Stefan Ingves: The central bank's objectives and means throughout
history - a perspective on today's monetary policy
Speech by Mr Stefan Ingves, Governor of the Sveriges Riksbank and Chairman of the Basel
Committee on Banking Supervision, to the Swedish Economic Association, Stockholm
School of Economics, Stockholm, 6 May 2015.
* * *
I would like to thank Hanna Armelius and Björn Lagerwall who helped me with this speech.
As you know, we are experiencing very unusual - not to say unique - times with regard to
monetary policy. The mind boggles - in September 1992 the policy rate in Sweden was
500 per cent, and now it is below zero. How could this happen? To understand the
background, we must go even further back in time.
The purpose of my speech today is to describe current monetary policy in an historical
perspective. The objectives and means of central banks have changed over time, usually as
a result of economic crises. During all periods, monetary policy has rested on some form of
nominal anchor. But regardless of how the anchor has been designed, it is a clear lesson
from history that when confidence in the anchor has been undermined, major problems have
arisen. The Riksbank is no exception in this respect. I hope that by accompanying me on a
journey through history you will gain a deeper understanding of current monetary policy. Let's
set off on our journey!
The Riksbank's objectives and means have been influenced by developments in
society
Figure 1 illustrates inflation in Sweden over the past 140 years and the exchange rate
regimes we have had during this period. Something that becomes clear is that even if we
have now become used to a flexible exchange rate, over a long period of time a fixed
exchange rate has been much more common. However, from time to time socioeconomic
developments in general have led to the prevailing monetary policy regime being
reconsidered.1
As you know, Sweden has not introduced the euro as currency, but on the other hand we
were part of a Scandinavian currency union between 1873 and 1924.2 This began a period
with different varieties of fixed exchange rate, which - with the exception of the First World
War and a brief period in the 1930s - came to last until 1992. During 1931-1937 the
Riksbank worked with a price stability target, for some years this was also combined with a
fixed exchange rate. It would take another 50 years until we introduced a price stability target
again.
The Bretton Woods regime, which came into force in 1951, saw the introduction of a
stabilisation policy regime where monetary policy, in addition to focusing on a fixed exchange
rate, was also marked by detailed regulation of both the volume and allocation of credits:
Liquidity ratios, loan caps and ceilings for lending rates were all weapons in the Riksbank's
arsenal, at the same time as there was an aim to allocate loans towards the housing sector.3
During the Bretton Woods era 1951-1973, the Swedish economy developed strongly at the
same time as inflation was also relatively low (see Figure 1).
But when the Bretton Woods regime collapsed in 1973, a period of more unstable economic
development began. Sweden entered a number of fixed exchange rate regimes (see
Figure 1). One condition for these arrangements to work was that economic policy would
largely be conducted in a way that was in harmony with international developments. The oil
price shocks of the 1970s were met with the so-called bridging policy, which involved using
expansionary fiscal policy to try to bridge over economic downturns. However, the oil price
shocks entailed what are usually known as negative supply shocks, which generate a
combination of low growth and high inflation. As these shocks were met with expansionary
fiscal policy, inflation in Sweden became higher and higher (see Figure 1).
With a fixed exchange rate and an inflation rate higher than that in other countries, Swedish
competitiveness deteriorated, which was dealt with by devaluation of the krona. Between
1976 and 1982 the krona was devalued five times. In this way, competitiveness was
temporarily restored, but inflationary impulses were boosted further. It became clear that the
fixed exchange rate was beginning to function poorly as nominal anchor. Credibility was
gradually undermined.
During the 1980s, the credit regulations were increasingly questioned and the large capital
flows meant that the effectiveness of the regulations was in doubt. As Englund (1999) writes:
"The stage was set for deregulation".4 For this reason, the deregulation of the credit markets
began in the first half of the 1980s, with an important stage being the phasing out of the loan
cap in 1985. This had the consequence that lending to companies and households increased
rapidly. However, this development was not met with tighter fiscal policy. In that monetary
policy was aimed at maintaining the fixed exchange rate, economic policy became on the
whole too expansionary.
We are now at the beginning of the 1990s. Following reunification in 1990, the German
economy grew strongly, which pushed up interest rates there. To defend the fixed exchange
rate, the Riksbank raised the repo rate. During 1990-1991 the major tax reform was
implemented, which meant that tax deductions declined significantly. All in all, the real
interest rate after tax rose very substantially over a short period of time, which subdued the
demand for credit substantially, and property prices took a sharp downturn. The end result of
this process was a banking crisis. The banking crisis also led to a dramatic deterioration in
public finances.
At the same time, there was a currency crisis in Europe. Sweden had abolished currency
regulation in 1989 and in 1991 pegged the krona to the ecu, the euro's predecessor.
However, partly as a result of the higher interest rates in Germany, an increasing number of
countries in the European Exchange Rate Mechanism, ERM, experienced a depreciation
pressure on their currencies. The previous history of devaluations also meant that there was
even greater pressure for another Swedish devaluation. In an attempt to defend the fixed
exchange rate, the Riksbank raised its policy rate to a massive 500 per cent. Finally, the
situation became untenable and the fixed exchange rate was abandoned on 19 November
1992. The route to the 500-per cent interest rate was thus part of a longer sequence of
events, with several interacting circumstances. It also provides a clear illustration of what can
happen when the confidence in the nominal anchor is lost.
1990s crisis: "Things abroad were quite OK, but Sweden was not OK"
I hope that it is clear from what I have described so far that the 1990s crisis was in many
ways domestically generated. Inflation was far too high in relation to other countries, and the
deregulation of the credit market and the too expansionary economic policy created an
overheating that ended in disaster: the banking crisis, a currency crisis and also a public
finances crisis. In somewhat simplified terms, I usually describe the crisis of the 1990s like
this: "things were quite OK abroad, but Sweden was not OK". There were thus many lessons
to be learned with regard to domestic economic policy and not least monetary policy.
Important lesson - increased elements of "norm-based thinking" give credibility to the
nominal anchor
Perhaps the most important individual lesson learnt from the 1990s crisis was the importance
of "norm-based thinking" and long-term game rules for economic policy.5 This came to mark
the thinking behind the new monetary policy regime.
Almost at once, the question arose of what would guide monetary policy in Sweden, now that
the fixed exchange rate had been abandoned.6 By this time, some countries had already
introduced inflation targets: New Zealand was the first in 1990, followed by Canada in 1991
and the United Kingdom in 1992. In January 1993 the Riksbank decided to introduce the
inflation target we have now: The annual rate of increase in consumer prices shall be 2 per
cent a year.7
As we saw earlier, it is extremely important that the nominal anchor is credible. The results of
academic research indicated that the conditions for attaining low inflation increased if one
delegated monetary policy to an independent central bank, which focused on a clearly
quantified target. This increased the element of "norm-based thinking" in monetary policy.
The motives for short-term deviations from the inflation target declined, for instance, by trying
to stimulate demand to gain political sympathies prior to an election. This also reduced the
so-called time inconsistency problem in monetary policy, where the long-term objective of
low inflation is not compatible with the short-term motives for high inflation.8 The new
Sveriges Riksbank Act meant that we have had an Executive Board with six members and
greater independence from the political system since 1999.9
Fiscal policy also became much more norm-based than before. There was a need to tighten
regulatory frameworks with regard to decisions on state income and expenditure. Several
important steps were taken, where the surplus target - the target of a 1 per cent surplus in
public finances over a business cycle - is the most well-known.
The increased element of "norm-based thinking" in monetary policy has also had clear
consequences for the way it is conducted in practice - moving away from detailed
regulations and credit allocation to a more "minimalistic" system, where the Riksbank steers
the repo rate to attain the inflation target.
Long period of economic stability following introduction of inflation target - but loss
of focus on financial stability
In many respects, the Swedish economy has developed better from the 1990s and onwards.
Productivity growth increased substantially during the second half of the 1990s. Possible
reasons for this include structural reforms, such as deregulation on several markets and
increased use of IT. This development continued until the mid-2000s and the Riksbank was
one of several analysts who were surprised by the strength - and resilience - of the growth
in productivity. The result was strong GDP growth with low inflationary pressures.
The reformed framework for public finances led to a declining trend in the national debt as
percentage of GDP. From being regarded as a heavy burden 20 years ago, public finances
rapidly developed into one of the Swedish economy's major strengths.
It is also clear in a long time series like the one in Figure 1 that a sharp slowdown in the rate
of inflation took place when the inflation target was introduced. The average rate of inflation
has been fairly close to the target of 2 per cent.10 Although several factors in addition to
monetary policy have contributed to the low inflation, such as productivity development,
stable public finances and improved wage formation, I would certainly claim firmly that the
inflation target has functioned largely as intended.
In several respects, developments in Sweden prior to the financial crisis reflect the
international trend that has come to be called the great moderation - that is, a long period of
stable growth combined with low inflation. The stable macroeconomic development -
combined with the insight that the long-run development of the economy is determined by
real factors - also affected the framework for monetary policy analysis. The models that
came to be used by many central banks, including the Riksbank, were not primarily
developed to capture long-run trends, but focused on cyclical fluctuations. Moreover,
financial markets and credits played a subordinate role in the analysis framework at this time.
An overall consequence of this was that monetary policy to a large degree had moved away
from "norm-based thinking" towards "fine tuning". One might say that there was also a kind of
blind faith in the ability of monetary policy to govern the macroeconomy in detail: During
which quarter would inflation exactly meet the target?
But history repeated itself - economic crises put the current monetary policy framework to
the test.
The financial crisis: "Things abroad were not OK, but Sweden was OK"
The global financial crisis that broke out in connection with the collapse of Lehman Brothers
in September 2008 was in some ways the direct opposite of the Swedish financial crisis at
the beginning of the 1990s. The crisis originated in the US housing market, and in other
areas, such as Ireland and Spain, collapsing housing markets also played a major role in the
course of events. As you know, the financial crisis was followed by a debt crisis in Europe.
Thanks to the lessons learned from the 1990s crisis, the Swedish economy was in a better
state than many others to manage the weak economic developments after the financial and
debt crises. For instance, Sweden's public finances were in good shape before the crisis
broke out. Unlike the 1990s crisis, here one can say that "things were not OK abroad, but
Sweden was OK".
This does not mean that the Swedish economy has been spared the repercussions of the
financial and debt crises - far from it. Sweden is a small, open economy. We are strongly
affected by developments abroad. The euro area is our largest export market, and the
problems there consequently have a very negative effect on demand for Swedish exports.
The developments in inflation reflect in many ways the repercussions from the weak global
demand in the wake of the financial and debt crises, something I will return to later.
Nor were the Swedish banks spared problems during the most recent global financial crisis.
But in some ways, this was also an entirely different course of events compared with the
1990s crisis. At that time, loan losses among the Swedish banks were very large, as I clearly
remember from my position as head of the Swedish Bank Support Authority then. The banks'
loan losses were from the commercial property sector, which was devastating for profitability;
it was a solvency crisis rather than a liquidity crisis. During the most recent global financial
crisis, loan losses on the domestic market were very limited; most losses arose on loans to
the Baltic region. This time, the solvency of the banks was not threatened; instead, an acute
shortage of liquidity in the banks arose when the functioning of the capital markets
deteriorated. This was managed by means of extensive loans from the Riksbank.
Important lesson - financial stability and price stability are interlinked
One major question after the financial crisis was whether monetary policy should give greater
consideration to financial stability. The prevailing international view during the great
moderation was that financial crises could best be managed by monetary policy when they
arose - this view has been described as the "Jackson-Hole consensus". Another description
of this view is that crises are managed by "mopping up afterwards". This did not mean that
there were no differing opinions, but as you know the advocates of these different views were
talking to deaf ears.11 However, the most recent financial crisis illustrates with great clarity the
size of the costs of "mopping up afterwards".
In this context, it should be pointed out that the Riksbank warned about developments in the
Swedish housing market long before the financial crisis.12 This was in turn connected to the
fact that we in Sweden had not in every aspect learnt our lessons from the 1990s crisis. One
can say that the new stabilisation policy framework had given us control over public debt and
inflation, but that there was no natural limit for indebtedness in the private sector. This led to
the substantial increase in housing prices and household indebtedness we have seen - with
a few brief intermissions - since the middle of the 1990s.
The experiences of the global financial crisis have also led to extensive international
regulatory work and to many countries now establishing new organisational structure and
tools within what is known as macroprudential policy. Unlike the traditional financial
supervision - microprudential policy - which focuses on the risks in individual institutions, the
focus of macroprudential policy is on risks in the financial system as a whole.
The European Systemic Risk Board, ESRB, began its operations in 2011, with the task of
identifying threats to the financial stability of the EU. However, the ESRB has no binding
instruments at its disposal; it can instead issue warnings and recommendations. For
instance, in January 2012 the ESRB published a recommendation to EU countries regarding
national mandates for macroprudential policy. This stated that responsibility for
macroprudential policy should rest with an institution or council and that this body should
have control over appropriate tools to attain its objectives.
The way the framework for macroprudential policy has been set up differs somewhat from
country to country. As you know, we have had such a framework in Sweden now for a year,
with Finansinspektionen (the Swedish Financial Supervisory Authority) having the main
responsibility for the macroprudential policy tools. The new framework also entailed
establishing a forum for representatives of the Government, Finansinspektionen, the
Swedish National Debt Office and the Riksbank to meet and discuss questions of financial
stability, what is known as the Financial Stability Council.
To some extent, macroprudential policy involves taking a backward step towards a greater
element of regulation in the credit market. As we see here, history has a tendency to repeat
itself. Some say that macroprudential policy is a "blend of old and new" policy area, and even
mention the Swedish credit regulations from the 1950s-1980s as an early example of
macroprudential policy measures.13 The "blend of old and new" also applies to the challenges
connected with the regulations. As I mentioned earlier, one reason for the deregulation of the
Swedish credit market in the 1980s was that the effectiveness of the regulations was
questioned. This was in turn because they were easy to circumvent. For example, the
combination of a loan cap and negative real interest rates created large incentives for
regulatory arbitrage, which led to the emergence of a "grey" credit market.
A major challenge for today's macroprudential policy is how one prevents "leakage" from
regulations in a particular sector to other sectors not covered by the regulations.14 One can
see macroprudential policy measures as a "shadow interest rate" for a particular sector of the
economy, which can be related to the policy rate set in monetary policy. The tendency to leak
will of course become higher the greater the tension between the policy rate and the "shadow
interest rate" that ensues from the regulations. I think that a proper discussion of this is often
missing in the Swedish debate.15
Personally, I think it is obvious that financial stability and price stability are closely interlinked.
There are two main reasons for this. Firstly, financial crises unavoidably lead to weak
economic development and major difficulties in controlling inflation. Secondly, it becomes
much more difficult to influence the economy via monetary policy, what we usually call the
transmission mechanism, if a financial crisis occurs. A characteristic element of the most
recent financial crisis was that the difference between the interest rates paid by households
and companies and the central banks' policy rates increased substantially.
I also think that a central bank can never "renounce" the responsibility for financial stability,
as we have many of the tools required to manage banks in distress, for instance, supplying
credit to banks with liquidity problems. This is indicated not least by developments during the
acute financial crisis 2008-2009. Moreover, the policy rate influences housing prices, credit
granting and general financial risk-taking in the economy - and thereby also financial
stability.16
We must continue to safeguard the inflation target, and learn the major lesson from
developments in the 1970s and 1980s, namely to ensure to retain the credibility of the
nominal anchor. And we must also learn the major lesson from the financial crisis, namely
that financial stability is a condition for low and stable inflation and good economic
developments in general.
The global dimensions of the financial and debt crises affect the conditions for
Swedish monetary policy
As I mentioned earlier, the Swedish economy, despite good conditions, has been greatly
affected by the financial and debt crises. One question that has arisen once again is how
much monetary policy in a small, open economy like Sweden's can deviate from that
conducted in other countries.17 The correlations between Swedish and international
(KIX-weighted) GDP growth and inflation since the 1980s are both above 0.8, which
indicates that a very large part of the variation in economic activity in Sweden stems from
abroad.18 Since 1993 the correlation between the policy rate in Sweden and the policy rate in
the euro area has been above 0.9.
One can capture this phenomenon using a model that hardly needs any detailed introduction
in this assembly: the Mundell-Fleming model, also known as the IS-LM model for a small
open economy.19 This model is greatly simplified, but nevertheless puts its finger on some
essential mechanisms. The model is intended to illustrate short-term cyclical variations, for
instance, prices are assumed to remain constant, which is more or less reasonable in the
short term. As the analysis refers to a small, open economy, it is also assumed that the
interest rate abroad is exogenous. Another central assumption is perfect capital mobility,
which can be assumed to have become increasingly reasonable in line with the ever more
globalised financial markets.
In a small, open economy with a floating exchange rate like Sweden's, tightening monetary
policy means that the exchange rate strengthens, as the interest rate in Sweden becomes
higher than that abroad.20 The appreciation of the currency continues until the domestic
interest rate is the same as that abroad. The stronger exchange rate pushes down net
exports and thus general demand and GDP. If the international interest rate falls instead, and
monetary policy in Sweden is held unchanged, the exchange rate will also strengthen,
because the Swedish interest rate is higher than the international rate. The currency will
appreciate until the domestic interest rate is the same as the international interest rate, and
the stronger exchange rate will lead to reduced net export and GDP. We thus see that a
lower international interest rate has a restraining effect on the economy through the
exchange rate in roughly the same way as a tightening of monetary policy in Sweden.
As I mentioned earlier, this model is a very simplified picture of reality. In practice, the results
will of course depend on why the interest rates are changing and also on other factors not
included in the simple model. But the conclusion, that a lower international interest rate has a
restraining effect on the economy through the exchange rate in roughly the same way as a
tightening of monetary policy in Sweden, is valid even in many more complicated models.
The effect of lower international interest rates on the Swedish exchange rate and the
Swedish economy has been discussed a lot at monetary policy meetings in recent years,
although the discussion has revolved around the effects on inflation in Sweden and not the
real economy.21
One can see that international interest rates are very important to Sweden if one studies
longer time series of international real rates. Figure 2 shows long real interest rates for a
number of developed countries. It is clear that large movements in real interest rates are
common to most developed countries, even if the smaller cyclical fluctuations can vary in
different countries. One also sees that the degree of covariation has increased over time, as
the financial markets have become increasingly integrated and globalised. This is also
something confirmed by more formal analysis.22.It is also striking that real interest rates have
shown a declining trend in recent decades and are currently around zero.23 At the end of the
1970s, real interest rates were also close to zero or negative in many countries, but at that
time inflation was high.
A practical example that is close to hand of how the conditions for monetary policy in
Sweden are affected by international developments is that the ECB has chosen to conduct a
very expansionary monetary policy in the euro area. In the slightly longer term, it is good for
the Swedish economy that the ECB's policy stimulates growth and inflation in the euro area,
as this contributes to higher exports and higher imported inflation in Sweden. In the short
term, however, problems may arise if the krona strengthens so that inflationary pressures
risk being lower in a situation where inflation is already too low and has been so over a long
period of time. As I demonstrated earlier in the simple model, a lower international interest
rate risks having a restraining effect on Sweden in the short term via the exchange rate, if we
keep our interest rate at a relatively higher level.
Current monetary policy reflects earlier lessons
This brings me to current monetary policy. As I have argued, monetary policy has changed
over time and has been adapted to the new situations that have arisen. And that's how it's
been this time too. I would say that current monetary policy has learnt many lessons from
earlier episodes.
Negative repo rate and bond purchases - to safeguard the credibility of the inflation
target
The fact that we now have introduced a negative interest rate and begun purchasing
government bonds in Sweden is basically because we want to safeguard the role of the
inflation target as nominal anchor. I mentioned earlier that monetary policy should give
consideration to financial stability. But this is because financial stability is a necessary
condition for attaining stable inflation in the long run. Conditions for being able to give
consideration to financial stability in monetary policy decisions are that inflation expectations
are firmly anchored around the target and that inflation is fairly close to the target. With
hindsight, we can see that inflation has been lower than the Riksbank and most other
forecasters had expected. And this doesn't only apply to Sweden; inflation is very low in most
developed countries.
What happened in Sweden last year, when inflation continued to be lower than expected at
the same time as inflation expectations continued to fall, has thus rather dramatically
changed the conditions for monetary policy. Although inflation has not been falling recently,
but has remained at a low level, and inflation expectations are fairly close to 2 per cent, it is
very important to ensure they do not fall further - especially given the coming wage
bargaining rounds.
As I mentioned earlier, the global dimensions of the fiscal and debt crises, combined with the
fact that Sweden is a small, open economy, have brought to the fore the question of how
much our monetary policy can deviate from that conducted abroad. When several central
banks abroad are conducting a very expansionary monetary policy, the conditions for
monetary policy in Sweden are affected. If the policy rate is higher in Sweden than abroad,
the krona exchange rate will tend to strengthen, contributing to lower inflation through lower
import prices. All other things being equal, the lower policy rates abroad thus argue for lower
policy rates in Sweden too.
It was in the light of all this that we began a series of repo-rate cuts, which resulted in the
repo rate coming down to zero per cent in October last year. When the repo rate approaches
its lower limit further complementary measures are required if monetary policy needs to
become more expansionary.24 The Riksbank has therefore cut the repo rate to -0.25 per
cent and has begun purchases of government bonds to a total value of SEK 80-90 billion. If
monetary policy were to need to be more expansionary we can extend the purchases of
government bonds, or cut the repo rate further and lower the repo-rate path. We also have
the possibility of introducing a programme of loans aimed at companies similar to the ECB's
TLTRO or the Bank of England's "Funding for Lending Scheme". Moreover, we can intervene
on the foreign exchange market.
How do complementary monetary policy measures work?
Regardless of which measure one chooses, the effects of complementary monetary policy
can be divided into two main lines; one is that they contribute to reducing interest rates in
general and the other that they increase the amount of money in the economy. The
purchases of government bonds reduce the supply available in the market, which leads to an
increase in the price and a decrease in the yield. When government bond yields fall,
investors find it more attractive to seek higher-risk assets, which pushes down interest rates
and raises prices there, too. This is usually called the portfolio balance channel. When the
price of the assets rises, the wealth of those who own the assets also increases, which
contributes to stimulating consumption and investment. More liquidity among the banks may
also lead to increased lending.
All in all, complementary monetary policy thus functions in roughly the same way as normal
repo-rate cuts.25 The supply of credit increases, at the same time as interest rates are
pushed down and the exchange rate weakens - aggregate demand in the economy
increases. When the economy is stimulated, inflation gradually rises, as companies can
charge higher prices and the lower unemployment pushes up wages. A weaker exchange
rate also leads directly to higher inflation, as prices of imported consumer goods rise faster.
Let me give an example of how the increase in the Riksbank's balance sheet in the form of
government bond purchases can spread throughout the economy. When we buy government
bonds, those who sell them receive liquid funds in the form of their bank account balance
instead of the bonds they previously held. To improve the return on the portfolio, they must
invest the liquid funds in some other assets, and the price of these assets will then be
pushed up. This could be, for instance, corporate bonds or foreign government bonds. In the
first case, companies could issue new bonds at more favourable rates. In the latter case, the
exchange rate could weaken, which could lead to higher import prices and inflation and also
benefit export companies.
Household indebtedness must be managed
However, these measures are no "free lunch". There are risks and costs linked to the very
expansionary monetary policy. Housing prices and household debts are now showing signs
of increasing faster again. I have on several previous occasions emphasised how important it
is that other policy areas ensure that these risks are managed. Measures are needed to deal
with the driving forces behind household indebtedness, such as reforms to increase housing
construction, but also further macroprudential policy measures. With regard to
macroprudential policy measures, it is worrying that Finansinspektionen's amortisation
requirement could not be implemented as planned. It is important, not least with regard to the
recommendation from the ESRB I mentioned earlier, that the responsible authority has
control over the appropriate tools to attain its objectives. I therefore consider it very important
that Finansinspektionen's mandate should be clarified and that the conditions for an
amortisation requirement are investigated as quickly as possible.
When it comes to the costs of the expansionary monetary policy, there is also a risk that
losses will arise on the Riksbank's balance sheet as a result of the bond purchases. In pure
accounting terms, the bond portfolio will be booked at market value. This means that the
value of the portfolio will vary as interest rates change. The cost of funding the holdings will
therefore increase when short-term interest rates eventually rise. If the Riksbank were to
suffer a loss, however, it would not entail any particular problem, but it would lead to the
surplus we pay to the state every year declining. There will thus be less money for the
Swedish Treasury.
We have nevertheless chosen to take these measures to emphasise that we want to
safeguard the role of the inflation target as nominal anchor for price-setting and wage
formation. Moreover, we have said that if more is required to