rosenberg, Deputy Governor of Sveriges Riksbank, to the Swedish Society of
Financial Analysts, Stockholm, 5 March 2003.
* * *
Thank you for the invitation to come here and speak at the Swedish Society of Financial Analysts. This
is my first public appearance in my new role as Deputy Governor of the Riksbank. It is stimulating to
meet people and discuss economic issues. At the same time, I feel a little nervous, as I know I am
facing an audience who are used to examining and interpreting statements by the Riksbank. One
difference between this post and my previous work is that a member of the Executive Board must to
some extent exercise caution when speaking publicly. This is to avoid creating any misunderstandings
among participants in the financial market, who try to translate statements by representatives of the
central bank into future interest rate policy. This means that some of you may not be acquainted with
me, but my aim is to be as honest and clear as I possibly can.
What I intend to start talking about today is the development of the economy in recent years and to
follow this with a look ahead at the challenges facing both the Swedish and international economic
climates, and finally say something about monetary policy.
Those of you who are familiar with the economic assessments I have made know that I sometimes
have not shared the Riksbank's conclusions. But please remember that this should not be interpreted
to mean that I have a different opinion of the Riksbank's objectives. I consider it a good thing to
conduct an open discussion on the policy pursued. And I hope that you intend to take part in this
discussion, as the whole point of an open central bank is to facilitate such discussion and allow it to
improve monetary policy.
Riksbank focuses on total inflation picture
I shall begin by describing the way the Riksbank works. The Riksdag has assigned two main
objectives to the Riksbank: to maintain price stability and to promote a safe and efficient payment
system. Today I shall concentrate on the first of these two objectives.
The Riksbank has defined the target for monetary policy as to limit inflation to 2 per cent, with a
tolerated deviation interval of plus/minus one percentage point. This tolerated interval indicates that
deviations are likely, but that they will be limited. The objective is worded in terms of the consumer
price index (CPI), which is a broad index consisting of the prices in a basket of goods and services
consumed by an average Swedish household. As interest costs and indirect taxes included in CPI
inflation are not assessed to have a long-term effect on inflation, the Riksbank has chosen to normally
focus on UND1X, which is an index that excludes these factors. From time to time there may also be
reason to disregard other price changes that are assessed as temporary. Our ambition will then be to
make it clear that we have done so.
By raising and lowering the steering interest rate - the repo rate - the Riksbank attempts to influence
inflation. As it is so difficult to steer inflation in the short term, the Riksbank makes an assessment of
developments for the coming 1-2 years. This is the period of time usually assumed necessary for an
interest rate adjustment to work its way through the economy and have a full impact on the rate of
price increase, i.e. inflation.
The Riksbank uses a simple rule-of-thumb when shaping its monetary policy. If the total picture of
inflation shows that it is expected to be above or below the target level, the steering interest rate is
adjusted accordingly.
There are four main factors in the analysis of future inflation that stand out as central to the shaping of
monetary policy: the development of total resource utilisation, international price trends, the exchange
rate and the general public's inflation expectations.
Inflationary pressure varies according to the demand situation and to changes in resource utilisation.
The stronger the upturn in demand in relation to potential production, the greater the risk that prices
and wages will rise rapidly and vice versa. This is why we who work in central banks around the world
must analyse the picture of economic activity as a whole, despite the fact that inflation is our target
variable.
International price trends, where, for instance, oil prices are an important factor, affect domestic
inflation by way of imports. An assessment of international resource utilisation can provide an
indication, for instance, of how international prices may develop.
The development in the is important in the assessment of inflation. A change in
value of the krona
the exchange rate has a direct effect on inflation in that the price of imported goods and services is
affected, and also an indirect effect via aggregate demand. If the value of the krona changes in
relation to other important trading currencies, this affects the competitiveness of Swedish goods and
services and thereby demand and resource utilisation.
Inflation expectations among households and companies can also affect the price-setting and wage
formation processes and thereby inflation. One purpose of a clear inflation target and a monetary
policy governed by such a target is to firmly establish the inflation target with the general public.
At the same time, one should remember that the Riksbank is forced to take into account many other
factors that influence price trends. These are often non-recurring factors, such as supply shocks in
various forms, which are often difficult to predict. But above all it can be difficult to use monetary policy
to prevent them having an impact on inflation. Monetary policy has an impact with a time lag, and it
does not always reach the source of such a price rise. For instance, a central bank cannot prevent oil
prices rising in the wake of the concern over a possible war in the Middle East. On the other hand, a
central bank could of course try to quickly tighten demand in the country to push down prices in other
areas and thus ensure the average rate of price increase remains in line with the target level.
The focus on inflation 1-2 years ahead, entails monetary policy being conducted gradually, little by
little, rather than a constant acceleration and braking, which would risk creating unnecessary
variations in demand and which could in turn have a negative effect on production and employment.
The focus on the coming 1-2 year period thus means that temporary rises or falls in the inflation rate
can be tolerated. However, it is important that the Riksbank is clear in its communication of whether it
considers the rise to be temporary and when it expects it to subside.
One-off shifts in price levels can have a more lasting effect on future inflation if, for instance, those
involved do not believe that the rise is temporary, assessing that it will be lasting and thus wishing to
compensate for the upturn. If this occurs, monetary policy must be used to intervene, even if the
economic situation in itself does not provide cause for concern with regard to inflation, to prevent
inflation taking a hold through expectations. The reason for this is quite simply that it is more costly in
terms of reduced production and employment to force down inflation expectations once they have
become established at a higher level rather than to prevent them rising.
Parallels between the current situation and 2001 plus 2002
Let us take a look at the current situation and begin with the price rises. Now, as in spring 2001,
inflation has risen as a result of temporary factors pulling up the general level of prices. During 2001
mad-cow disease and foot-and-mouth disease pushed up meat prices and poor harvests led to
soaring prices on fruit and vegetables. Then as now there was also a water shortage in the
hydroelectric power companies' reservoirs, which pushed up electricity prices. At the moment, it is
electricity and oil prices that are soaring and have pushed up inflation figures above the target level in
January. This becomes particularly clear if one separates energy prices from the inflation figures for
January (Diagram 1).
The Riksbank's assessment is that the upturn in inflation is temporary, as it was in 2001, and we can
expect to see lower inflation as early as the late spring and summer. However, our assessment is
based on the assumption that those setting prices will not try to compensate themselves for the
temporary price increase. If this occurs, there is a risk of inducing tendencies towards an inflation
spiral, which the Riksbank could not stand by and witness in silence. At the same time, it would be
very unfortunate, particularly in the light of the challenges facing the Swedish economy, to be forced to
manage contagion effects from the energy price rise with interest rate rises.
If one looks at the economic climate, I consider the similarities between the present situation and this
time last year to be more striking than a comparison with 2001. Here I am mainly referring to the fact
that economic prospects were at that time very uncertain with regard to how far the adaptation process
had come after the over-optimism of the previous years, which had led to abnormally high share prices
and overly large investments by companies in the USA. Let me go back in time roughly one year and
see what conclusions can be drawn from last year and what implications they might have for future
developments.
Developments 2002 to 2003
At the beginning of last year there were signs of a light at the end of the economic outlook tunnel. I
wasn't working at the Riksbank then, so don't be surprised if parts of my historical description differ
slightly from that of the Riksbank, as expressed in the Inflation Reports.
The signs of a turnaround were most pronounced in the USA, but there were also some signals that
Europe was on the threshold of a recovery. The reduction in stocks appeared to be well on its way,
which is usually the first requirement for an upturn in production. However, for a production increase
brought about by adjustment in stocks to be durable, it must be supported by a lasting increase in
demand. Household consumption continued to increase, but there was no upturn in investment. The
imbalances in trade and industry in the USA were perhaps more tangible than many had anticipated.
Bankruptcies and accounting scandals created further unease on the financial markets, which then fell
at a rate reminiscent of the 1930s crisis.
In Europe the signs of economic recovery mainly concerned more optimistic expectations;
expectations which were not later realised. The largest euro economy, Germany, in particular proved
to be in a poorer condition than anticipated. However, here it was not a question of imbalances like
those in the USA, but structural problems, such as a high level of unemployment that had set in and
weak public finances, which made it difficult to conduct an economic policy that would support the
business climate. Furthermore, the expected supporting forces from the other side of the Atlantic for
the export industry were weaker the expected.
In Sweden, the slowdown during 2001 had a limited effect on unemployment. The Riksbank's
calculations at the beginning of 2002 indicated that resource utilisation was relatively strained.
Economic policy had a stimulating effect on the economy, through lower taxes and higher transfers.
Given these conditions, when the signals of a recovery became clearer at the beginning of 2002, the
Riksbank elected to raise its steering interest rate on two occasions during the spring, by a total of
0.5 percentage points to 4.25 per cent. These increases should also be regarded in the light of the fact
that inflation was still at a high level then and risked having a negative effect on inflation expectations.
During the spring the rate of price increase turned back towards the target of 2 per cent as forecast.
As an external analyst my assessment differed slightly from that of the Riksbank. This applied to both
the international picture, where it was uncertain whether a turnaround had actually taken place, and
resource utilisation in Sweden and the risk of tension that could cause rising inflation. I interpreted the
high rate of wage increase that we had then as a delayed effect of an overheated labour market during
2000 and part of 2001. Shortages on the labour market had eased considerably in spring 2002. In the
services sector, as in construction, capacity utilisation had fallen significantly, which indicated that
wage increases would gradually become more subdued. I therefore perceived the inflation risk as less
evident and did not see any immediate need for raising the interest rate.
It is clear that the inflation risk the Riksbank seemed to see declined as unease on the financial
markets grew in the wake of bankruptcies and corporate scandals in the USA. Gradually, unease
increased because of security policy developments. The financial unease gradually infected the real
economy; confidence among companies and consumers began to fall in several countries over the
summer and it became increasingly clear that total demand had been negatively affected. This
contributed to enabling the Riksbank to lower the repo rate twice during the autumn, measures that
were in my assessment quite fitting under the circumstances.
What we can observe today, compared with one year ago, is that the questions baffling forecasters
are roughly the same and that they are dominated by the question of how far the adaptation process
following from the stock market bubble has come. Today an additional factor making assessments
more difficult is the threat of war in the Middle East. We do not know whether there will be a war or
how it will all end. The crisis also creates uncertainty that makes it difficult to correctly interpret
economic signals. In addition, the more prolonged the crisis is, the greater the risk that the actual
uncertainty will have a negative effect on the real economy.
I shall now turn towards the future and discuss developments over the coming 1-2 years.
Right conditions for a recovery in the USA...
One difference now compared with the situation one year ago is that the adaptation of the imbalances
in the US economy has probably progressed further. Consolidation of balance sheets has continued,
productivity is strong and normal business activity patterns indicate that the conditions should be
relatively favourable for an increase in industrial production during the spring. Low stocks levels in
relation to sales and an investment ratio that is below the long-term trend would indicate this is the
case. An expansionary economic policy provides further support for the optimism. However, the
question most people are asking themselves now, as they were in 2002, is whether the adaptation to
the imbalances has reached a sufficient stage to enable a broad, lasting increase in demand that can
take over as the driving force behind a production increase. It is much too early to be able to give a
clear answer here.
If we look at households in the USA, we can see that they have become more passive since the
December Inflation Report was published. The explanation could be the security policy unease and
the still weak stock markets. Continuing high oil prices will also cut into disposable incomes. However,
the expansionary economic policy should partly counteract these effects.
All in all, I believe that the picture of a relatively prolonged recovery in the USA, where growth
gradually increases over the year and attains the economy's long-term sustainable level, remains for
the most part intact.
... while the conditions for a turnaround in the euro area are poorer.
The total international recovery expected during the coming year does not look to be as strong as the
Riksbank anticipated in December. The background to this is that developments in the euro area in
general and in Germany in particular look rather gloomier than they did before. The euro area's export
industry is hampered by international uncertainty, as well as a stronger euro and a weak labour market
is affecting households' consumption and confidence in the future.
This means that the international economic prospects look rather poorer now, which was also the
conclusion of the Executive Board at its monetary policy meeting on 6 February. However, this
assessment is based on the assumption that the Iraq crisis will develop in a way that will not
significantly deteriorate economic prospects.
Flat growth path for the Swedish economy
The financial unease has also affected the Swedish economy. Industrial production has stood still
during the autumn and order books have been slow to fill. This is perhaps not so strange in the light of
the "wait-and-see" mentality prevailing on important export markets. However, as the international
economic climate improves, this and the cyclical pattern for investment are expected to give impetus
to industrial production in Sweden.
Over the past six months, Swedish households have become increasingly pessimistic in their view of
the future, which is perhaps understandable taking into account the negative news with which they are
confronted: rising energy prices, higher taxes and expected cuts. The scope for consumption will be
under pressure from these factors in the near future. At the same time, households' savings were at a
high level in 2002, which means that there may be some scope to increase consumption despite the
restraining effects.
Altogether, I believe there is also reason for a downward revision of the estimate of the Swedish
growth rate over the coming years. The expected upturn is assessed to be somewhat superficial. This
also assumes that the Iraq conflict does not develop in a way that will seriously deteriorate future
prospects.
The shaping of monetary policy
A decisive factor in the shaping of monetary policy in future is the total picture of inflation prospects. A
slightly more subdued growth in demand both in Sweden and abroad is expected to lead to capacity
utilisation being slightly less strained. At the same time, energy prices have pushed up inflation.
However, the Riksbank's assessment is that the upturn in inflation is temporary and that there is
reason to expect lower inflation as early as the late spring and summer. Although, as I said earlier, this
assumes that those setting prices and wages do not attempt to compensate themselves for the
temporary price rise.
All in all, it is a question of balancing the risks of, for instance, a weaker growth in the economy,
against the risk that the upturn in inflation will have contagion effects.
This is what the Executive Board must do at its monetary policy meeting on 17 March.
UND1X including and excluding
Chart 1
energy
4 4
UND1X
UND1X excluding energy
3 3
2 2
1 1
0 0
1995 1996 1997 1998 1999 2000 2001 2002 2003
Sources: Statistics Sweden and the Riksbank