Stefan Ingves: Flexible inflation targeting in theory and practice
Speech by Mr Stefan Ingves, Governor of the Sveriges Riksbank, to the Swedish Economics,
at the Swedish Economics Association, Stockholm, 12 May.
* * *
Mikael Apel, Carl Andreas Claussen and Niklas Frykström have contributed to this speech.
It is enjoyable, inspiring and a privilege to come here and speak at the Swedish Economics
Association. It is one of the few occasions when I can take a break from current practical
monetary policy and discuss issues of a more academic nature. I intend to take up some
issues that I have been considering "on the side" for some time now. If I were to try to coin a
title that summaries what I am going to talk about, it would probably be "the link between
theory and practice in monetary policy", and more specifically where I believe the boundaries
are as to how close the links can be. I would like to point out that these are my personal
reflections and not official Riksbank views.
Monetary policy's tasks in general terms...
According to the Sveriges Riksbank Act, the objective of monetary policy is to maintain price
stability. The Riksbank has specified this as a target for inflation - where the annual change
in the consumer price index (CPI) is to be 2 per cent. At the same time as monetary policy is
aimed at attaining the inflation target, it is also supposed to "support the objectives of general
economic policy for the purpose of attaining sustainable growth and a high level of
employment". The Riksbank does this by not merely striving to stabilise inflation around the
inflation target, but also striving to stabilise the real economy, that is, production and
employment. The Riksbank thus conducts what is known as flexible inflation targeting.
Flexible here means that the Riksbank does not focus solely on inflation.
To be rather more concrete, one might say that every time we make a decision we try to find
a forecast path for the repo rate that means monetary will be, as we say, well-balanced. This
means that we try to find an appropriate balance between stabilising inflation around the
inflation target and stabilising the real economy. One way of illustrating this balance is to say
that the deviations arising during the forecast period between, on one hand, inflation and the
inflation target, and, on the other, the real economy and a trend, may not become too great.
...and in theory
It is common in the literature to describe flexible inflation targeting as the central bank
minimising a loss function that is a weighted sum of a measure of the variation in inflation
and the variation in the real economy. The loss function can be written as
,
π
where is the forecast for inflation, π* is the inflation target and is the forecast
deviation between actual resource utilisation in the economy and the long-run sustainable, or
"normal" level of resource utilisation.1 The first term represents the central bank's target of
stabilising inflation and the second its ambition to stabilise the real economy.
λ
The parameter represents the importance the central bank gives to stabilising the economy
λ
in relation to stabilising inflation. If were zero, this would mean that the central bank does
not care at all about developments in the real economy, but merely tries to bring inflation as
λ
close to the target as possible. If is large, this means that the central bank places great
emphasis on stabilising the real economy in relation to stabilising inflation. The term loss
function comes from the fact that the larger the deviation, or "gap", the further away we are
from where we want to be, and thereby the greater the "loss".
In this theoretical description the central bank's task is described in slightly more detail than
the general wording of "finding a suitable balance between stabilising inflation and stabilising
the real economy". More specifically, it is a question of finding the interest rate that will
minimise the squared forecast deviations during the forecast period between actual inflation
and the inflation target and between actual and normal resource utilisation, where the latter
λ
deviation is weighted by - a bit of a tongue-twister to put into words.
But it can be illustrated relatively conveniently with the aid of a figure. The figure measures
the variation in inflation along the horizontal axel and the variation in the real economy along
the vertical axel. The variations are measured using the mean squared gap, that is, the
average squared deviation across the forecast horizon. Such mean squared gaps can be
calculated for various possible interest rate paths and one can then compare different
interest rate paths by marking the mean squared gap in the figure. The closer to origo, or the
further south-west in the figure, the smaller the two mean squared gaps are, and the better
success the accompanying interest rate path has in stabilising inflation and the real
economy.2
We say that inflation targeting, or the interest rate path, is effective if it is not possible to
reduce one of the mean squared gaps without the other gap increasing in size at the same
time. Theoretically, we could imagine there is a very large number of effective points. These
points form a "front" as illustrated in the figure. Where the central bank chooses to position
itself on this front depends on how important it considers stabilising the real economy to be in
λ
relation to stabilising inflation, that is, which the central bank has.
Figure 1. Mean squared gap for resource utilisation and inflation, and the effective
front.
The step from theory to practice is not uncomplicated
This theoretical approach, where the central bank minimises a squared loss function with
inflation and resource utilisation has been in the monetary policy toolbox for a long time, and
it has been useful in developing flexible inflation targeting. It captures in an illustrative and
relatively simple way the essence of inflation targeting and it has helped to structure our
thinking. The mean squared gap analysis makes it easier for the central bank to explain why
it chooses a particular monetary policy - what it means more specifically by a "well-balanced"
policy. It can also provide support when assessing monetary policy.
But however good the tool is, the step from theory to practice is not without complications. I
intend to discuss some circumstances that in various ways complicate things when taking
this step.
Arguments in loss function less clear in practice than in theory
One such circumstance is that although the variables included in the loss function - inflation
and resource utilisation - are in theory unambiguous and well-specified, in practice it is far
from evident how they should be measured. Resource utilisation can be regarded as a
summary of developments in the real economy and shows to what extent labour and real
capital are being used at a particular time. It normally states use in relation to the level
sustainable in the long run, which is often regarded as a "normal" level. One complication is
that it is not possible to directly observe how high the level of resource utilisation in the
economy is, and nor is there any generally-accepted view of this should be calculated.
Different measures can give fairly different results and it is therefore difficult to determine to
any great degree of precision the level of resource utilisation at any given time.
The Riksbank uses a broad approach in its analysis of resource utilisation and describes a
number of indicators in its reports, such as measures based on surveys of companies and on
"gaps", for instance the GDP gap and the number of hours worked gap, where the trend or
normal level is calculated according to some method.3 The Riksbank weighs together these
indicators and makes an overall assessment of the current level of resource utilisation. The
assessment is qualitative and can be expressed as resource utilisation being "higher than
normal", "normal" or "lower than normal". A qualitative assessment regarding how resource
utilisation will develop during the forecast period is also provided. This can be expressed, for
instance, as "resource utilisation will rise and be close to normal at the end of the forecast
period". Although we publish forecasts for different gaps in our reports, we do not make a
quantitative forecast that reflects the overall assessment of how resource utilisation will
develop.
One alternative would be for the Riksbank to simply decide to use one particular measure of
resource utilisation as a starting point when setting the interest rate. But we have chosen not
to do this. For instance, the difficulties in estimating what is a "normal level" for resource
utilisation indicate it may be risky to commit oneself to any specific method. Another reason
is that the Executive Board of the Riksbank is what is usually known as an individualistic
committee.4 Put simply, this means that the members of the Executive Board act as
individuals, both in the communication of monetary policy and when deciding on the interest
rate. They can thus make their own assessments of which measure or measures of
developments in the real economy they consider should be the focus of monetary policy. I
will return shortly to the consequences of our being a group that makes such decisions.
The second variable in the loss function, inflation, is not as problematic as it can be
measured in a much better way than resource utilisation. But it is not entirely clear which
measure of inflation should be used. Although the inflation target is worded in terms of the
CPI, when the repo rate changes a lot, as it did during the crisis, it will have a large direct
impact on the CPI through households' mortgage expenditure. It may then be more
appropriate to focus on an inflation measure that excludes these direct effects of interest rate
changes. This is what the Riksbank has done recently, focussing primarily on CPIF inflation.
However, it is largely a question of judgement which measure of inflation one should focus
on. For instance, it is possible that one might sometimes want to disregard other components
of the CPI, for instance, the direct effects of oil price increases.
An illustration
One can illustrate the complications that may arise in the actual work with the aid of the type
of figure I showed earlier, where one marks the average squared deviations, the mean
squared gaps, during the forecast period. For a concrete example of a time when the
differences were particularly visible, we can study the forecast from September 2008.
In addition to the repo rate path in the main scenario, the Riksbank usually also analyses two
alternative repo rate paths; one that is higher than the one in the main scenario and one that
is lower. The mean squared gaps for different measures of inflation and resource utilisation
generated by these three interest rate paths in September 2008 are shown in Figure 2.
Figure 2. Mean squared gaps September 2008
Source: The Riksbank
Note: Red dots show the main scenario, blue dots show the alternative with a higher repo rate path and yellow
dots show the alternative with a lower repo rate path.
If inflation is measured in terms of the CPIF, that is, the CPI excluding direct effects of
interest rates, and if resource utilisation is measured with a gap calculated on the number of
hours worked in the economy, one obtains the three dots up on the left-hand side of the
figure. It is clear that in this case it is the higher repo rate path that gives the least overall
squared deviations during the forecast period - its dots are furthest to the south west, closest
to origo. The lower repo rate path gives the largest deviations. But if inflation is instead
measured in terms of the CPI and resource utilisation is measured in terms of the GDP gap,
the result is the opposite. Here, it is the lower repo rate that gives the overall smallest square
deviations. Thus, the variables used to measure inflation and resource utilisation can play an
important role regarding which repo rate path one prefers.
It is also worth noting that the repo rate path in the main scenario does not give the smallest
overall mean square gap in any of these cases.5 This has been the case also on other
occasions. At first sight, this may seem rather strange. But let me explain why it is not
necessarily so - and also point out some other circumstances that can complicate the step
from simple theories to practical policy.
Interest rate scenarios produced in different ways
A slightly technical explanation as to why an alternative interest rate path may give an
apparently better outcome than the repo rate path in the main scenario concerns how the
various scenarios were made. When we at the Riksbank make forecasts we use various
macroeconomic models. For instance, the Riksbank uses what is known as a general
equilibrium model of the Swedish economy named RAMSES (the Riksbank's Aggregate
Macromodel for Studying the Economy in Sweden). But the models always need to be
supplemented with personal judgements. These judgements become particularly important
when unusual events and structural changes occur that alter the functioning of the economy.
This was the case during the financial crisis, for instance. Figure 3 shows the RAMSES
forecast for the GDP gap and the Riksbank's forecast in the Monetary Policy Report
published in February 2009. As you can see, there is a fairly large difference between the
forecast generated solely from a model and the published forecast supplemented with
personal judgements.
Figure 3. Forecasts for the GDP gap Monetary Policy Report 1/2009
Source: The Riksbank
The significance of the personal judgements becomes even clearer when we see the
forecasts for the repo rate (Figure 4). According to our forecast, a much more expansionary
monetary policy was needed during the crisis than was suggested by RAMSES.
Figure 4. Forecasts for the repo rate Monetary Policy Report 1/2009
Source: The Riksbank
Personal judgements are also necessary in normal situations; and the forecasts in the main
scenario published by the Riksbank in the Monetary Policy Reports and Updates are
produced in this way - with support from models but with the addition of considerable
personal judgements. The forecasts gradually emerge during a rather long and
labourintensive process that spans several weeks.
The forecasts in the alternative repo rate scenarios, on the other hand, are produced in a
different manner. Here we use the main scenario as a starting point and then make a purely
model-based adjustment using RAMSES. No personal judgement over and above that in the
main scenario has been made. The forecasts in the alternative repo rate scenarios are thus
less thoroughly analysed than those in the main scenario. If the alternative repo rate
scenarios were supplemented with personal judgements, the forecasts and mean squared
gaps would probably look different.
The main reason for this simplified approach is that it would require too many resources to
produce complete, detailed forecasts for several different repo rate paths. Of course, it is not
written in stone how main forecasts and alternative scenarios should be produced, and the
Riksbank is currently reviewing the decision-making process to see how it could be
improved. But this is the way we have worked until now. One can thus imagine that part of
the explanation as to why an alternative repo rate scenario may give a smaller mean squared
gap than the main scenario could be that it is only a purely model-based adjustment of the
main scenario.
This raises another question: If one were also to supplement the alternative repo rate paths
with personal judgements, would one always conclude that the main scenario would give the
lowest loss? The answer to this question should reasonably be "yes, at least most of the
time" - there are some reservations, which I will discuss in a moment. We try to conduct the
policy we judge to be the best or "best balanced" and if we judged that another repo rate path
than that in the main scenario would give a better outcome, we would of course choose that
one instead. This should be visible in the mean squared gap analysis, that is, there should
not be alternative repo rate paths that give a dot that lies south-west of the main scenario.
Consideration to developments beyond the forecast horizon and risks
There may also be other reasons why the main scenario does not necessarily provide
smaller mean squared deviations than an alternative repo rate scenario. One is that the
calculations are based on forecasts that extend no further than three years ahead. But there
may sometimes be reason to consider what might happen beyond this time horizon, even if
this is difficult to capture in a normal quantitative forecast. This could mean that the central
bank chooses a repo rate path that, while it does not give the lowest squared deviations over
the three-year forecast period, is nevertheless judged preferable from a longer-term
perspective. For instance, the bank may hold the policy rate higher to try to prevent a credit
boom that is feared would cause problems - with large squared deviations - beyond the
forecast horizon.
A closely-related reason is that the central bank under certain circumstances gives
consideration to specific risks when setting interest rates. This is something I personally find
to be one of the most important factors missing in the simple analytical framework. This could
also be expressed as the central bank holding the policy rate at a higher level to reduce the
risk - within or beyond the forecast horizon - that, for instance, a credit boom would continue
too long and cause problems. The central bank might also wish to hold the policy rate at a
higher level to reduce the risk of inflation expectations rising too high, which could also be
problematic. The higher policy rate could give larger deviations during the forecast period,
but may nevertheless be preferable as it reduces the risk of a really poor outcome.
Framework more difficult to apply with an Executive Board
Another circumstance that I perceive as complicating matters with regard to putting the
theoretical approach into practice is the fact that there are six of us making the monetary
policy decisions. The theory usually assumes that one single person determines the policy
rate - despite the fact that it is now fairly rare for this to be the case in practice. The loss
function I mentioned earlier then reflects this single policymaker's view of how monetary
policy should be conducted.
In the cases where the theory acknowledges that there may be several different monetary
policymakers, it is often also assumed that the only thing that distinguishes them from one
another is that they have different preferences as to how much they want to stabilise inflation
in relation to stabilising the real economy - that they have different λ.6 Otherwise the
policymakers are assumed to see things in the same way: They have the same view of the
loss function, what it should include, and they make their forecasts of inflation and resource
utilisation in the same way, in the same "model". If this were the case in practice, the
monetary policymakers could quite simply vote on the various effective dots presented in the
figure with the mean squared gaps.
But the reality is quite different. The complications I have mentioned so far, such as how the
variables in the loss function should be measured or how to take risk into account, would
cause problems even for a single monetary policymaker. But of course things become even
more complicated with several different policymakers who may have differing views on these
issues.
Scepticism towards far-reaching parallels between theory and practice
So how do the monetary policymakers view the relationship between monetary policy
theories and the practical implementation of monetary policy? We can gain one indication
from a survey carried out a while back. In this, a questionnaire was sent to all of those who
are or have been members of the Executive Board of the Riksbank since it was first created
in 1999.7 The questions concerned, for instance, how the members view different hypotheses
within the research into monetary policy decision-making by a committee. As far as I know,
this is the only such survey carried out on a monetary policy committee. An equivalent study
is now under way in Norway.
Some of the questions concern the link between the way monetary policy is often described
in academic research and how monetary policymakers view it with the eyes of a practitioner.
For instance, the following question was included: "Would you consider - using your own
judgement or, for instance, the Riksbank's analysis resources - stating in terms of a figure
how much importance you would normally place on stabilising resource utilisation in the
economy in relation to stabilising inflation (that is, stating your λ)?"
A total of nine persons out of the twelve who responded to the survey replied that they would
not consider this. These members were given a number of alternatives to select as the
reason for their response. The explanation the members themselves considered to apply the
best was that the idea that one can use a figure to explain the relative weight of stabilising
inflation against that of stabilising resource utilisation in the economy is overly simple. Many
also considered that it was meaningless to try to quantify the relative weight given to inflation
and resource utilisation, partly because this could depend on the situation in the economy
and thus vary over time, and partly because the measures of resource utilisation are so
uncertain.
It thus appears that there is fairly broad scepticism among the members towards drawing
farreaching parallels between how monetary policy is described in theory and how they view it
as practitioners. All of those who are or have been members of the Executive Board agree, I
am sure, with the general wording that the Riksbank is to stabilise inflation around 2 per cent
and, in addition, to stabilise the real economy. But after that I believe that the views differ
quite substantially as to how far one can go in using theory when conducting practical
monetary policy. The reaction many people probably have is that if one were to reduce
monetary policy to a choice between dots on the figure I showed you, it would make it appear
as though monetary policy had an exactness that does not actually exist. My guess is that
this scepticism is not unique to the Executive Board of the Riksbank, but is shared by other
countries' monetary policy committees.
Differences are good
Essentially, it is positive that the members of the Executive Board have fairly different views
on things. When the Executive Board was established in 1999 there was a more or less
explicit aim that it would consist of people with different backgrounds, experience and
knowledge. This type of diversification appears to be something that most countries with
monetary policy committees strive to attain. One reason for this is that there is a widespread
belief that committees tend to make better decisions than individual policymakers, as a
committee can "pool" its experiences and knowledge.8 The decision can thus be made on a
broader and better basis. As the saying goes: "two - or rather more - heads are better than
one". And in order to have something to "pool", the people on the committee should not be
too alike. If they all are cast in the same mould and think in the same way, one might just as
well have one single policymaker.
If there are so many different wills and ways of thinking, how can we actually manage to
agree on a detailed, quantified forecast and an exactly determined repo rate path? Also here
we can receive guidance from the survey I mentioned earlier. One question in the survey
was whether the members had refrained from entering a reservation against one or more
monetary policy decisions, despite considering that another decision than the majority view
would have been better. Seven of the members, that is, more than half of them, replied that
they had. The most important motivation given for this was that they said there was some
"bargaining margin" in the repo rate decisions and that the decision reached was sufficiently
close to what they would have advocated. In terms of the mean squared gap analysis, one
could express this as the members actually preferring different dots, but given that the main
scenario dot was sufficiently close to their own, they accepted the main scenario. I believe
that this is a fairly important insight: The forecasts we present are often a compromise and
an approximation. They point to the probable and desired direction, but the exact figures
should probably be taken with a pinch of salt.
An important balancing act
At the same time, it is important to realise that the problem that constantly lies below the
surface is how to find an appropriate balance between what one could call diversification and
clarity: On the one hand the central bank wants to benefit from the fact that the decisions are
made by a committee. We are not supposed to be cast in the same mould. There should
thus be a sufficient degree of freedom and scope for individual members to make their own
analyses, draw their own conclusions and make decisions as they see fit.
On the other hand, this should not mean that monetary policy becomes unclear, that it is
characterised by more or less loose opinions - and that it thus becomes more difficult to
understand and thus to assess. Ultimately, it is the confidence of the general public that is at
risk here; the legitimacy of monetary policy. This was strongly emphasised when the
inflation-targeting regime was introduced. The Riksbank then put considerable energy into
explaining what inflation targeting was all about and this probably contributed to the relatively
quick acceptance of this policy. Now the inflation-targeting policy is much more established,
but there is of course still a need for clarity and structure.
So although I have highlighted some of the problems regarding drawing parallels between
theoretical analysis and practical monetary policy, this should not be interpreted to mean that
I do not think that theory has a role to play. I am convinced that, used wisely, it can provide
good support when explaining and assessing monetary policy.
But exactly how theory can be used in the practical work, and exactly where the optimum
balance lies between diversification and clarity, or between the degree of freedom and
structure in an uncertain world is something that every central bank must try to ascertain. I
can assure you that this is something we have considered at great length at the Riksbank. It
is also an important part of the work on reviewing the decision-making process that I
mentioned earlier. I do not believe it is possible to capture everything with the aid of two
aggregates. Now and then something is likely to disappear on route.
New challenges - the importance of managing systemic risk
I have so far only discussed "traditional" complications in the step from theory to practice. I
have given examples of challenges we have faced more or less continuously since inflation
targeting was introduced. But if we look ahead, it is likely that the picture will be further
complicated by the changes that will follow in the wake of the financial crisis. What I am
mainly thinking about here is the increased focus on macroprudential policies.
After the financial crisis we have learnt two main lessons. The first is that the central banks'
interest rate-setting must take into account financial stability to a greater degree. The second
is that we need new regulation in the financial market that focuses on systemic risk. But the
macroprudential policies may have effects that are in many ways similar to the effects of
monetary policy - particularly if the tools are varied over time. This increased interaction
between monetary policy and macroprudential policies is another circumstance that means
that the connections between the simple theoretical framework and practical monetary policy
become twisted.
Of course, it is not the case that monetary policy and regulation were two entirely
independent policy areas prior to the crisis and that after the crisis they will be fully
integrated. But I nevertheless believe that monetary policy and regulation will come closer to
one another in the future.
When I was here a year ago, I spoke at length on how monetary policy can contribute to
maintaining financial stability and how different types of regulations can affect monetary
policy and its transmission mechanism. I will not go into this again today. Instead, I would like
to focus on something I did not say so much about then, namely the institutional solutions
and division of responsibility with regard to monetary policy and macroprudential policy.
There are a number of interesting questions here: Should the responsibility be centralised to
one authority or spread across two or more authorities? If the responsibility is spread out,
what mandates should the different authorities have, or, to express it in simple theoretical
terms, how should their loss functions look? Should they act independently of one another or
should they coordinate their measures?
At present, considerable effort is being put into finding answers to these questions, both in
the academic world and on the political plane. There are no clear answers as yet, and I will
not be able to give any here. But I would nevertheless like to think aloud on a specific
question that I find particularly interesting, namely what might happen if the responsibility for
monetary policy and for macroprudential policies are split between two authorities that do not
coordinate their measures.
Risk of poorer policy mix if responsibility is split?
I shall use an example to illustrate the potential problems. Let us assume that the
macroprudential policy is a time-varying capital requirement.9 A financial supervisory
authority controls the capital requirement, while the central bank controls the interest rate.
kmax
There is an upper and a lower limit for the capital requirement, and kmin. This is
illustrated by the two horizontal lines in Figure 5. Changes in the capital requirement affect
developments in the economy. For example, we can imagine that a tightening will reduce the
banks' credit granting and thus slow down demand in the economy.
The green line shows the level of the capital requirement the financial supervisory authority
considers to be best for each level of the interest rate. The red line correspondingly indicates
the combinations of interest rate and level of capital requirement preferred by the central
bank. The two authorities' views of what can be considered an appropriate policy mix in a
given situation thus differ. The financial supervisory authority is more concerned over
systemic risk than the central bank. This is expressed in that for each level of the interest
rate the financial supervisory authority wants a higher capital requirement than the central
bank would have set if it had control over both tools. It is likely that the differences in the
views of what constitutes a good policy mix are greatest when the interest rate is low, so let
the curves in the figure apply to a situation with a low interest rate. I will return to this in a
moment.
Figure 5. Illustration of the interplay between the central bank and the financial
supervisory authority
Let us assume that the interest rate and the capital requirement started off at the blue dot in
the figure. Let us assume that demand in the economy has fallen, and that a need for more
expansionary policy has therefore arisen to stabilise the real economy and inflation. The
central bank then wants to cut the policy rate so that it is on the red curve.
But at this low interest rate the financial supervisory authority may worry that risks are
beginning to build up and it will therefore raise the capital requirement. However, the higher
capital requirement not only means that the risks decline, it also has some negative effect on
demand in the economy. This has the consequence that the central bank wishes to cut the
policy rate further, which in turn makes the financial supervisory authority want to raise the
capital requirement, and so on, and so on. This leads to a "race", which ultimately leads to
the capital requirement reaching its upper limit at the same time as the interest rate is
extremely low.
It is easy to imagine that this final mix of the