Mr. Bäckström gives a broadbrush picture of the Swedish economy and
Speech by the Governor of the Bank of Sweden, Mr. Urban Bäckström, held
monetary policy
at seminars before the Midland Bank and Merrill Lynch, respectively, in New York on 30/4/97.
Economic developments in recent years
In the past few years Swedish economic policy has achieved tangible results.
• By an improvement in credibility, important progress has been made
towards greater economic stability. Favourable economic growth in
Sweden has been combined with a rate of inflation that is the lowest for
several decades.
• There is broad political agreement in Sweden on the consolidation of
government finance. This is manifested in the so called convergence
programme that aims to eliminate the budget deficit not later than 1998.
The budget reinforcements which the Government and the Riksdag
(Sweden's parliament) have undertaken in recent years are extensive. The
six-monthly monitoring arrangement provides a means of ensuring that
government finance is developing as planned. Moreover, in the Economic
Bill this spring the Government states that the long-term target for the
general Government budget is a surplus of 2 per cent of GDP as a cyclical
average. The gradual adjustment to this goal is also specified.
The general government financial balance has been strengthened from
12.3 per cent of GDP in 1993 to -2.5 per cent in 1996. This is a substantial
improvement. The Government calculates that in 1997 the deficit will be
2.1 per cent and that the target of eliminating it in 1998 will be achieved.
• With the improved confidence in budget and monetary policy, together
with the tighter interest rate policy from the second half of 1994 up to the
end of 1995, it has been possible to check the earlier inflationary
tendencies and bring inflation expectations down appreciably. Sweden is
now among the countries in Europe with the lowest inflation rate
regardless of which measure one uses. This, in turn, paved the way for a
gradual lowering of our main instrumental rate - the repo rate - in 1996.
• What used to be an almost chronic deficit on current account has now
been turned into a substantial surplus. This is reducing Sweden's external
debt, which also contributes to greater financial stability.
• Many structural measures have been implemented since the late 1980s.
There are signs that, together with economic policy's focus on stability,
this has reduced the economy's inflation propensity and raised potential
output.
Against this background, the direction of Sweden's economic policy contrasts
sharply with the unstable, inflationary path we experienced in the 1970s and '80s and which
contributed to the recession in the early '90s, which was the worst for over sixty years.
A new direction in economic policy
The 1970s and '80s illustrate how a period of inflation creates an atmosphere of
uncertainty and instability, with a speculative climate and "short-termism" in economic
decisions. Slowly but surely, production's long-term conditions deteriorate.
It was partly in the light of such experiences that Swedish economic policy was
realigned at the turn of the 1980s. Since then, the focus on price stability has gained broad
support in our society, including the political parties.
However, in view of the severe economic problems in the early 1990s, with
inflation expectations based on our historical record and a massive budget deficit, it took time
for the new direction of economic policy to acquire credibility. This has been evident, for
instance, in the periods of interest and exchange rate unrest. Financial market trends particularly
in the longer run can be regarded as an indicator of the prevailing degree of confidence in the
determination and ability to conduct an economic policy that is consistent and oriented towards
stability.
With the free movement of capital and the globalisation of financial markets,
economic policy decision-makers need to be highly disciplined. In the light of our experience
since the policy realignment at the turn of the '80s, this is a fact that is widely recognised today
in Sweden. Turning the clock back would not be feasible.
Experience from other countries, where the policy realignment had already been
made in the early 1980s, indicates that the creation of confidence in a low inflation regime takes
time and a lot of hard work. But it also shows that after a while, such a process does yield its
reward in the form of low interest rates, a stable currency and ultimately a favourable economic
development.
The price stability target
Following the move to a flexible exchange rate, monetary policy in Sweden is
directed at a quantified inflation target. In this it resembles the situation for monetary policy in
Australia, Canada, New Zealand and the United Kingdom, where inflation targets are also used.
In Sweden the target is formulated as being to limit the increase in the consumer
price index to 2 per cent. This target is to be assessed, not in terms of isolated twelve-month
change figures but in a somewhat longer, annual, perspective. As monetary policy obviously
cannot control price developments exactly, the target is accompanied by a tolerance interval of
±1 percentage point. This tolerance interval also serves to absorb temporary deviations from
trend inflation. Such deviations may arise, for instance, from political decisions to alter indirect
taxes and subsidies, changes in interest rates as well as from international price shocks.
For March 1997 the consumer price index showed a twelve-month fall of 0.4 per
cent. However, this figure was to a large extent influenced by last year's sharp repo rate cuts.
When home owners renew mortgage loans at lower interest rates we get a transitory downward
effect on inflation.
It is important to distinguish between CPI changes and underlying inflation.
Transitory effects, for example changes in interest rates or in indirect taxes and subsidies, may
cause the general price level to jump up and down. In the conduct of monetary policy it is
therefore important to keep an eye on underlying inflation; the transitory effects are of
secondary significance as long as they do not affect inflation expectations and thereby trend
inflation.
Given the time lag that applies to monetary policy, a central bank that targets
inflation has to monitor the various factors which determine inflation one to two years ahead.
In a simple analysis of inflation's determinants one can start from the familiar
augmented Phillips curve. The rate of inflation is determined by two factors: the relationship
between supply and demand in the economy - the output gap - and inflation's expected rate.
Note, however, that while the output gap is a useful starting point for an inflation
analysis, there is no simple way of measuring it. This makes it necessary to go into more detail
and study a variety of indicators in order to analyse any tensions between demand and supply.
Still, the output gap is a suitable starting point for my present purpose.
The simple model tells us that when the output gap is closed, inflation is constant
and equal to the expected rate. This means that, with normal capacity utilisation and given a low
level of inflation expectations, actual GDP can follow potential output. In such a situation some
form of external shock is needed to shift inflation upwards or downwards. This can mean either
that production falls below or rises above the level for normal capacity utilisation or that
inflation expectations move up or down. The latter case is ultimately a matter of confidence in
economic policy's consistency and its future reactions.
The ability of monetary policy to influence inflation has to do with the impact of
the instrumental rate on the path of GDP and thereby on the degree of capacity utilisation,
together with its effect on inflation expectations. In practice a period of restricted demand has
frequently been necessary for the central bank to show that expectations of high inflation are
unfounded. Besides monetary policy, expectations are affected by other factors. One of these is
the budget. Unsustainably large budget deficits are liable to undermine confidence in long-term
price stability.
Our inflation forecast serves as a foundation for decisions about monetary
conditions. If monetary policy is directed at stabilising inflation at 2 per cent, it will over time
help to stabilise demand so that this is in line with the economy's available capacity.
In order to clarify our line of reasoning and our inflation assessments, the
Riksbank publishes an inflation report four times a year. A range of indicators is reviewed in
these reports, accompanied by a discussion of risks and opportunities in the field of inflation.
The present situation
In the latest inflation report, published this March, GDP growth in 1997 and 1998
was expected to be around 2 and 3 per cent, respectively. It was also argued that sizeable
capacity restrictions should not arise in the course of the period. Given that, and inflation
expectations being low, underlying domestic inflation (measured with the CPI excluding
transitory effects on inflation) in the coming two years was put at between 1.5 and 2 per cent.
As we all know, to forecast inflation is a complicated task. In view of the
shortcomings in such estimates, it is more a matter of assessing the balance of risks. Our latest
inflation report therefore includes a discussion of two alternatives in which future inflation
might be either lower or higher than in the main scenario.
One alternative is that inflation could be lower than in the main scenario, mainly
if private consumption were to be weak. The other envisages the opposite - higher inflation - on
account of a weaker exchange rate that stimulates a stronger growth of exports and GDP, leading
to increased inflationary pressure.
What are the economic tendencies that have appeared during the last months?
During winter there were signs of a slowdown in manufacturing. The December
survey from the National Institute of Economic Research showed an unchanged inflow of orders
and expectations of subdued production. The order statistics from Statistics Sweden, which
fluctuate fairly widely from month to month, gave the impression of relatively weak orders in
the fourth quarter of 1996. In December and January, however, the order inflow has picked up
and more recent survey data likewise paint a brighter picture of activity in manufacturing. The
improvement mainly applies to production for export but even the domestic market is somewhat
optimistic about the future. Against this background, exports and industrial production could
develop somewhat better than expected earlier. The changes are not very large but to date
various indicators, including the continued undervaluation of the krona, do point in the same
direction.
In the case of private consumption, the indicators to date are not uniform. On the
one hand, in the first three months of 1997 the number of new car registrations for private
individuals has risen in annual terms by more than 60 per cent, albeit from a low level.
Moreover, the survey of household purchasing plans by Statistics Sweden shows that since the
autumn, household's economic expectations have become more optimistic. The development of
monetary aggregates such as M0 is also an indication of rising private consumption. On the
other hand, the lower than expected savings ratio in 1996 may increase uncertainty regarding
possible increases of private consumption in 1997 and 1998. Another indicator of a slower
increase in private consumption could be the weak labour market.
In summary it can be said that, on the one hand, exports seem to be doing
somewhat better than expected, though the differences are not all that great. On the other hand,
the signals about private consumption point either to agreement with the main scenario or to a
somewhat weaker course.
The conclusion in the latest inflation report was that monetary policy is well
balanced. That conclusion still holds true.