Mr. Heikensten discusses independence and transparency in monetary policy
Speech by the Deputy Governor of the Bank of Sweden, Mr. Lars Heikensten, at the City
Executive Club in Gothenburg on 25/9/98.
This morning, rather than discuss current monetary policy, I shall be considering
some questions that have to do with monetary policy's long-term conditions.
Next year, a proposal that has received the preliminary approval of the Riksdag
(Sweden's parliament) will make the Riksbank more independent. Here, Sweden is participating
in a development that has been in progress in the industrialised countries for a couple of decades
- monetary policy decisions are being delegated to the central banks. This has been criticised,
both because monetary policy is considered to focus too one-sidedly on a single objective and
because the increased independence is said to limit democratic influence unduly. It may therefore
be appropriate to review the arguments behind the changes and comment on what they require of
the Riksbank.
A discussion of the process towards more independent central banks - and the
considerations that underlie this process - must take monetary policy's objective as a starting
point. I shall therefore begin by discussing why low inflation is important. Then I shall consider
the arguments for central bank independence and outline the changes that are in train in Sweden.
Finally I shall put the case for the importance of monetary policy transparency.
Why low inflation?
From time to time in the debate, the importance of having low inflation as
monetary policy's objective is called into question. The critics consider that the fight against
inflation is overdone and results in an unnecessary restriction on growth and employment. So
allow me to motivate the wisdom of focusing monetary policy just on low inflation.
The Riksbank's basic function is to provide Sweden with a stable and efficient
payment system. In practice, this amounts to being accountable for maintaining a fixed value of
money and ensuring that the banks provide money in satisfactory way. If the payment system is
to function properly, however, it must have a solid reputation. If people believe, for example, that
the value of money will be appreciably eroded, or will fluctuate markedly, they will be more
uncertain and confidence in the payment system will be weakened. That can result in wrong
decisions.
In other words, low inflation renders the economy more efficient and makes it
easier for households and firms to arrive at long-term decisions. A look at the situation in
Sweden in the 1980s will illustrate this. High inflation, recurrent cost crises and devaluation
cycles made economic development erratic, with weak investment and productivity as a result.
More and more misplaced investments were made as a "bubble" grew and when the property
market subsequently collapsed, Swedish society was burdened by heavy adjustment costs.
Inflation also leaves its mark on the distribution of income and wealth. High
inflation tends to widen existing differences in wealth because it varies in its impact on different
types of earnings and saving. A person who has savings in a bank and earns a fixed nominal
wage is a loser from inflation, whereas someone who can save in real assets, for instance as a
home-owner, stands to gain from rising inflation. Once again, Sweden in the 1970s and '80s is a
good example: prices rose sharply for houses and tenant-owned dwellings, while bank assets
were eroded. Inflation widened the gaps.
So far, so good, most people would say. Few desire a return to the earlier
inflationary and speculative economy. A knottier question is just what rate of inflation to aim for.
In Sweden we have chosen to focus policy on an annual CPI inflation rate of 2 per
cent. As monetary policy is not capable of directing inflation exactly, when the target was
established in 1993 it was surrounded by a tolerance interval of ±1 percentage point.
This target is well in line with the rate of inflation that other industrialised
countries, not least in Europe, are aiming for, though there are some minor differences. It is also
well in line with a statement some years ago by Mr. Alan Greenspan, head of the US Federal
Reserve, to the effect that inflation should be so low that economic agents need not worry about
it when making economic decisions. Perhaps that is as close to the truth as one can come.
Policy for low inflation
Low inflation has been the normal state of affairs in the Swedish economy. Over
the past one hundred years the rate has fluctuated around two per cent. It is only in the post-war
period, more exactly from the late 1960s onwards, that inflation has taken off. The same thing
happened in other countries. Part of the reason seems to have been that economists and
politicians changed their view of what monetary policy could achieve. At that time many people
considered that monetary policy could induce permanently higher employment; more jobs could
be brought about simply by letting inflation rise. What they overlooked was the central banks'
primary function of safeguarding the payment system's stability.
History has also clearly demonstrated that this strategy does not work; in many
countries, unemployment rose parallel with inflation. In Sweden the rate of inflation rose to
twodigit figures, accompanied by the erratic economic development which meant that we dropped
down the "growth league". Then, when the inflation bubble burst, unemployment rose.
What the economists and politicians had not allowed for was how rising inflation
would leave its mark on expectations of future inflation. The original idea - that higher inflation,
via lower real wages, would result in higher demand and employment - did not hold in the longer
run when firms and households realised that their elected representatives and central banks were
fuelling inflation. In the original scenario, the higher inflation was supposed to come
unexpectedly and therefore would not result in wage compensation. In practice, the increased
inflation affected expectations of future inflation, for which employees demanded compensation.
With the higher nominal wages, real wages rose again and labour demand fell back. A situation
rose where prices and wages chased each other in an upward spiral. Unemployment remained in
the best case at its initial level.
When it was realised that monetary policy could not generate permanently
increased employment, politicians and people in general had to think again. The attempt to
stimulate increased economic activity and employment by means of fiscal and monetary
measures had failed. This line therefore had to give way to a policy that focused on permanently
stable fundamentals for economic development. One of these fundamentals is low inflation; the
central banks were in the best position to shoulder the task of safeguarding the value of money.
Sweden switched to the same track as other countries in the early 1990s. Policy
was directed at price stability with the explicit ambition of thereby laying a good foundation for
future growth and employment. The next few years were onerous for Sweden's economy. The
bill for the excesses of the 1980s had to be paid at a time when global activity was weakening
and Europe was hit by currency crises. Since the summer of 1993, however, events have taken a
different turn. Growth above the rate in the boom years in the late 1980s has been combined with
lastingly low inflation. Employment is now picking up but in order to push unemployment down
towards the earlier, very low levels, changes are presumably needed in the workings of the labour
market and wage formation.
Increased independence for the Riksbank
Today, therefore, most, though not all, economists and politicians are broadly
agreed that monetary policy has a very limited potential for permanently altering the state of
employment. But monetary policy is capable of influencing growth temporarily. So for those who
decide economic policy, there is always the temptation to try to strengthen economic activity in
the short run and push unemployment down. In order to restrict the scope for such a policy,
governments and parliaments in most industrialised countries have taken the initiative and
decided to make their central banks more independent. This is often combined with a clearer
price stability objective. Some countries have also established procedures for assessing and
exacting accountability.
Experience shows that the countries with a far-reaching delegation of monetary
policy have had a favourable development of inflation. It is probably not just the formal
framework that has resulted in low inflation. Central banks have been most successful in
countries where the aversion to inflation is strongest and most widespread.
Central bank independence is thus, you might say, a straightjacket that parliaments
and governments have put on themselves. Paradoxically, it is just by tying their hands in this way
that the legislators have actually given monetary policy more scope to pay some heed to cyclical
considerations. This is so as a result of greater independence and because everyone can rest
assured that inflation will continue to be low in the future. In actual fact, a credible inflation
target strategy normally caters to cyclical factors. An economic slowdown tends to be
accompanied by a weakening of inflationary pressure, making it possible to ease the monetary
stance. The stance is then tightened again when inflationary pressure rises. In this way monetary
policy can contribute to economic growth, without unnecessary upsets, at a rate that is consistent
with the development of productivity, employment and so on.
A government bill proposing increased formal independence for the Riksbank as
of 1999 was presented to the Riksdag in November 1997. Five political parties in the Riksdag lay
behind the proposals and they have also given the constitutional amendments their preliminary
approval.
The new legislation accordingly gives the Riksbank the constitutional function of
conducting monetary policy. The constitutional provisions also state that the Riksbank is not to
take instructions from authorities concerning the construction of monetary policy. The
Riksbank's current obligation to hold consultations with the government prior to important
decisions of monetary and exchange rate policy is converted into an obligation to inform the
government. The price stability objective is incorporated in the Riksbank Act, which stipulates
that the objective of monetary policy is to safeguard the value of money and promote a safe and
efficient payment system.
The greater independence also involves changes in the Riksbank's management.
Instead of being directed, as at present, by a Governing Board appointed by the Riksdag, there
will be an Executive Board with six full-time members, chaired by the Riksbank Governor. It is
the Executive Board that will manage the Riksbank and be accountable for all monetary policy
decisions. Unlike the system in the United Kingdom, besides acting as a committee for monetary
policy decisions, the Executive Board will be responsible for managing the whole of the
Riksbank.
Even under the new law, however, the Riksbank will still have a Governing
Board. It will consist of eleven members, instead of eight at present, and will have a more
supervisory role. Its principal functions will be to monitor and control the activities of the
Riksbank, appoint the Executive Board and, if necessary, dismiss any member of the Executive
Board who no longer fulfils the conditions required for the performance of duties or is guilty of
serious misconduct.
In this context I also want to say something about the timetable this autumn that
the new legislation requires. As usual, our newly elected Riksdag will appoint a new Governing
Board in accordance with the existing procedure. As previously, these eight Delegates will direct
the Riksbank and decide monetary policy, up to the turn of the year. When the constitutional
amendments have been approved a second time, the Riksdag will appoint a Governing Board
under the new order; this will probably be done in late November or early December. Before the
end of 1998 the new Governing Board - which for a month or so will accordingly exist side by
side with the current arrangement - must then appoint the members of the new Executive Board.
The new Governing Board and the new Executive Board will then take over from 1 January
1999.
As there will be little time for the two new Boards to prepare their necessary
initial decisions, preliminary work will have to be done this autumn. Matters that the new
Governing Board will have to decide at its first meeting include the Riksbank's rules of
procedure, while at more or less the same time the Executive Board will have to finalise the
details of work at the Bank: which matters can be delegated further down the organisation, how
matters should be drafted in the Bank and similar questions. At its first meeting, moreover, the
Executive Board will have to decide the frequency of its meetings, which tasks its various
members are to be responsible for and how the Board is to communicate with the general public.
Importance of transparency
This brings me to the degree of transparency in monetary policy. In recent years
the Riksbank has worked to make monetary policy more transparent, with good communication
with market players and the general public.
A basic reason behind our drive for transparency is the need for clarity. The idea is
that clarity in monetary policy will make the policy more effective. If market agents and others
understand how we are reasoning, there will be less risk of unnecessary fluctuations in interest
rates and the exchange rate. That in turn should help to make general economic development
more stable. In drastic terms one could say that we aim to make the markets so familiar with our
analytical framework and our deliberations that the available information would enable them to
set the interest rate on their own.
Another reason for transparency has to do with the Riksbank's social function.
This responsibility is augmented in that the increased independence has the force of law. It is
then all the more important to develop and communicate the arguments behind the Riksbank's
actions. This is a prerequisite for a sound discussion and evaluation of our policy and for holding
the Riksbank accountable if the policy is not conducted in a reasonable way.
More generally, moreover, the Riksbank should continue to work for increased
transparency in order to promote a widespread understanding of what we are doing. In the current
discussion, for instance, there is some criticism of the low-inflation target. The Riksbank is said
to be unduly focused on combating inflation at the expense of growth and employment. We
therefore need to persist with an open dialogue to explain that we, too, desire and strive for high
economic growth but that the best thing monetary policy can do to this end is just establish a
stable framework for other components of economic policy.
The internal work at the Riksbank also calls for external transparency. Doing
away with a hush-hush attitude to outsiders makes a frank internal discussion easier. Clear policy
goals are also a help in focusing internal work and analysis on the relevant issues.
The open presentation of a clear line of thought simplifies the educational task.
The Riksbank's line consists of an explicit inflation target and an account of the factors that we
consider affect inflation; it also includes how monetary policy measures are constructed in the
light of the inflation assessment. Current forecasts and assessments are presented in the quarterly
Inflation Reports. In between we try to comment, in speeches and other ways, on any changes in
our appraisal of inflation.
Unfortunately, a soundly constructed line of thought does not always suffice.
From time to time we are highly uncertain about how the available information should be
interpreted. That is something which we and all economic agents must learn to live with - an
exact statement may not be possible in such situations.
One matter connected with the independence and transparency of the Riksbank is
whether or not the Riksbank should publish minutes of its discussions and/or show how
decision-makers have voted. One reason why this issue has attracted so much attention recently
is no doubt that the new Bank of England legislation stresses the monitoring of how individual
members have voted.
The Riksbank's new Executive Board will clearly have to adopt a position on this
matter. So permit me to raise a couple of relevant aspects. It seems to me that a distinction can be
made between requiring accountability on the one hand and clarity or distinctness of policy on
the other.
As regards accountability, it is clearly important how individual members
•
vote. The Governing Board's long-term influence over Riksbank policy will,
after all, be exerted primarily through the composition of the Executive Board.
It follows that the Governing Board - presumably the general public as well
needs to be in a position to assess how different members of the Executive
Board have acted. The knowledge that voting is made public no doubt also
makes every member of the Executive Board all the more keen to arrive at a
personal conclusion about the difficult issues that have to be resolved.
• As regards transparency, on the other hand, what matters most in my opinion
is to have a clear line of thought, as I outlined earlier, and on this basis find
ways of communicating how assessments change over time. The latter can be
done in Inflation Reports and speeches, as at present, as well as in
communiqués after board meetings, etc. In this context, information about
how the individual board members have voted is not so self-evidently
important.
There will doubtless be reason to return to this issue. The conclusion from such a
discussion is not automatic. A good combination of the two perspectives above is probably
feasible. A further consideration is the need to create an Executive Board that functions properly
not only when it comes to making wise monetary policy decisions but also in the Riksbank's
effective management.
Concluding remarks
Since the early 1990s the Riksbank has clearly had the task of establishing price
stability in Sweden. Strong confidence in the Riksbank means that monetary policy is able to
achieve the desired results without resorting to emphatic interest-rate signals. In an environment
with low inflation and high credibility, monetary policy may be in a better position to smooth
fluctuations in growth and employment.
Confidence in the low-inflation policy does seem to have been established.
Inflation has been low and inflation expectations are in line with the inflation target. A tight
fiscal policy is contributing to this but so, of course, is a monetary policy that focuses
consistently on low inflation. The credibility of policy is, however, a continuous question. The
process will be facilitated by the Riksbank's statutory independence but the Riksbank must also,
for example, work continuously to communicate its policy deliberations clearly and distinctly.
The conditions for policy are affected by many factors. A labour market and wage
formation that function better make it possible to combine low inflation with higher employment.
Fiscal policy is another central matter; it needs to be sustainable in the long run and preferably
also help to counter any signs of incipient overheating.
If some component of economic policy fails to promote the inflation target, the
burden on monetary policy will be heavier. Stronger measures by the Riksbank will be needed as
a clear demonstration of the determination to achieve low inflation. Insufficient support for the
inflation target and policies that are not permanently sustainable would then be a burden not just
for the Riksbank but for the economy in general.