Lars Heikensten: Some topical monetary policy issues
Speech by Mr Lars Heikensten, First Deputy Governor of Sveriges Riksbank, at a seminar of the
SNS - Center for Business and Policy Studies, Stockholm, 23 October 2001.
* * *
Thank you for inviting me to talk here about monetary policy and the economic situation.
The economic seminars arranged by the Centre for Business and Policy Studies are an established
tradition that is well worth maintaining. This is my sixth appearance here as Deputy Governor of the
Riksbank and for me, these have been good occasions both for looking back and reflecting on all that
has happened in the field of monetary policy during the past year and for considering what the future
may have in store. My talk today is arranged along similar lines.
From the viewpoint of economic policy and in keeping with the latter part of the 1990s, last year's
economic developments gave relatively little cause for concern. GDP growth had provided a series of
pleasant surprises at the same time as inflation had been lower than expected. This had been
accompanied by a rapid improvement in the public finances.
Signs of poorer tendencies were, however, beginning to appear. Stock markets were already starting
to fall in the early part of 2000 and in the late autumn a number of indicators pointed to an economic
slowdown, first in the United States and then, early this year, in other parts of the world. To begin with
this was perceived as just a temporary dip - a blip in the stocks cycle, a minor adjustment in the IT
sector or something else. But stock markets seemed to be clearly over-valued and it would have been
odd, particularly after such a long upward phase, if this had not led to a certain amount of
overinvestment. There were also clear signs of insufficient saving, particularly in the United States.
Consequently there were grounds for believing that once a slowdown had started, it could prove to be
both relatively deep and long. Against this background, in the March Inflation Report we talked not so
much about a V-shaped path as a U-shaped one or a "banana". Since then the outlook has become
darker but more of that later.
For monetary policy, turns in the business cycle are not inherently a major problem, apart from the
difficulty of foreseeing them. Falling resource utilisation, for example, should normally led to lower
inflation in the future. That in turn can pave the way for interest rate cuts. In the past year, however,
things have not been quite as simple as that. Two partly interrelated factors have contributed to this.
One is inflation, which has been higher than expected and also above our target. The other is the
exchange rate, which has been weaker than anticipated and also weaker than the real economy
warrants. During a period in the late spring, moreover, the krona fell rather uncontrollably in the
absence of similar movements in other currencies. All this has made our work harder than in the
preceding years.
Price tendencies
I should like to comment first on the high inflation figures.
Fluctuations in inflation are commonplace
Recently people have been asking whether the higher inflation outcomes constitute a failure. Some
years ago, when inflation month after month, not to say year after year, turned out to be lower than we
had predicted and below our 2 per cent target, people asked exactly the same thing. I did not see it on
the whole as a failure then and neither do I do so now. The lower inflation at that time was mainly due
to downward effects of a transitory nature even though the economy was expanding rapidly and
capacity utilisation was rising. Similarly, the higher rates at present primarily stem from transitory
factors. Earlier we noted that some upward shift in inflation could be achieved in the short run but only
by means of drastic interest rate cuts. The corresponding remedy today would be drastic hikes. Such
an approach would make interest rate policy erratic and result in unnecessary fluctuations in economic
activity.
What we can do - and do - is to aim consistently at our 2 per cent target. There is then a good chance
of succeeding in the longer run, particularly if economic agents take us at our word and rely on future
inflation being in line with earlier assessments. Judging from the various indicators of inflation
expectations, on the whole we seem to have been successful (Diagram 1). Although inflation has
actually fluctuated markedly, for a number of years money market players, for example, have counted
on future inflation being approximately 2 per cent. Neither have they been greatly mistaken. Since we
began to target inflation, the rate measured by the CPI has averaged 1.3 per cent, while UND1X
inflation has averaged 1.8 per cent.
1. Inflation expectations among money
market players
Per cent
5 5
Jan 95
4 4
Mar 00
3 3
Feb 96
Feb 97
Sep 01
2 2
CPI
Feb 98
1 1
Sep 00
0 0
-1 -1
94 95 96 97 98 99 00 01 02 03 04 05 06
Sources: Statistics Sweden and Prospera Research AB
If we have anything to reproach ourselves for, perhaps it is that, despite our efforts to the contrary, we
seem to have induced many segments of society to believe that we can fulfil the target, if not always
then almost so. That is evidently not the case. Inflation fluctuates, sometimes a lot. The same seems
to apply in most other relatively small countries. Compare inflation in, for instance, the individual euro
countries with the average rate in the European Union. In Sweden's case the fluctuations are possibly
accentuated by the price-setting being comparatively centralised in some important respects, for
instance the labour market and rents.
2. UND1X and product groups that
fluctuate
Percentage annual change
9 9
UND1X
7 7
electricity, telecom, meat, petrol, light fuel oil,
fruit and vegetables
5 5
3 3
1 1
-1 -1
-3 -3
Jul-95 Jul-96 Jul-97 Jul-98 Jul-99 Jul-00 Jul-01
Jan-95 Jan-96 Jan-97 Jan-98 Jan-99 Jan-00 Jan-01
Source: The Riksbank
Still, there are good reasons for taking a close look at the latest inflation outcomes. The prise rise has
come mainly from food and energy but also from telecom prices (Diagram 2). In the case of food and
electricity, the price increases, particularly during the spring, largely stemmed from factors on the
supply side: foot-and-mouth disease, mad cow disease, a relatively dry winter, production problems at
oil refineries and so on. It is, in fact, these CPI items that normally fluctuate most. It is not just a
coincidence that in Canada, for example, the inflation index that primarily guides monetary policy does
not include either food or energy prices. The rather large price fluctuations that are a normal feature of
these goods and services can be taken to indicate that the recent increases do not constitute a
ketchup effect, so that the conditions for a return to a rate in line with the target should be relatively
good.
Not just transitory effects
At the same time I definitely do not want to make light of the increase in inflation. Even excluding the
goods and services I just mentioned, inflation has moved up more than expected and it has done so
even though resource utilisation is lower, at least at present, that we counted on earlier. That is the
main reason why, in the latest Inflation Report, we have slightly revised our appraisal of how resource
utilisation is likely to affect inflation.
A conceivable interpretation of the revision is that today we consider that resource utilisation last year
was higher than we reckoned on earlier. That is not self-evident, however; this year's wage outcomes
have been lower, which one would not expect if resources have been more strained. Another
possibility is that, even if resource utilisation was not in fact higher, price increases have occurred due
to insufficient competition.
In the past, the Riksbank has presented a picture of goods and services divided into those that are
priced in a market as opposed to administratively. This showed that in 1996-97, for instance, goods
and services priced administratively kept inflation up even though resource utilisation was falling
(Diagram 3). Perhaps we are now seeing a similar phenomenon. When turnover in a competitive
market falls, prices normally decline, too, but in some respects the opposite now seems to apply. Local
authorities, for instance, are trying to make up for a loss of tax revenue by raising prices for water,
public transport and the like. From the media it looks as though there is a similar tendency in civil
aviation authorities and some air transport, for example.
3. CPI and administratively priced
services
Percentage annual change
5 5
Administrated prices on
services
4 4
CPI
3 3
2 2
1 1
0 0
-1 -1
Jul-95 Jul-96 Jul-97 Jul-98 Jul-99 Jul-00 Jul-01
Jan-95 Jan-96 Jan-97 Jan-98 Jan-99 Jan-00 Jan-01
Source: The Riksbank
The Riksbank has no direct cause to regard administratively determined price increases differently
from market increases: both contribute to inflation. But when the former accompany declining resource
utilisation, it obviously complicates matters for monetary policy. In addition, these observations
naturally raise other questions that have to be dealt with, not by the Riksbank but by parliament and
the local authorities and have to do with competitive conditions in the Swedish economy.
The exchange rate
Recently the exchange rate has also been the subject of a lively discussion. That is only to be
expected when the krona has fluctuated markedly, besides being clearly under-valued on the whole in
recent years.
Differences in inflation and growth could previously explain most things
In a longer perspective there are explanations for a large part of the krona's depreciation. In the past
three decades the nominal exchange rate has weakened about 90 per cent. More than half of this
deterioration can be attributed to the higher inflation in Sweden compared with the rest of the world in
the 1970s and '80s. Mostly of the remaining part of the real deprecation can be explained in terms of
relative GDP growth and worsening terms of trade in the same period. But neither of these two factors
is relevant to the period since 1992 with a flexible exchange rate: inflation, growth and terms of trade
have been at least on a par with the rest of the world.
Various flows may have played a part in the short run. Looking back, it is evident that export growth
and rapidly rising Swedish share prices may have contributed to the high exchange rate with the euro
twelve to eighteen months ago. During the past year the opposite has applied. Another factor has
been large investments in foreign shares when earlier barriers to risk diversion were removed from the
pension system. In September there was also general financial unrest. However, variables such as
these have proved to be of little value for forecasting.
So personally I do not think it has always been hard to understand the direction, upwards or
downwards, of exchange rate movements in recent years. It is the tendency for the krona's average
value to be unduly low that has been more difficult to interpret. To some extent, this has presumably
been a consequence of the American dollar being generally over-valued against European currencies.
I also believe that some part may have been played by various structural factors, for example the
construction of the tax system, the internationalisation of the corporate sector with the attendant
relocation of certain functions, the status of the Swedish krona as the importance of the euro grows in
Europe and so on.
Some of these notions are supported both by arguments from principle and by somewhat anecdotal
information. There is reason to believe, for instance, that the taxation of both capital gains and wealth
has had effects. Moreover, at least a part of the residual item in the statistics could have to do with a
tendency for firms not to repatriate export receipts to the same extent as before, which in turn may be
a consequence of a larger proportion of their central functions now being located abroad. But we do
not know how quantitatively important these factors are and I believe that perhaps one should be wary
of exaggerating them. Still, these are questions that deserve further scrutiny and we intend to pursue
them. To date we have published a report on EMU's conceivable importance for the Swedish krona;
the conclusion was: not much, provided - and it is a major proviso - Sweden provides equal conditions
in other respects for wealth formation and business enterprise.
The krona's part in the assessment of inflation has varied
One of the topics in the discussion during the past six months has been how the Riksbank reacts to
the exchange rate in the formation of monetary policy. We have been accused of being indistinct or
dithery during the summer and autumn. First let me say that there is a pattern to this that I find familiar.
Conducting and interpreting monetary policy is more difficult when the situation is appreciably affected
by other factors than resource utilisation, for instance the exchange rate or inflation expectations. The
assessments are then more complex and the Riksbank faces greater educational challenges. The
decisions also tend to be more controversial because there is a clearer conflict between different
goals, so that more criticism is only to be expected.
Our forecasts are always based on a variety of factors. A traditional model for determining inflation in
the context of a Phillips curve, for example, points to resource utilisation, inflation expectations and the
exchange rate as central components. However, these variable's relative importance for inflation
changes over time.
To illustrate our reasoning over the past nine months, here is a presentation of resource utilisation, our
view of international prices and the exchange rate (Diagram 4).
4. Assessment of growth* and export
prices* and the TCW index
* Percentage annual change
150 150
145 145
TCW index
140 140
135 135
130 130
125 125
120 120
115 115
110 110
Jan-98 Jul-98 Jan-99 Jul-99 Jan-00 Jul-00 Jan-01 Jul-01
4.0 4.0
Forecasts exportprices
Forecast of growth 2001 and 2002
1.4 1.4
3.5 3.5
3.0 3.0
1.2 1.2
2.5 2.5
1.0 1.0
2.0 2.0
1.5 1.5
0.8 Forecast 2001 0.8
Growth Forecast 2001
1.0 1.0
Growth Forecast 2002 Forecast 2002
0.6 0.6
0.5 0.5
0.0 0.0 0.4 0.4
IR 00:4 IR 01:1 IR 01:2 IR 01:3 IR 00:4 IR 01:1 IR 01:2 IR 01:3
Note. IR = Inflation Report. Sources: Hanson & Partners and the Riksbank
Last December, when it still looked as though resources would continue to become increasingly
strained, we were concerned about the exchange rate and its effects on prices. We counted on GDP
growth rates last year and this of 4 and 3.5 per cent, respectively. Since then our appraisal of resource
utilisation has changed a good deal. We now know that last year's growth stopped at 3.6 per cent and
for this year we are counting on 1.3 per cent. This means that as a percentage of GDP, resource
utilisation at the end of 2001 will be between 2 and 3 points lower, which is a marked downward
revision. Another aspect is that the slowdown is connected with a weak tendency in the rest of the
world. Consequently our assessment of international export prices has also been revised downwards
and this, too, counters the inflationary impact of the weaker exchange rate. So although we continue
to point to the weak krona as an inflation risk, this risk now seems to be smaller, mainly in view of the
downward revisions of capacity utilisation.
In June we had some additional factors to consider. The krona suddenly weakened dramatically in the
absence of a general increase in financial unrest. This suggested that the causes were specific for
Sweden. As inflation had moved up appreciably more than expected in the previous months, this was
particularly troublesome. Although a large part of the increased inflation was presumably transitory,
the Riksbank perceived a risk of higher inflation expectations. Rather than take that risk, we decided to
raise the interest rate and intervene in the currency market.
The forecast
In conclusion I want to make some brief remarks about the future, using our latest Inflation Report as
the chief starting point. The main scenario there is based on the prospect of what might be called a
normal cyclical development, driven above all by an international recovery, good disposable incomes
and a relatively weak exchange rate (Diagram 5).
5. GDP Sweden, percentage annual
change before and after bottoming out of
economy
1977 Q4
6 6
1981 Q1
1993 Q3
5 5
1997 Q1
4 2002 Q2 4
Forecast
3 3
2 2
1 1
0 0
-1 -1
-2 -2
-3 -3
-4 -4
-6 -5 -4 -3 -2 -1 0 1 2 3 4 5 6
Source: The Riksbank
Unchanged appraisal of the krona's fundamental value
Our assessment of the future exchange rate is somewhat less optimistic than before. This has to do
not so much with new information as with the weak tendency in the past year. In the case of a variable
that is so notoriously difficult to predict, the assumption about the future is always partly educational. A
major aim on this occasion was to avoid an assessment of inflation that could be perceived as
unrealistic. But the krona fluctuates sooner than the time it takes to revise our forecast, as is clear from
what has happened.
In the discussion that followed the publication of the Inflation Report it has been suggested that the
Riksbank has lost faith in the krona. I think that's overdoing it. And regardless of the forecast we
presented, I see no strong reasons for altering the appraisal of what is a reasonable fundamental
exchange rate in the long run, any more than there were grounds for revising the basic principles for
share valuation just because stock markets had shot up to record levels a couple of years ago. That
does not mean that some time in the future there could be a case for a different opinion about the
exchange rate's reasonable level in relation to the real economy. But that would stem in turn from an
altered view of Sweden's relative production potential, terms of trade or some other fundamental
variable. In this context it should be borne in mind that an unduly weak exchange rate generates
effects that should favour an appreciation further ahead: the balance of trade continues to be strong,
corporate profits become higher than elsewhere, making Swedish shares more attractive, and so on.
Calculations of the krona's fundamental value will no doubt become topical at the latest if Sweden is to
adopt the euro and we require a picture of the exchange rate that will be serviceable in the longer run.
Experience has shown that once such rates have been communicated, they guide the market to a
high degree up to entry.
Lower resource utilisation but large risks in both directions
In the Report we count on inflation falling back again next spring. This year's appreciably lower
resource utilisation has a lot to do with that but so does the prospect of last spring's rapid price
increases coming to an end so that the earlier effects drop out. In the latter part of the forecast period
inflationary pressure in the main scenario becomes somewhat stronger as the economy recovers fairly
rapidly.
Support for this picture is to be found if one goes behind the price statistics and looks at wages and
unit labour costs (Diagram 6). Even with the rather substantial downward revision of productivity
growth, these costs rise at a moderate rate throughout the forecast period. That should ensure that
even if inflation does not fall back quite as much as calculated, its level will be low. The overall
assessment is that in September next year CPI and UND1X inflation will 1.5 and 1.7 per cent,
respectively, while the rates in September 2003 will be 2.1 and 2.0 per cent.
6. Development of unit labour costs in trade and
industry, and total agreed wage increase
Per cent
8 8
Unit labour cost
7 7
Total wage increase
6 6
5 5
4 4
3 3
2 2
1 1
0 0
Mar-96 Mar-97 Mar-98 Mar-99 Mar-00 Mar-01 Mar-02 Mar-03
Sources: National Institute of Economic Research, Statistics
Note. Forecast 2001-2003. Sweden and the Riksbank
The main downside risks are connected, for example, with the possibility that the adjustment in the
United States after the long upward phase could take longer than expected. After September 11,
moreover, terrorist attacks and military action can clearly cause developments to take very different
paths, with markedly divergent outcomes for the global economy. Another aspect is the highly
expansionary direction that economic policy has now taken in many countries, not least Sweden. If
confidence in the future is restored, the table is really laid for a quick upturn. But all in all, there is
considered to be a strong probability of inflation being lower as a result of the slowdown abroad being
deeper and more protracted. Such a development would be likely to lengthen the slowdown in
Sweden as well.
There are also risks of inflation being higher than in the main scenario. One has to do with the fact that
inflation has risen more than expected. Our main scenario makes some allowance for the higher
outcomes but the revision is rather small. It was just with such small, cautious revisions that we coped
with the surprisingly good inflation outcomes earlier. Without more knowledge it is difficult to see how
one can act very differently. In addition to the marginal revision in the main scenario, the risk spectrum
now contains a further upside component. Another upside risk for inflation lies in the exchange rate,
even though a persistently weak currency is presumably the most likely alternative in conjunction with
slacker economic activity and thereby lower resource utilisation.
There are always grounds for highlighting the spectrum of risks as an important element in our
assessment. I want to end by emphasising this particularly at present. In many respects the situation is
unusually difficult to assess. It is easy to see that developments could quickly take a different turn from
the main scenario. That in turn could led to interest rates becoming either higher or lower than at
present.