Eva Srejber: The transmission mechanism
Speech by Ms Eva Srejber, Second Deputy Governor of the Sveriges Riksbank, at Umeå University,
Umeå, 15 May 2001.
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The Riksbank has a statutory duty to maintain price stability. However, it has the power to decide how
to operationalise monetary policy and the monetary policy strategy that is to guide the monetary policy
decisions. In the annual assessments of the performance of the Riksbank made by the Riksdag
Finance Committee, both the objective and the strategy adopted have won acceptance. Monetary
policy is governed by an inflation target expressed as the annual rate measured by CPI is to be limited
to 2 per cent with a tolerance interval of ± 1 percentage point.
However, the decision to define price stability as a reduction in the value of the krona by two per cent
per year in relation to the basket of goods and services consumed by Swedish households is by no
means self-evident. In principle, another rate of price increases, other weighted combinations of goods
and services, financial assets or currencies could serve as the anchor in relation to which the value of
the krona is to be kept stable. When the inflation target was adopted in 1993, conditions did not favour
a return to any form of fixed exchange rate. The decision that had to be made then was how best to
design monetary policy to cope with the transition from a high to a low-inflation economy while, at the
same time, creating suitable conditions for returning to a fixed exchange rate regime. CPI was
deemed to be the best known measure of inflation and this was one reason why it was very suitable in
a situation where confidence in stable prices was to be attained. An inflation rate of two per cent was
considered to be well in line with inflation in the rest of the EU and this was adopted to create a basis
for stabilising the nominal exchange rate of the krona in relation to the European currencies.
By monetary policy strategy I mean the entire framework used to comply with the ultimate objective
that monetary policy is intended to achieve. Besides operationalising the target, this concerns, for
instance, how the system is to be designed to enable the central bank to influence interest rates and
how open and clear monetary policy is to be. It is also about taking decisions on any intermediate
objectives and the time horizon in which fulfilment of the objective is to take place.
The decision on monetary policy strategy fundamentally rests on conceptions of how the mechanisms
operate that permit the central bank to determine the value of money - what is known as the
transmission mechanism. For the most part, however, there is little knowledge of these very
complicated mechanisms. The rapid development in the financial markets means moreover that the
conditions for monetary policy are continually changing. It is therefore natural for the rules of action
and strategies that govern monetary policy to be discussed and evaluated. I am going to begin by
giving a short review of how the transmission mechanism is usually described and to discuss the
changes that have taken place. Against this background, I will then briefly describe how the Riksbank
conducts its monetary policy.
What is the role of money?
The quantity theory describes in a simple way how inflation is determined. In this theory, the price
level is determined by the quantity of money in the economy. Production is determined over a
somewhat longer period by access to labour and by the development of productivity; monetary policy
does not affect production in the long term. It is intuitively easy to understand that at a given level of
production the price level will increase if the quantity of money increases and vice versa if the quantity
of money decreases. In an economy where only banknotes and coins serve as means of payment, the
central bank can control inflation by determining the quantity of banknotes. This is conditional on the
central bank knowing how much is required at a given price level in order for a particular quantity of
goods to be produced and circulated - the speed or velocity of circulation must be known in order for a
money quantity target to be used to control price movements.
Developments in the financial markets in general and of the payment system in particular have,
however, led to a reduction in the importance of banknotes and coins as a means of payment, i.e.
money. An increasing proportion of payment flows takes place by transfers between accounts and the
ability of the central bank to influence the quantity of money in the economy is largely only through its
ability to affect the demand for money by the general public. The quantity of money required by the
general public depends on its demand for transaction funds for the purchase of goods, services and
financial assets, which in turn is affected by the interest rates encountered by the general public. For
instance, lower interest rates increase demand for money when businesses' demand for capital goods
and households' demand for consumption increases. Thus, demand for goods and services are both
sensitive to interest rates and largely reflect one another.
By controlling the interest rate, the central bank thus affects both the demand for goods, services and
financial assets and the demand for money. Banknotes, coins and bank deposits can immediately be
transformed into means of payment and are therefore often used to define the quantity of money. The
banks can increase the quantity of money by, for instance, increasing lending or by purchasing
securities from the general public since a large part is returned as liquid deposits.
However, the quantity of money in the form of deposits and banknotes and coins that the general
public decides to keep as a liquidity buffer in readiness for coming transactions is also affected by the
stability of the value of other assets and how rapidly they can be transformed into means of payment.
Having funds in a current account at a bank or keeping banknotes in a mattress does not produce a
return. It is therefore better, of course, to, for instance, purchase interest-bearing treasury bills which
can be rapidly converted into transaction funds when wishing to make a payment.
The ability to borrow money quickly also affects the willingness to keep a liquidity buffer in the form of
banknotes, coins and liquid bank deposits. Efficient second-hand markets and access to overdraft
facilities have, for instance, affected the needs of the public to keep a liquidity buffer. The public's
need for transaction funds for purchase of shares has probably also increased and it is likely that it
varies with developments in the stock market. Many factors have thus contributed to changes in the
rate of circulation of money1 and it has therefore become more difficult to predict.
To sum up, the role of money for the level of prices in the economy has not fundamentally changed.
What has happened is that the trend in the financial markets has meant that it has become more
difficult for the central banks to use the quantity of money as an intermediate target for an ultimate
price stability objective. Most central banks therefore now use the quantity of money as one indicator
of inflation among others. However, there are considerable differences between the assessments
made by different central banks of the importance of the quantity of money as an indicator of price
trends. The European Central Bank - the ECB - notifies, for instance, a reference value for the
increase in the quantity of money that is considered to be compatible with their price stability
objectives.
The influence of monetary policy on the output gap
The difficulty of using the quantity of money as an intermediate target for an ultimate price stability
objective has contributed to an increasing number of central banks moving over to direct control
through an inflation target. Put simply, they use the mechanisms that enable the inflation target to be
described as follows: A change in the instrumental rate affects GDP which in turn has an effect on
inflation. If GDP increases at a rate that makes full use of production resources, inflation is not
changed although if demand is so high that production resources are under pressure, then inflation will
increase. When resources are under pressure, it is said that there is a positive output gap and vice
versa when there are free resources in the economy. When growth is balanced, it is said that GDP
increases in accordance with its potential growth path. According to this simple model, the central
bank is able to affect inflation through its ability to affect the output gap.
The emphasis here is not on the effect of the interest rate changes on demand for money, for
instance, to be able to make payments for investments and consumption, but directly on the effect that
the interest rate has on the real demand.
The channels that enable the steering interest rate to have an effect on the output gap can be
categorised in different ways:
The most important channel is probably the interest rate channel. A change in the steering interest
rate directly affects the shortest market rate. The banks can normally finance a deficit and invest a
surplus at that rate. The shortest market rate and market expectations on future changes in the
instrumental rate therefore constitute the alternative cost of the banks' financing or the alternative
return on the bank's loans and holdings of securities. The banks' lending rate and the interest rate on
securities are therefore affected by the actual and expected instrumental rate. Monetary policy thus
also has a direct effect on the interest rates encountered by the general public.
i. Investment and consumption decisions are affected directly by the interest channel. The
required return on investment is reduced at a lower interest rate at the same time as saving
is less profitable.
ii. Interest rate changes also have an income effect through interest income and interest
expenditure on existing assets and liabilities.
iii. Interest rate changes also affect share prices and real estate prices - lower interest rates
increase demand for shares and properties and prices increase. An interest rate reduction
also affects household wealth through higher share and property prices which in turn affect
consumption decisions.
The interest rate channel therefore affects demand for goods and services and thus the output gap
with some time lag through many complicated mechanisms. Changes in the use of resources or the
output gap then affect inflation in turn, with some time lag.
The impact of changes in the instrumental rate on demand and inflation may also be affected by the
lending rate set by the banks. The channel that is mediated by the behaviour of the banks can be
generally referred to as the credit channel. Higher interest rates may, for instance, reduce the
willingness of the general public to keep funds deposited in current accounts, which have a very low
return. Deposits have a very low financing cost for the banks and if they have to finance an increased
proportion of their lending in another way, the banks may compensate for this by a higher lending rate.
However, it is uncertain how the behaviour of the banks affects the impact of monetary policy.2
Changes in the instrumental rate have an effect through the "exchange rate channel" partly by
changes in the nominal exchange rate for the krona affecting the relative prices for net export. Higher
interest rates should thereby strengthen the domestic currency and make domestic goods more
expensive relative to other goods and vice versa. Higher interest rates thereby dampen export at the
same time as import becomes cheaper and increases. Lower demand for domestic goods contributes
to reducing the use of resources and subduing inflation. A stronger nominal exchange rate dampens
consumer prices at the same time since part of consumption is directed towards imports when prices
are dampened. However, lower import prices also increase the real purchasing power which per se
contributes to increasing purchasing power. In economies with diversified industry an increase in the
interest rate thus also leads via the exchange rate channel to lower inflation. The strength of the effect
depends inter alia on income and price elasticities and on the composition and size of foreign trade. In
certain cases the positive effect on incomes from stronger currency can even predominate and vice
versa.
Changes in the nominal exchange rate probably have less impact on import and export prices if the
changes are not considered to be lasting. In a floating exchange rate regime, it is therefore probable
that changes in the nominal exchange rate will not have such a great effect as in the case of a
devaluation or revaluation in a fixed exchange rate regime.
The role of inflation expectations
The channels I have now pointed out operate in most cases through demand and the output gap. One
channel that is probably very important and which does not operate through resource use in the
economy is the effect of monetary policy on inflation expectations and its impact on price-setting
conduct and how price changes are received in the economy. There is scarcely any doubt that
inflation expectations played an independent role prior to the inflation target achieving credibility in the
mid-1990s. Now that the inflation target appears to be well known and generally accepted and inflation
expectations are well in line with the inflation target, the role of expectations in the transmission
mechanism is not so self-evident. However, stable and low inflation expectations should affect
businesses' pricing and wage formation. If the players in the economy are confident that inflation really
will be held at a low level, this could also lead to companies not considering that they have to change
their prices so often, for instance, in the event of changes in costs that are perceived as temporary. If
the expectations are not met, there is a risk that price changes will be large when they finally occur.
Stable inflation expectations can thus lead to inflation not varying continuously with the output gap
which paradoxically can make the conduct of monetary policy more difficult. In recent years, it has
been difficult to find clear and reasonable correlations between the demand situation and inflation for
Swedish data. The monetary policy decisions are based on forward-looking assessments of inflation
and here the assessment of the relationship between the expected output gap and inflation is an
important determining factor. A lower correlation could depend on inflation expectations having
stabilised in recent years. Individual companies can, for instance, hold back price increases even if
resource use has increased, if they believe that their competitors are not intending to raise their prices.
As long as inflation expectations are not affected, prices will not be changed. If the forward-looking
inflation assessments that serve as the basis for monetary policy decisions, assume, for instance, that
the correlation between growth and inflation will continue to be as low as has been observed, this can
result in changes in the output gap not leading to any immediate monetary policy response. The risk is
that inflation expectations will then accelerate and that inflation will increase. In the same way, prices
may be slow to respond in the case of falling resource use. In other words - if monetary policy does
not act as expected on fluctuations in resource use, the correlation between growth and inflation can
again increase. Presumably the relation between the output gap and inflation varies both with the level
of the output gap, with the speed of the change in the output gap and with the expectations on central
bank behaviour.
The Riksbank's monetary policy strategy
An important part of the Riksbank's monetary policy inflation target strategy is clarity and openness
about the bases on which monetary policy decisions are made. The intention is to create support for
the price stability target and understanding of what governs interest rate decisions. This clarity means
that the Riksbank's interest rate decisions are often expected and this increases the ability of the
Riksbank to affect the somewhat longer rates through its analysis. This openness should also
contribute to stabilising inflation expectations.
The monetary policy decisions are based on forward-looking inflation assessments of CPI and UND1X
- a price index adjusted for certain temporary effects. These assessments are reported in the
Riksbank's inflation reports which are published four times a year. The minutes of the monetary policy
meetings which are held between six and eight times a year are published with a couple of weeks
time-lag.
Inflation assessments are made with a two-year time horizon while paying some attention to the
potential developments in the third year. Important determining factors for inflation are the
development of demand and the output gap. A number of inflation indicators are used, however, to
make the assessments. The quantity of money has no special role in the analysis although it is used
as one of many indicators.
The reason for decisions resting on forward-looking assessments of inflation is that monetary policy
has an effect with some time lag. The major part of the effect of an interest rate change is expected to
occur after one to two years although monetary policy is assumed to have some effect before and
after this time horizon.
The channels that allow monetary policy to have an effect on inflation are assumed to a large extent to
operate through the output gap which means that a change in interest rates will first affect resource
use which will then only have a tangible effect on inflation later. Normally, inflation assessment puts
most weight on the next one to two years in the conduct of monetary policy. However, the perspective
that monetary policy aims at also depends on the expected economic situation. If inflation diverges
considerably from the objective in the coming period, this may weigh more heavily than a small
deviation later on. Likewise, an anticipated higher or lower inflation after the one-to-two year
perspective can be weighed in.
Since the impact of a change in interest rates on inflation in the first year can be assumed to be small,
large changes in interest rates are required to have an effect on inflation already in the first year.
Attempts to affect inflation already within a year would in the view of the Riksbank lead to major
fluctuations in employment and production.
The correlation between interest rate changes, GDP and inflation is, however, not so unambiguous
and clear. There may be considerable uncertainty on the time lag and the strength of the effect of
monetary policy on inflation. It is probably the case that the strength of the effects and the time lag will
vary. As I previously discussed, it is also uncertain what role inflation expectations play in the
transmission mechanism.
Should monetary policy take asset prices into consideration?
A discussion that has become pertinent due to the great increase in the price of IT and technology
shares in particular that preceded the economic downturn in the United States as well as in Sweden
- is the extent to which it is reasonable and possible to counteract the building-up of financial
imbalances by monetary policy. If monetary policy is exclusively focused on an inflation target, asset
prices are taken into account to the extent that they affect inflation by wealth effects and stimulation of
investments and consumption. Appreciation of the currency, temporary productivity gains and loan
financing of financial assets can, however, lead to the accumulation of major financial imbalances
without this being fully visible as inflationary pressure. This was the case in Japan in the 1980s,
Thailand in the 1990s and in the United States today. Unmotivated increases in asset prices will
sooner or later lead to corrections, however. The strong boom in growth will then be replaced by a
deep and prolonged downturn. If the level of debt is high in the initial position and confidence in the
economy is weak, it may be difficult for monetary policy to affect demand and inflation in this situation,
which has been the case in Japan in recent years.
Some analysts consider that both prices and production would develop in a more stable way over time
if monetary policy counteracted exaggerated price increases in shares and other financial assets. It is
said that it is not much more difficult to determine when share prices indicate unrealistic future
increases in profit than it is to determine how quickly production in an economy can grow in the long
term. And such assessments are of key importance to all monetary policy decision-makers. Others
think that besides it being difficult to determine when asset prices are exaggerated, it is doubtful how
large an effect an increase in interest prices would have. This is particularly the case with regard to
share prices in small countries since the stock markets are so internationalised.
Clarity and flexibility
What I have discussed here shows that monetary policy decisions cannot be made on the basis of
mechanical rules of action. The transmission mechanism is complicated and probably not stable over
time either. Regardless of the monetary policy strategy adopted, monetary policy decisions must rest
on uncertain assessments. This may relate to assessments of the output gap and the correlation
between growth and production, the rate of circulation of the quantity of money and the effects of large
increases in asset prices.
Monetary policy must then be conducted in a flexible way based on the available information. This
means, for instance that assessments of whether financial imbalances are being built up and the risks
that are associated with this must be taken into consideration in some way when monetary policy
decisions are made. And even if the possibility for an individual central bank to influence a strong
international stock exchange increase through interest rate hikes is very limited, nothing will be
improved by an excessively expansive monetary policy. The increase in share prices is moreover
often followed up by a price increase in the real estate market and in contrast to the stock exchange,
this is local and thereby to a greater extent dependent on the national interest rates. A more in-depth
analysis of the quantity of money and expansion of credit can give leads as to what happened with
household and corporate balance sheets and in the financial institutions, In certain periods, it can
therefore be justified to give the analysis of lending and monetary policy increased weight.
The complexity of the transmission mechanism combined with the necessity of clarity and openness
sets considerable challenges for monetary policy decision-makers. It is important to avoid simplifying
to such an extent, in the endeavour to create understanding of what one is doing, that one
compromises one's freedom of action.