Per Jansson: The Riksbank's monetary policy strategy - in tune or out of
tune with the rest of the world?
Speech by Mr Per Jansson, Deputy Governor of the Sveriges Riksbank, at a meeting at
SEB, Stockholm, 2 June 2014.
* * *
Was the strategy for monetary policy that was formulated in the decades before the global
financial crisis - and which long appeared so successful - actually too narrow? Does
monetary policy need to put greater effort into preventing financial imbalances from arising?
The crisis turned many things upside down and forced both central banks and researchers
around the world to rethink their arguments and theories.1
Today I intend to talk about the rather lively discussion conducted among central banks and
in the academic world on this issue. This is a discussion that is both interesting and
important, but which I feel has made very little impact on the debate in Sweden. While the
discussion here in Sweden for the most part is based on the answer being already given, the
attitude in the international debate is much more open and inquiring.
Most people agree that macroprudential policy should be the first line of defence against
financial imbalances. But an increasing number have also begun to take the view that
monetary policy may need to give macroprudential policy support by, as it is often called,
"leaning against the wind". This is an idea I have considerable sympathy for in principle, and I
shall try to explain why in my speech today.
Lessons from the crisis: price stability is not enough to prevent financial imbalances
The foundation for the monetary policy strategy we use today is the changeover in monetary
policy in the early 1990s, when some central banks began to switch to explicit inflation
targets. This turned out to be an effective way of anchoring inflation expectations and in this
way attaining price stability. Inflation targeting became the standard for central banks. The
way the policy was implemented could differ slightly, but on the whole there was agreement
on the fundamental principles. A credible inflation target also creates some scope for
monetary policy to stabilise the real economy. Monetary policy could therefore be flexible and
focus on attaining a good balance between on the one hand price stability and on the other
hand the stability of the real economy, a couple of years ahead. There was also a consensus
- sometimes referred to as the "Jackson Hole consensus" - that monetary policy would not
try to counteract rapid increases in asset prices or credit growth.2 I shall return to this shortly.
The long period of relatively stable inflation and robust growth - "the Great Moderation" -
that preceded the financial crisis was considered to be proof that the chosen monetary policy
strategy functioned well. The experience from the crises that nevertheless arose, for instance
the year 2000 when the dot-com bubble burst, was that one could also manage more difficult
situations. However, the financial crisis 2007-2008 and the deep and protracted downswing
that followed have meant that central banks have been forced to closely examine things that
were previously taken for granted. In this way, the situation is a little reminiscent of the
situation at the beginning of the 1990s when inflation targeting was introduced. Then, too,
there were crises that made it necessary to question the prevailing monetary policy doctrine.
And then, too, it was the central banks that - of necessity - took the first steps and adjusted
their strategies and practical policy before there was any real consensus from academic
research to lean on.
One of the fundamental economic policy insights from the period of "the Great Moderation"
and the crisis years after this is that low and stable inflation, combined with robust growth,
without any direct signs of overheating, is no guarantee that the financial side of the
economy will be problem-free. In brief: price stability is not sufficient to prevent financial
imbalances.3 One lesson learnt from this is that the economic policy toolbox needs to be
extended. In addition to the tools already available for fiscal policy, monetary policy and the
supervision of individual financial institutions, new tools are needed and old tools may require
modification to be more usable in counteracting the type of financial imbalances that
contributed to the crisis. There is broad agreement on this. And in recent years there has
been intensive work around the world on defining and implementing this so-called
macroprudential policy.
Does monetary policy also need to give greater consideration to financial imbalances?
However, the insight that price stability does not prevent financial imbalances from arising
has also raised a question of principle in central banks. Has the focus on price stability,
which has been the basis for monetary policy, been too narrow? Financial imbalances can
aggravate economic downswings with severely negative effects on unemployment and
economic growth. If it gets really bad, the imbalances may even result in a financial crisis.
Should monetary policy therefore put greater effort than before into preventing financial
balances from building up?
Even before the crisis, there was of course an insight that financial imbalances entail risks for
macroeconomic developments and for financial stability. Maintaining financial stability has
traditionally been one of the central bank's main tasks, in addition to maintaining price
stability. And analysing financial risks has been an important part of this work. But in the
standard framework, financial risks and other financial stability aspects could, and even
should, on the whole be kept separate from the monetary policy deliberations - at least over
and above the impact that these factors have on the inflation forecast and economic outlook
for the coming years.4
There were of course arguments in favour of monetary policy explicitly taking financial risks
into account.5 These discussions most often concerned "bubbles" on the asset markets and
whether monetary policy should counteract their build-up - "leaning monetary policy against
the wind" as it came to be called. However, the consensus among both practicians in central
banks and academics was that this is difficult and that in practice it can do more harm than
good. Better then to wait and to use monetary policy to stimulate the economy once the
bubbles had burst - to "clean up afterwards" instead. However, the financial crisis showed
that the effects of financial imbalances and, in some cases, financial instability could be
enormous and that the "cleaning up" could require massive and prolonged efforts from
economic policy. The earlier consensus has thus been increasingly brought into question.
An excellent status report on this debate can be read in a jubilee issue of the Riksbank's
Economic Review, published in November last year. It is a paper by Frank Smets, adviser to
the President of the European Central Bank, which he also presented at a conference
organised by the Riksbank last summer.6 Mr Smets argues that after the crisis one can
discern three different views with regard to the question of to what extent monetary policy
should deal with financial imbalances.
"Modified Jackson-Hole consensus"
The first view is in principle based on the same monetary policy strategy as I have described
earlier and called the standard prior to the crisis, but with a few small additions. Smets calls
this view a "modified Jackson-Hole consensus". According to this view, there is indeed a
need to prevent financial imbalances, that is, it is not enough to wait until afterwards and deal
with the problems caused by the imbalances. But the preventive work should be entirely
done by macroprudential policy, while monetary policy should have the same role as before.7
The monetary policy strategy as such thus does not need to be changed very much.
The most common argument in favour of this view, according to Smets, is that monetary
policy is a blunt instrument and has limited effects on the financial risks one wishes to
counteract. The macroprudential policy tools, on the other hand, are regarded as much more
effective for this purpose. The interaction between macroprudential policy and monetary
policy can thus be kept to a minimum, and it is perfectly simple to keep the objectives and
tools separate from one another.
"Leaning against the wind vindicated"
Characteristic of the second view is that one is more doubtful that macroprudential policy will
always manage to prevent financial imbalances on its own. It could, for instance, be because
the macroprudential policy tools are not as effective in practice as many people believe and
hope. If this were the case, macroprudential policy would need support. And despite the
central bank's policy rate not being an ideal tool in this context, it may nevertheless play a
useful role, together with macroprudential policy, when it comes to preventing imbalances.
Leaning against the wind is therefore vindicated - an expression Smets uses as an overall
term for this view. Preventing financial imbalances should thus be included in the tasks of
monetary policy, in addition to price stability. This means that the central banks have more
deliberations to make and that monetary policy becomes more complicated than it was prior
to the crisis. But it is nevertheless not a completely different framework.8
"Financial stability is price stability"
The third view goes even further. According to this, the objectives of financial stability and
price stability are so closely linked that they cannot really be separated - financial stability is
price stability, to use Smets' expression.9 It is therefore not appropriate to separate monetary
policy and macroprudential policy. Traditional monetary policy can also be regarded as
stabilising the financial system in the sense that it oils the wheels of the monetary
transmission mechanism and counteracts financial markets that are functioning poorly.
Taken to an extreme, this view probably means that the standard monetary policy strategy
would need to change on a more fundamental level.
I think that the division into these three main views provides a good reflection of the current
debate. But there are of course no sharp dividing lines between them, rather the dividing
lines are relatively fluid. And where one finds oneself on the scale ultimately depends on
which argument or arguments one allocates the greatest significance. It will probably come
as no surprise to those of you who follow the monetary policy debate in Sweden that I myself
have great sympathy for the principle that monetary policy needs to support macroprudential
policy. I would therefore place myself fairly close to the second view in Smets' description.
So what has led me to this view? Allow me to begin by giving my interpretation of what a
monetary policy that leans against the wind entails.
What does it mean that monetary policy leans against the wind?
There are different ways of illustrating how and why financial imbalances and risks should be
included in the monetary policy deliberations. Essentially it is a question of avoiding
scenarios where the imbalances will lead to very negative effects on GDP, unemployment
and inflation. So in principle it is a question, as usual in monetary policy, of stabilising
inflation and the real economy.
An outline: trade-off between target fulfilment in the short and long term
Last year the Riksbank published an article with an outline for how financial imbalances can
be included in the monetary policy deliberations.10 The point of departure was that a central
bank now needs to have a more long-run focus than was traditionally the case. The
reasoning leads to the conclusion that monetary policy should be regarded as a trade-off
between target attainment in the coming years, that is, the period for which central banks
normally make forecasts, and target attainment in the longer run, beyond the forecast
horizon.11 The idea is that a monetary policy that solely focuses on target attainment a couple
of years ahead could miss the fact that financial imbalances are building up, which risk
leading to very poor macroeconomic outcomes in the longer run. So according to this outline,
central banks need to balance target attainment in the shorter run against target attainment
in the longer run.12
Inflation target still the foundation, but may take longer to attain
The first important thing to note is that this trade-off does not mean throwing away the
inflation target. Attaining the inflation target thus remains the foundation for monetary
policy.13 However, one consequence of conducting a policy that tries to counteract financial
10
Sveriges Riksbank (2013).
11
Mervyn King, the former governor of the Bank of England, has used a closely-related means of illustrating why
monetary policy should give consideration to financial imbalances, where he instead uses the so-called Taylor
curve - a curve that illustrates a central bank's trade-off between stabilising inflation around an inflation target
and stabilising the real economy (GDP, unemployment, employment and so on) around a long-run sustainable
level. See King (2012).
12
This reasoning is thus based on the notion that risks linked to financial imbalances can be taken into
consideration in monetary policy by incorporating their effects in the longer-run forecasts for inflation and the
real economy (for instance, measured in terms of GDP). There are also arguments in favour of the central
bank having the stabilisation of financial imbalances as an explicit objective for monetary policy. The financial
frictions that give rise to the imbalances could, for instance, entail welfare costs for society, over and above
the effects on inflation and GDP, which the central bank may have reason to counteract directly, see for
instance, Cúrdia and Woodford (2009). Monetary policy would then have three factors to weigh against one
another: stabilisation of inflation around the target, stabilisation of GDP around a sustainable level and
stabilisation of some relevant measure of financial imbalances. Regardless of the theoretical argument, this
way of including financial imbalances in the deliberations could have practical benefits, for instance by
reducing the need to incorporate the risks in the forecasts for inflation and GDP. There could therefore be a
point to following both these lines in the internal analyses.
13
Woodford (2012) illustrates this in a formal model analysis.
imbalances - that leans against the wind - could be that it takes longer for inflation to attain
the target than it would have if the central bank had not included financial imbalances in its
deliberations. Although this policy can be justified in ensuring a good development in the
longer-run perspective, in practice there are of course limits as to how much and for how
long inflation can be allowed to deviate from the target. This has been a very important point
in my own monetary policy deliberations and I will return to this at the end of my speech.
The dividing line in the debate: how effective are the respective policy areas?
Another important thing to note is that a monetary policy that leans against the wind is not
intended to replace macroprudential policy measures. This could of course be necessary if
there is no macroprudential policy in place or during a period when macroprudential policy is
being organised. But once it is in place, macroprudential policy shall be the first line of
defence against financial imbalances. This is definitely my opinion and as far as I can see it
is shared by most of those participating in the debate, that is, even those who think that
monetary policy should be able to lean against the wind.
The dividing line is instead at the question of whether monetary policy may need to support
macroprudential policy to counteract imbalances.14 Which side of the line you end up on
depends on what you believe about the effectiveness of the tools for macroprudential policy
and monetary policy respectively. How well do they counteract specific imbalances and what
consequences do they have for the rest of the economy?
If one believes that the instruments available to macroprudential policy can effectively keep
the imbalances in check, and that monetary policy is too blunt an instrument and mostly
affects the rest of the economy - well, then one probably ends up in the "Modified
JacksonHole-consensus", to return to Smets. On the other hand, if one is more uncertain about the
effectiveness of the macroprudential instruments and believes that monetary policy
nevertheless has some sting, then there is a greater probability that one will have the view
that monetary policy may need to lean against the wind. If one is very uncertain about the
effects of both policy areas, one probably also prefers monetary policy to be used parallel to
macroprudential policy, at least until more is known about the effects.
Monetary policy may need to support macroprudential policy
Those who are sceptical about a monetary policy that leans against the wind often state, as I
mentioned earlier, that the policy rate is a blunt and ineffective instrument in counteracting
financial imbalances. But even if this were the case, it would not automatically lead to the
conclusion that macroprudential tools are significantly more effective. Some of the tools are
new, some have been around for a while but used partly for other purposes. The practical
experiences gained so far are thus fairly limited and it is difficult to draw any conclusions
from them. It is therefore natural that a number of questions should be raised as to how
effective macroprudential policy will be in practice and whether it may need support from
monetary policy.15
Uncomfortable measures may be difficult to implement
One question concerns their feasibility - will measures be taken in time, or even at all? Some
of the macroprudential policy measures have a direct impact on households' finances, similar
to fiscal policy measures. They can be perceived to create relatively major changes in the
economic playing-field and thus risk obtaining little acceptance from households, which could
make it difficult to implement such measures. In addition, imbalances risk being aggravated
in economic upswings, which means that some measures need to be implemented in
situations where there is probably a general resistance to them - what is usually compared
to "taking away the punchbowl just as the party gets going".16 Thus, the measures may also
be politically difficult to implement in some cases. The extent to which this affects
macroprudential policy in practice will of course depend on the institutional set-up chosen.
Difficult target to define and assess
The inherent difficulty in defining concrete targets for macroprudential policy may affect the
ability to implement various measures. A common formulation for the objective of
macroprudential policy is "to counteract risks to the financial system as a whole", or
something similar. Regardless of the exact formulation, it is difficult to specify what the target
actually entails in practice. When has it been attained? Let us say that macroprudential
measures are implemented over a couple of years and that no problems arise in the financial
system. Have the measures then been justified or unnecessary? The only thing the general
public can observe is a lack of problems, and there could thus be a risk that the need for
macroprudential measures is questioned.17
Measures could be circumvented
It could also prove difficult to design a system for macroprudential policy that functions
efficiently enough, and which inventive market participants are not able to circumvent. In this
situation, monetary policy may need to support macroprudential policy. The policy rate is a
blunt instrument in counteracting financial imbalances, as it has a broad impact on the
economy. But at the same time, it can be a strength compared with macroprudential tools
exactly because it is difficult not to be affected by a policy rate increase - monetary policy
"gets in all of the cracks", to use an expression minted by Jeremy Stein, previously on the
Federal Reserve Board of Governors.18
Low interest rates over a long time can contribute to imbalances
Macroprudential policy may also need support if monetary policy is actually a contributory
factor to the imbalances the macroprudential policy is trying to counteract. This is an
argument that has arisen both with regard to "the Great Moderation" and the origins of the
financial crisis, and to the period that followed. If monetary policy is very expansionary over a
long period of time, it may contribute, despite being justified with regard to the prevailing
economic situation, to the build-up of imbalances on the financial side of the economy - for
instance, the formation of distorted expectations of how high interest rates will be in the
future and of how the housing market will develop, and so on. In this type of environment
monetary policy may need to support macroprudential policy, by contributing less to such
imbalances building up in the first place.
Little acceptance for this view in the Swedish debate
To summarise: in my view, macroprudential policy should be the first line of defence against
financial imbalances.19 But it is possible, and even quite probable, that in some situations it
may need support from monetary policy. And there is thus, at least as I understand it, good
reason to extend the strategy for monetary policy and allow greater consideration to be given
to financial imbalances than was the case prior to the financial crisis.
One of the main arguments against this view in the Swedish debate is that monetary policy in
practice has little effect on the risks linked to financial imbalances. So the gain in leaning
monetary policy against the wind is small in relation to the relatively large costs of such a
policy in terms of inflation undershooting the target and negative effects on the real economy.
Ultimately, the size of the gains and the costs is an empirical question, as is the question
about the effectiveness of macroprudential policy. But judging by the debate in Sweden, both
of these questions appear to have been decided already, and it would appear that the only
correct point of view is a modified Jackson-Hole consensus, to return to Smets.
My impression is that the debate in Sweden has to a large extent been coloured by the few
existing quantifications of the costs of leaning against the wind and of the effects of monetary
policy on the risks linked to household indebtedness. This is despite all of these
quantifications being very uncertain. This uncertainty should also permeate the policy
conclusions drawn from the quantifications.
Take, for instance, the estimates of the effects of monetary policy on indebtedness. One
argument in the debate has been that the relationship between debt and interest rates is
actually the opposite of what the Riksbank believes - in actual fact, both real debt and the
debt ratio should decline, not increase, if the policy rate is cut.20 Earlier this year, the
Riksbank presented the results from an empirical study, which estimated the relationship
between interest rates and indebtedness during the period 1995-2013 with the aid of a
commonly-used empirical method.21 The estimates show the reverse, that there is clear
support that both the debt ratio and real debt increase when the policy rate is cut, even if the
effect is not so great.22
But it is also important to emphasise that these estimates are not the final word and that the
effects of monetary policy may very well be greater. For instance, the effects have been
calculated for a temporary change in the policy rate. A lasting change would have quite
different and much greater effects.23 One risk with holding the policy rate low over a long time
is that it can distort households' expectations of future interest rates, so that they act as
though it were a lasting change in interest rates. Also, the empirical method used does not
capture specific circumstances, such as the fact that the Riksbank has conducted extensive
communication to make households aware of the risks linked to high and growing
19
Of course, the best thing is always to remedy the direct causes of the imbalances. In the specific Swedish
case, with rapidly-rising housing prices and credit growth, it is a question of remedying the fundamental
structural problems on the demand side and, perhaps most of all, the supply side of the housing market. This
is quite essential to achieve a lasting solution, but it is beyond the theme of this speech. See also Jansson
(2013).
20
See, for instance, Svensson (2013).
21
Sveriges Riksbank (2014).
22
It has been claimed in the debate that the calculated effect is not statistically significant from a classical
statistical perspective. However, the calculations were made using a so-called Bayesian method and it is
therefore misleading to use a classical approach to test the hypothesis that the effect is positive. Moreover, it
is important to note that here we are talking about a systematic relationship. Of course, one cannot rule out
the possibility that under special circumstances the debt ratio or real debt might decline when the policy rate is
cut. But it appears very improbable that this is the case on average.
23
See, for instance, Sveriges Riksbank (2014) and Alsterlind et al (2013).
indebtedness. This type of communication could in itself affect households' behaviour on top
of the effects of the actual interest-rate policy.
Greater openness for a change in monetary policy strategy abroad
While in Sweden one seems to assume that the answers are given, the attitude in the
international debate is less "dead certain", at least this is my experience from meetings and
conferences and from the discussions pursued on economic blogs and in academic
research. Although no clear majority has emerged in favour of any of Smets' views, my
impression is nevertheless that many economists who study monetary policy issues have
increasingly moved toward the view that a monetary policy that leans against the wind may
be justified. Smets himself, for instance, reaches this conclusion and economists at
policyoriented institutions such as the IMF, the OECD and the Bank for International Settlements
(BIS) have also expressed support for this point of view.24
The argument in favour of monetary policy possibly needing to counteract financial
imbalances has also made an impact on other central banks. Unsurprisingly, the most
obvious examples of this can be found in countries struggling with roughly the same
problems with indebtedness and the housing market that we have in Sweden. The exact
formulations differ somewhat of course, but there are clear similarities.
For instance, Norges Bank (2012) writes: "At the same time, interest rate setting should be
robust and counter the buildup of financial imbalances in the economy." The Reserve Bank
of New Zealand (2012) has the following wording: "In addition, the PTA's [Policy Targets
Agreement] stronger focus on financial stability makes it clearer that it may be appropriate to
use monetary policy to lean against the build-up of financial imbalances, if the Reserve Bank
believes this could prevent a sharper economic cycle in the future." The Bank of Canada
(2012) makes it clear that these deliberations can imply that it takes longer for inflation to
attain the target: "[A] tighter monetary policy that keeps inflation below target longer than
usual could help to prevent excessive borrowing and a broader buildup of financial
imbalances."25
In countries where the housing market collapsed in connection with the financial crisis, and
where housing prices have already fallen heavily, the deliberations have of course been
somewhat different. There, the monetary policy discussion has mainly concerned ways to
stimulate the economy and get out of the deep recession. But the idea that monetary policy
may need to be used in support of macroprudential policy and contribute to preventing new
imbalances arising on financial markets is nevertheless a question that is climbing higher up
the agenda in these countries, too, as the economy and the housing market recover.26 A
clear example is the United Kingdom, where the most recent remit for the Bank of England's
Monetary Policy Committee (MPC) states that circumstances may arise in which the MPC
may choose to temporarily deviate from the inflation target to support the target of the
committee with responsibility for macroprudential supervision.27
Riksbank's strategy well in line with international debate
Let me conclude by returning to the question in the title of my speech today. Is the
Riksbank's monetary policy strategy in tune or out of tune with the rest of the world? Right
now there is an international debate on potential changes in the strategy for monetary policy
that was common prior to the crisis. One of the most central questions is whether monetary
policy should give greater consideration to financial imbalances. Most people agree that
macroprudential policy should be the first line of defence. But an increasing number have
also begun to take the view that monetary policy may need to provide support by leaning
against the wind.
Given this, it is difficult to understand the critics who try to claim that the monetary policy the
Riksbank has conducted in recent years is strange and our own invention. On the contrary, I
would say that the Riksbank's monetary policy strategy has been well in line with the
international debate. To be sure, this claim may seem strange to someone who has only
followed the Swedish debate on monetary policy. And this worries me somewhat. It is not a
good thing if the debate in Sweden is not as open and inquiring as the debate going on in the
world around us.
For me, it is quite simply a question of which strategy provides the best conditions for the
Swedish economy to develop in the best possible way. A policy that leans against the wind
essentially entails avoiding imbalances leading to very negative effects on GDP,
unemployment and inflation. This does not mean abandoning the inflation target - this is still
the foundation of our monetary policy. But the result of such a policy could be that it takes
longer for inflation to attain the target than it would have done otherwise. There are thus both
gains and losses with such a policy, which need to be weighed against one another.
My own stance has always been guided by this deliberation. The recent low inflation
outcomes have meant, for instance, that I have placed greater emphasis on the more
shortterm outcome for inflation. At our most recent monetary policy meeting I said that my
tolerance for further downward revisions of inflation prospects in the near term has now
reached its lower bound and that I will not vote for a repo-rate increase until CPIF inflation
picks up and rises above 1.5 per cent.
Does this mean that I am in effect contradicting myself? Not at all. What I have talked about
today concerns principles for monetary policy - arguments that the strategy needs to be
flexible and allow financial risks to be included in the monetary policy deliberations. But this
does not mean that the monetary policy decisions will be self-evident. There are always
several aspects to be taken into account and the question of which scale weighs the heaviest
will depend on the specific situation at the time of each repo-rate decision. And the further
inflation is from the target, and the longer it remains so, the greater the weight this scale will
carry, despite the remaining risks linked to household indebtedness and the housing market.
References
Alsterlind, Jan, Holmberg, Ulf, Jönsson, Kristian, Lagerwall, Björn and Winstrand, Jacob
(2013), Risks to the macroeconomy and financial stability from the development of
household debt and housing prices. Memo 6 of the analysis group of the Council for
Cooperation on Macroprudential Policy. Sveriges Riksbank.
Bank of Canada (2012), Backgrounders - Monetary Policy.
Bayoumi, Tamim, Dell'Ariccia, Giovanni, Habermeier, Karl, Mancini-Griffoli, Tommaso,
Valencia, Fabián and the IMF Staff Team (2014), Monetary Policy in the New Normal. IMF
Staff Discussion Note 14/3, IMF.
Bayoumi, Tamim and Habermeier, Karl (2014), The Evolution of Monetary Policy: More Art
and Less Science. Post on the IMF's blog iMFdirect, available at blog-imfdirect.imf.org.
Bernanke, Ben S. (2011), The Effects of the Great Recession on Central Bank Doctrine and
Pract