Lars E O Svensson: Differing views on monetary policy
Speech by Prof Lars E O Svensson, Deputy Governor of the Sveriges Riksbank, at
SNS/SIFR Finanspanel, Stockholm, 8 June 2012.
* * *
I would like to thank Hans Dellmo, Karolina Ekholm, Gabriela Guibourg, Per Jansson, Stefan Laséen,
Ulf Söderström, Staffan Viotti and Anders Vredin for valuable discussions and views. Pernilla Johansson, as well
as Joanna Gerwin and Marianne Sterner at Sveriges Riksbank, has contributed to this speech. The views
expressed are my own, and are not necessarily shared by the other members of the Riksbank's Executive Board
and other employees of the Riksbank.
My view is that monetary policy should stabilise inflation around the inflation target and
unemployment around a long-run sustainable rate. In my opinion, this mandate for monetary
policy follows from the Sveriges Riksbank Act and the government bill that contained the
proposal for this legislation.1 According to the Sveriges Riksbank Act, the objective of
monetary policy is to maintain price stability. The Government Bill states that the Riksbank
should, without prejudice to the objective of price stability, support the objectives of general
economic policy with the aim to achieve high employment. Accordingly, the mandate is to
maintain price stability and to attain the highest possible sustainable employment. In
practice, it is the same thing as stabilising inflation around the inflation target and
unemployment around a long-run sustainable rate. At each monetary policy meeting it is
therefore a matter of choosing the repo-rate path that according to the corresponding
forecasts for inflation and unemployment best stabilises these around the inflation target and
a long-run sustainable rate respectively. In recent years I have therefore entered
reservations against the majority decision, preferring a lower repo-rate path as I consider this
would lead to better target fulfilment for inflation and unemployment.
Several objections to my view of monetary policy have been expressed in the monetary
policy discussion. As far as I understand it, these objections are that monetary policy should
have more objectives than stabilising inflation and unemployment or other real-economy
objectives than stabilising unemployment. The objectives of price stability and the highest
sustainable employment - from which stabilisation of inflation and unemployment follows -
can thus be set aside for a period if one wants to slow down growth in mortgage lending or to
hold interest rates at a higher level, as low interest rates are assumed to build up
imbalances. But several objectives, and unclear ones, would risk making monetary policy
arbitrary and disjointed. This is contrary to the government bill, according to which the
delegation of monetary policy to an independent Riksbank requires a clear objective for
monetary policy. This is to ensure there is no scope for arbitrary monetary policy and so that
the Riksdag (the Swedish parliament) can evaluate monetary policy on the basis of the
established objectives. In my view, it should only be possible to neglect price stability and
highest sustainable employment for a limited period if there are clear signs of problems with
financial stability, if there are no means of addressing these problems without setting aside
price stability and highest sustainable employment and if it can be credibly demonstrated that
another, for example a higher, repo-rate path would lead to better target fulfilment for inflation
and unemployment in the longer run. This last condition is important. The government bill
that contained the proposal for the Sveriges Riksbank Act states namely that the policy rate
may only be used to prevent a financial crisis if such a crisis threatens the price stability
objective.
In my opinion, there are no clear signs of problems with financial stability at present, there is
no lack of means to maintain financial stability and if necessary to limit growth in mortgage
lending, and nor is there any theoretical or empirical support for the view that a low policy
rate would lead to imbalances in Sweden. If anything, a lower policy rate might instead mean
that the banks have less incentive to seek short-term funding in foreign currency and thus the
risks linked to this funding will decline.
If the Riksbank succeeds in stabilising inflation around the target and unemployment around
a sustainable rate, average inflation should be in line with the target over a longer period of
time. In Sweden, however, inflation has significantly undershot the target of 2 per over the
last 15 years. In other countries that have had a fixed inflation target for the same length of
time as Sweden, the average inflation rate has instead been on target. At the same time,
inflation expectations in Sweden have been anchored to the target. According to established
economic analysis, anchored inflation expectations lead to a negative relationship between
average inflation and average unemployment. Then the long-run Phillips curve is no longer
vertical, but down-ward sloping, which is confirmed by data. That the average inflation rate
has undershot the target in Sweden has thus probably led to substantial costs to the real
economy in the form of higher average unemployment. This makes it important to ensure
that average inflation is henceforth on target for an extended period of time. The too high
average unemployment rate also means that the long-run sustainable rate of unemployment
may have been overestimated.
The Riksbank's mandate for monetary policy
Price stability and the highest sustainable rate of employment
My view is thus that the Riksbank's mandate for monetary policy means that monetary policy
should stabilise inflation around the inflation target and unemployment around a long-run
sustainable rate. I consider that this follows from the Sveriges Riksbank Act and the
government bill containing the proposal for the current Act. The Sveriges Riksbank Act states
that the objective of the Riksbank's monetary policy shall be to maintain price stability. The
government bill also states that the Riksbank, without prejudice to the objective of price
stability, should also support the objectives of general economic policy with the aim to
achieve sustainable growth and high employment.
The general economic policy that the Riksbank should support is very much a policy for full
employment. According to the 2012 Spring Fiscal Policy Bill, the most important objective for
the present government's economic policy is full employment.2 Full employment has also
been an important objective for previous governments.
High employment is the same as the highest sustainable rate of employment. The Riksbank
therefore writes at the beginning of every Monetary Policy Report that it strives to stabilise
employment around a path that is sustainable in the long run. The Riksbank therefore
conducts what is generally referred to as flexible inflation targeting.
If one follows this line of reasoning, then the Riksbank's mandate for monetary policy is price
stability and the highest sustainable rate of employment. It may be interesting to note in this
context that the Riksbank has in principle the same mandate as the Federal Reserve.
According to the Federal Reserve Act, the US central bank should "promote effectively the
goals of maximum employment and stable prices". In this case too, maximum employment
means maximum sustainable employment.
It is sometimes claimed that the Riksbank's mandate is a so-called hierarchical mandate,
while the Federal Reserve's mandate is a so-called dual mandate. With a hierarchical
mandate, price stability is a primary objective and highest sustainable employment is a
subordinate objective, while with a dual mandate price stability and highest sustainable
employment have equal status. As I point out in Svensson (2004), there is in practice no
difference between these mandates. It is a question of distinguishing between means and
variances, what is known in statistics as first and second moments. With regard to mean
inflation and mean employment, the mandate is hierarchical. The central bank sets just one
target, which is the inflation target. The highest sustainable rate of employment is not set by
the central bank; it is determined by the structure of the economy and the way it functions,
and it may change over time. It can only be estimated, not set, by the central bank. With
regard to the variance in inflation and employment, the mandate is dual. There it is a matter
of stabilising both, in an appropriate trade-off. This applies both to the Riksbank and the
Federal Reserve.
Stabilising employment around a long-run sustainable path is in practice the same thing as
stabilising unemployment around an estimated, long-run sustainable rate.3 One can therefore
regard stabilising unemployment around a long-run sustainable rate as an operational target
to stabilise employment around a long-run sustainable development path.
According to the government bill, the Riksbank should support the objectives of general
economic policy with the aim to achieve not only high employment but also sustainable
growth. However, the idea is hardly that there is any conflict between sustainable growth and
high employment. The Riksbank writes at the beginning of every Monetary Policy Report
that, in addition to stabilising employment, it also endeavours to stabilise production around a
long-run sustainable development path. Nor is the idea here that there is any conflict
between stabilising production and stabilising employment around a long-run sustainable
path. However, in practice, the estimation of a sustainable path for production in addition to a
sustainable path for employment requires assumptions about and estimates of sustainable
average working hours, sustainable total factor productivity and a sustainable path for the
capital stock. These assumptions and estimates introduce such large sources of error, and
such a large degree of arbitrariness in a sustainable path for production, that in practice such
a path provides no guidance for monetary policy. It is better to focus on stabilising
unemployment around an estimated long-run sustainable rate. To estimate the long-run
sustainable unemployment rate is not easy, but it is much easier than estimating a long-run
sustainable path for production. Estimates of the long-run sustainable unemployment rate
can also be examined and evaluated, while estimates of a long-run sustainable path for
production will in practice become more or less impossible to verify.
With regard to specifying price stability, what measure of inflation should be used? There is a
generally-accepted principle that looking a few years ahead, CPIF inflation is the relevant
operational measure of inflation. The reason for this is that in the short term, CPI inflation is
affected directly by the Riksbank's own repo-rate adjustments and monetary policy should
not react to these temporary effects. CPIF inflation does not include these effects. In the
longer run, these effects largely cancel one another out, and then it is CPI inflation that is
relevant.4
The point of using CPIF inflation as the operational measure is thus to best stabilise CPI
inflation in the longer run. In the longer run, monetary policy should therefore be assessed
with regard to how well it stabilises CPI inflation around the target and unemployment around
a long-run sustainable rate.
A more expansionary monetary policy gives better target fulfilment
My view of monetary policy implies that at each monetary policy meeting one should choose
the repo-rate path that with the corresponding forecasts for inflation and unemployment best
stabilises inflation around the target and unemployment around a long-run sustainable rate. It
should not be the case that a lower or higher repo-rate path leads to better target fulfilment
for both inflation and unemployment. In other words, it should not be the case that inflation
and the inflation forecast are below the target while unemployment and the unemployment
forecast are above a long-run sustainable rate. Based on Norwegian central bank deputy
governor Qvigstad's (2005) criteria for a good repo-rate path, this can be worded as: For
monetary policy to be well-balanced, the inflation gap (the gap between inflation and the
target) and the unemployment gap (the gap between the unemployment rate and the
longrun sustainable unemployment rate) should have the same sign.
My view is also that the target fulfilment for inflation and unemployment during the entire
forecast period is what is important, not just the target fulfilment at the end of the forecast
period. For an unemployed person there is a major difference between getting a job in one or
two years' time and getting one in three years' time.
It is possible to assess these things with the aid of the so-called four-panel figures that I
usually refer to at the monetary policy meetings, and which are included in the minutes of the
meetings. These figures are central to monetary policy, as they make it possible to compare
different repo-rate paths and to see what level of target fulfilment for inflation and
unemployment they result in. I consider these figures very useful when choosing a repo-rate
path, when justifying the choice of the repo-rate path and when evaluating monetary policy.
In Figure 1 I summarise some possible policy choices at the monetary policy meeting in April.
The figure is based on the assessment of the current situation and the economic outlook
presented in the Monetary Policy Update (Sveriges Riksbank 2012c).5 The figures show
clearly that a lower repo-rate path entails better target fulfilment, with inflation closer to the
target and unemployment closer to a long-run sustainable rate.
At the monetary policy meeting in April I considered that the forecast for foreign policy rates
presented in the Update was too high, and that a much lower forecast in line with implied
forward rates was more realistic. I also considered that the forecast for euro area growth was
too optimistic. As I illustrated with a further figure at the meeting, an even lower repo-rate
path would then be needed to best stabilise inflation and unemployment.
Given these factors, I entered a reservation against the decision, preferring a much lower
repo-rate path than the one proposed by the majority. At the next monetary policy meeting in
July, there will be a new assessment, with new four-panel figures.
Objections to monetary policy focusing on inflation and unemployment
The Sveriges Riksbank Act, the government bill proposing it and economic analysis thus all
provide strong support, in my opinion, for monetary policy aiming to stabilise inflation around
the target and unemployment around a long-run sustainable rate. At the same time, it is clear
that the majority of Executive Board members have conducted a monetary policy that aims to
do something other than this. As I discuss in detail in Svensson (2011), the majority of the
Executive Board began to raise the repo rate in July 2010, despite the forecast for CPIF
inflation being below the target and the forecast for unemployment being above any
reasonable long-run sustainable rate. In recent years, according to the forecasts made at the
time of each monetary policy meeting, a lower repo-rate path than the one chosen by the
majority would have led to better target fulfilment for both inflation and unemployment. If a
more expansionary monetary policy had been conducted instead, as advocated by my
colleague Karolina Ekholm and myself, inflation would have been higher now and closer to
the target, and unemployment would have been lower and closer to a long-run sustainable
rate.
So what are the most important objections to monetary policy stabilising inflation and
unemployment as expressed in the monetary policy discussions at the Riksbank and which
can thus justify conducting a different policy?
An overall objection appears to be that monetary policy should have more objectives than
stabilising inflation and unemployment, or other real economic objectives than stabilising
unemployment. Objectives that could thus justify neglecting the objective of price stability
and highest possible sustainable employment.
In line with this, it has been claimed that it is too narrow to merely focus on unemployment,
that is, there are other or further variables than unemployment and employment that should
be real-economy target variables. It has been claimed that it is resource utilisation more
generally that should be stabilised and that a broad approach to the assessment of resource
utilisation is preferable. This means that resource utilisation in a more general and abstract
sense would be the target variable, and not unemployment. Using several different measures
of resource utilisation is highlighted as desirable as individual estimates are uncertain and a
single measure does not capture the different dimensions of resource utilisation.
It has also been said that it is not self-evident which measure of inflation should be used, that
is, that some other index than the CPIF, for instance the CPI, could be appropriate as an
operational target variable within the forecast period.
Another objection is that monetary policy should also be aimed at maintaining financial
stability, which then presumably becomes a separate objective for monetary policy. The
objective of price stability and highest sustainable rate of employment could then be
neglected for a certain period of time, for instance, to avoid unsustainable financial
imbalances building up.
A more precise objection is that monetary policy should counteract an unsustainable
development in household indebtedness. In this case a sustainable development of
household indebtedness will become a separate objective for monetary policy, which can
justify neglecting the objective of price stability and the highest sustainable rate of
employment.
A more concrete variation of these objections assumes that there is a correlation between a
low policy rate and the build-up of unsustainable financial imbalances. A normal level of the
policy rate then becomes a separate target for monetary policy and can justify neglecting the
objective of price stability and the highest sustainable rate of employment.6
One kind of objection thus concerns the fact that, with regard to price stability, it is not as
simple as to merely focus on the CPIF during the forecast period and the CPI in the longer
run. It is actually not clear which target variable for inflation should be used. With regard to
real economic stability, it is not as simple as merely focusing on employment and
unemployment. It is actually not clear which real-economy target variable should be used.
The other kind of objection ultimately entails sustainable growth in mortgages and financial
stability being separate objectives for monetary policy. One can then neglect the objective of
price stability and highest sustainable employment for a while in an attempt to slow down
mortgage growth, promote financial stability and maintain a higher interest rate, as it is
assumed that low interest rates would build up unsustainable financial imbalances.
Clear targets mean that monetary policy is less arbitrary and easier to assess
In response to these objections I would like to state that several and unclear targets for
monetary policy risks making it arbitrary and difficult to assess, which the work on formulating
the Sveriges Riksbank Act aimed to counteract. Delegating monetary policy to an
independent Riksbank requires that monetary policy has clear objectives.7
I therefore consider it important that monetary policy is conducted in a clear and
comprehensible manner so that it can be evaluated easily and fairly. At present, the
Riksbank makes a qualitative assessment of resource utilisation based on a number of
different measures. This contributes to making the justification for the monetary policy
decisions unclear and it also makes it more difficult to assess the Riksbank and hold it
accountable.
I thus instead want to focus on stabilising unemployment around a long-run sustainable rate
and not on trying to stabilise a number of other, quite shaky measures of resource utilisation
in the economy, such as the output gap. Compared with other measures of resource
utilisation, unemployment has a stronger link to household welfare, is better understood and
more familiar to the public, is measured often and with fewer errors and is seldom revised.
The fact that other measures of resource utilisation are not appropriate as targets for
monetary policy of course does not prevent them from playing an important role as indicators
when assessing inflationary pressures and constructing inflation forecasts.
Nor do I see that there is any support for a qualitative assessment of resource utilisation
instead of a quantitative, measurable target fulfilment. In economic policy it is now
wellknown that targets must be measured quantitatively to obtain sufficient weight and to be
fulfilled in practice. "What is measured gets done," as they say. This is why there is an
inflation target and why fiscal policy endeavours to have measurable surplus targets in public
finances. It is thus important to have a measurable, quantitative target fulfilment not just for
inflation but also for resource utilisation, and then in the form of unemployment.
Monetary policy should not focus on financial stability as there are better instruments
With regard to the view that monetary policy should also aim to limit growth in mortgage
lending and more generally to maintain financial stability, I would like to state the following:
The policy rate is a blunt, indirect and inappropriate means of influencing financial stability in
Sweden and it has a direct effect on inflation and unemployment. As I said in the beginning,
the objective of price stability and highest sustainable employment should not be neglected
out of consideration for financial stability, except in extreme circumstances and then only for
a limited time. This only includes such situations where there are clear indications of threats
to financial stability and where there are no means to manage these threats without
neglecting the objective of price stability and the highest sustainable employment. At the
same time, there should be confidence that this type of temporary neglect will in the longer
run lead to a better development of inflation and unemployment. This last condition is
important. According to the government bill, the monetary policy instruments should only be
used to maintain price stability and they should only be used to prevent a financial crisis if
this threatens the objective of price stability.8
A further motive [for a clear objective] is that a far-reaching delegation of monetary policy should be combined
with follow-ups and controls. The Riksdag as the Riksbank's principal must therefore have the possibility to
evaluate its activities on the basis of an objective that is set for the activities." (Government bill 1997/98:40
p. 52)
8
"The Riksbank shall also promote a safe and efficient payment system. This is a fundamental task for the
Riksbank and not an actual objective for its activities. The corresponding task applies to the ESCB. It could be
claimed that this task could come into conflict with the Riksbank's objective of price stability, as the Riksbank
could in certain situations use the policy rate to avoid a crisis in the banking system. However, the monetary
policy instruments shall, in accordance with the government's proposal, only be used to maintain price
stability. The Riksbank has at its disposal other instruments for managing such situations, for instance, the
possibility to grant liquidity assistance, as lender of last resort. At the same time, there may be situations in
which a crisis in the payment system threatens to jeopardise the price stability target. In these situations it
should of course be possible to use the monetary policy instruments to prevent a crisis." (Government bill
1997/98:40 p. 54, my italics)
In the present circumstances in Sweden I therefore see no clear signs of problems with
financial stability, there is no lack of means to maintain financial stability and nor is there any
reason to believe that higher policy rates would provide better outcomes for inflation and
unemployment in the longer run. I shall elaborate further on this.
Financial stability can be defined as a situation where the financial system is able to perform
its most important functions - converting savings into funding, enabling risk management
and mediating payments - and has sufficiently large resilience to shocks that may threaten
these functions. Under normal circumstances, one can maintain financial stability with the aid
of financial supervision and regulation and by publishing analyses and leading indicators,
which can warn of threats to stability at an early stage. When it comes to financial stability,
monetary policy should thus be the last line of defence, not the first. In Sweden, stricter
capital requirements for the banks and minimum levels for liquidity measured by the Liquidity
Coverage Ratio (LCR) and the share of stable funding measured by the Net Stable Funding
Ratio (NSFR), according to the Basel III agreement and in accordance with the Riksbank's
recommendations in the latest Financial Stability Report (Sveriges Riksbank 2012a), provide
better means to manage financial stability than the policy rate.
A view is sometimes expressed in the monetary policy debate that monetary policy should
give consideration to the risks of imbalances resulting from low real interest rates over a long
period of time. There is a lot of talk about a low policy rate entailing risks for rapid credit
growth that will lead to high leverage and greater risk in the financial sector. However, I
consider that there is no theoretical or empirical support for a low policy rate in itself leading,
for instance, to excessively high leverage in the Swedish financial system. This is because
the Swedish system is dominated by a few major banks and does not have a large
difficultto-regulate shadow-banking system of financial intermediaries and broker-dealers.
Experiences from different crises indicate that it is not low policy rates in themselves that
lead to imbalances and threats to financial stability. It is if the low policy rates lead to an
overheated economy that problems arise, such as in Sweden prior to the crisis at the
beginning of the 1990s and more recently in Greece, Portugal, Ireland and Spain. It is the
overheated economy that entails exaggerated optimism, with for instance property prices
being pushed up above levels that are fundamentally motivated, an excessive construction
boom and risky investments. It is not the low interest rates in themselves. Low interest rates
that do not lead to an overheated, but to a balanced, development in the real economy and
inflation do not appear to entail imbalances. There is thus hardly any support for low interest
rates in themselves causing problems for financial stability or for high interest rates in
themselves improving financial stability.9
The current situation in Sweden is rather that higher policy rates may have a negative effect
on financial stability. Swedish banks are now choosing to fund themselves by short-term
borrowing in foreign currencies, which is cheaper than borrowing in Sweden as interest rates
are higher here than abroad. But this entails some risks as foreign investors are an unstable
source of funding (Sveriges Riksbank 2012a). When the policy rate in Sweden is raised in
relation to interest rates abroad, it becomes even more attractive for the banks to borrow in
foreign currency. This is thus an example of a situation where raising the policy rate will if
anything increase the risks to financial stability.10
Using policy rate to influence housing prices is costly
There are also many references to developments in housing prices in the monetary policy
debate. Monetary policy would appear to have very little effect on housing prices. If one
nevertheless uses the policy rate to influence housing prices (and thereby mortgage growth)
this will lead to large costs to the real economy. A study by Claussen, Jonsson and Lagerwall
(2011), which is included in the Riksbank's inquiry into the risks in the Swedish housing
market shows, for instance, that it would have been very costly in terms of both production
and inflation to try to prevent the upswing in housing prices from 2004 onwards using
monetary policy. Keeping housing prices at a long-run trend level in 2004-2010 would have
required repo-rate increases over several years of up to 5 percentage points in both 2006
and 2007. GDP growth would then have been on average almost 2 percentage points lower
up to 2010, which corresponds to an accumulated GDP loss of around 12 per cent. CPIF
inflation would have been on average 3 percentage points lower during the same period. The
study confirms for Sweden what several other international studies have concluded, such as
Assenmascher-Wesche and Gerlach (2010).
One argument that has been put forward for trying to slow down an increase in housing
prices is that future falls in housing prices would have negative effects on future inflation and
the real economy. However, Claussen, Jonsson and Lagerwall show that the
macroeconomic effects of a 20 per cent fall in housing prices would be relatively limited and
possible to counteract by adopting a more expansionary monetary policy. This is shown in
more detail in the minutes of the monetary policy meeting held in June 2010, when I
presented simulations of how expansionary monetary policy can stabilise CPIF inflation and
GDP growth following such a fall in housing prices (Sveriges Riksbank 2010).
According to Finansinspektionen's (the Swedish financial supervisory authority) report on the
Swedish mortgage market (Finansinspektionen 2012), Swedish mortgages do not constitute
any threat to financial stability at present. Mortgage borrowers have a good debt-servicing
ability and pass stringent stress tests, credit assessments are thorough, the loan-to-value
ratio for new mortgages is declining and the loan-to-value ceiling appears to be effective. If
the growth in mortgages or the loan-to-value ratio were to develop in a problematic way
further ahead, it is possible to lower the mortgage cap. This is a better means of influencing
growth in mortgages and loan-to-value ratios than using the policy rate.
All in all, I consider there is no reason to neglect the objective of price stability and highest
sustainable employment to conduct some form of "leaning against the wind" policy,
conducting tight monetary policy in the belief that one is thereby improving financial stability,
for instance, by limiting mortgage growth. I cannot see that there is any theoretical or
empirical support for a higher policy rate in the current conditions being able to significantly
improve financial stability in Sweden. To achieve this there are currently better tools within
macroprudential policy, for instance, capital adequacy rules, a mortgage cap and minimum
levels for the LCR and NSFR. These instruments have a greater and more direct effect on
financial stability and mortgage growth. With the Riksbank's work on its financial stability
reports and Finansinspektionen's work on its report on the Swedish mortgage market these
institutions have very good information on potential risks.
I think that we should do in Sweden what they now appear to be doing in the United
Kingdom, that is, conduct monetary policy and financial stability policy separately, with
separate policy committees with separate objectives and instruments but, especially given
the overlap of some committee members, with full information on which policy is being
conducted in each area. This is also natural, as financial stability has a longer cycle and
thereby needs less frequent decision-making than monetary policy. The well-functioning
relationship between separately conducted monetary policy and fiscal policy in Sweden can,
in my opinion, serve as a model for how the relationship between monetary policy and
financial-stability policy should be.
If one mixes together monetary policy and financial stability, it also becomes more or less
impossible to evaluate monetary policy. Then an overly tight monetary policy can be blamed
on an endeavour to maintain financial stability.
Inflation and unemployment in the longer run
Average inflation has undershot the target
If the R