SPEECH
SVERIGES RIKSBANK
DATE:
3 December 2019
SE-103 37 Stockholm
SPEAKER: (Brunkebergstorg 11)
Deputy Governor Per Jansson
VENUE:
Danske Bank, Stockholm
Tel +46 8 787 00 00
Fax +46 8 21 05 31
registratorn@riksbank.se
www.riksbank.se
Contemplations of an interest-rate dove
and inflation hawk*
Those who follow the media reporting on monetary policy have probably noted
that I have been considered the most dovish member of the Riksbank's Executive
Board for some time. By this, I mean that I am considered to be the one who, at
least for the time being, is inclined to conduct the most expansionary policy. For
anyone unfamiliar with the terminology, the opposite of a dove is a hawk,
someone who instead advocates a tighter monetary policy. An alternative terminology
that is common in theoretical models is that a hawkish policy instead attaches
considerable importance to the inflation target and gives less weight to other
things.1 So actually, as I think it is justified to prioritise the inflation target and
confidence in it, I could also be considered a hawk. More precisely, I could be
described as a combination of an inflation hawk and an interest-rate dove.
Describing the orientation of monetary policy-makers in ornithological terms is
rather practical. Apparently, however, it is not entirely uncomplicated and misses
some subtle differences. I would therefore like to start by elaborating on my view
of current monetary policy and my reasoning at the most recent monetary policy
meetings. The picture given in the monetary policy minutes can easily become a
little compressed and I would therefore like to provide a slightly more
comprehensive and cohesive account here.
After that, I intend to address slightly more fundamental issues. More specifically,
I would like to give my view of the advantages of the current framework, with an
inflation target and a floating exchange rate. I feel that the debate over the last
few years has been biased towards emphasising the disadvantages of this system
and that the positive aspects have been overshadowed or perhaps even entirely
forgotten. I think it is good to remind people of these now and again.
Communication is of great importance
To describe what has perhaps been my most important basis for the policy I have
recently advocated, I would like to start by referring back to a speech I made two
years ago. It concerned the international ideological debate on monetary policy
and the lessons I thought could be learnt from developments in Sweden.2 One of
the lessons I highlighted then was that it is important not to lose sight of inflation
and inflation expectations. What I had in mind was the period from 2011 and a
few years onwards when inflation in Sweden was unexpectedly low and
periodically below the inflation target by quite a wide margin. Once inflation had
undershot the target for a while, long-term inflation expectations also began to fall. In
addition, there were signals from the labour market parties that the inflation
target was no longer a given starting-point in wage negotiations. In other words, a
risk began to arise that confidence in the inflation target would weaken to such an
extent that the target would no longer function as an anchor for price-setting and
wage formation. As is well known, we eventually managed to reverse the
development and bring up inflation to the target again, but it took a long time and
required a very expansionary policy, as well as a slice of good fortune.
An important reason for inflation being so low for so long was the debt crisis in
Europe which hit after the financial crisis and which most analysts had not seen
coming, at least not with so much force and so soon. It slowed down the recovery
that had begun and caused economic activity to deteriorate again, dragging down
inflation in the process. The Riksbank underestimated the inflation effects, but we
were far from alone in doing so.3 That expectations gradually followed actual
inflation downwards was perhaps not so strange in itself but it took a while, at least
for me, to understand how serious the situation was about to become.
Another factor that may have contributed to the fall in inflation expectations, and
which I also raised in my speech a few years ago, was how the Riksbank
communicated monetary policy at the time. Overheated and structurally deficient housing
markets had exacerbated the effects of the financial and debt crisis in many
countries. Concern that this would also happen in Sweden made us direct much of our
communication towards highlighting the risks associated with the development of
debt and housing prices. Even though our forecasts still made it clear that we
were striving to fulfil the inflation target and this was also emphasised in our
communication, it may very well be the case that we talked a little too much about
the risk of financial imbalances and a little too little about the importance of
inflation being close to the target. This may have created uncertainty among economic
agents regarding the actual status of the inflation target, and, in turn, may have
contributed to the weaker confidence in the inflation target. The emerging
suspicion was perhaps that we, so to speak, had taken our eye off the ball.4
The important lesson to learn here is, as I see it, that it is absolutely key to show
that you always do have your eye on the ball and do not let other factors come
into the picture in a way that risks economic actors starting to doubt that this is
the case.
I have been reminded of this lesson on a number of occasions lately, most
recently at the monetary policy meeting in October. The picture we painted at that
time of monetary policy going forward, in which we predicted that the repo rate
will be raised very slowly to take it back into positive territory in the longer term,
was one that I largely considered to be well-balanced. However, I expressed
considerable doubt over the next increase in the repo rate happening as early as
around the turn of the year, most probably at our next meeting in December, as
implied by our forecast for the repo rate.
There were several reasons why I did not think it was a good idea. First, our
forecast was that inflation would remain below the target in the near term, and was
not expected to stabilise at 2 per cent until late 2022. Of importance here was
also the fact that I could not see any appreciable upside risks for the inflation
forecast either. Second, as I saw it, an increase in the interest rate in the near future
could hardly be expected to lead to a greater probability of the downward trend
in inflation expectations reversing. This worried me quite considerably as it can
affect the inflation rate on which the labour market organisations base their
forthcoming wage negotiations. Third, I felt there was reason to worry about the
consequences of both the Federal Reserve and the ECB increasing their monetary
policy stimuli while in Sweden, if the announced rate rise were to be implemented,
we would be going in the opposite direction.
Many analysts also interpreted the signals from the meeting in October as the
Riksbank viewing the abolition of negative rates as an end in itself. This applies
not only to analysts in Sweden but also internationally. A couple of examples are
articles from Bloomberg and in the Financial Times, in which the authors argue
that the Riksbank has now realised the problems of negative interest rates and is
therefore keen to get away from them.5 A number of analysts have also
speculated that the Riksbank sees the zero level as so important in itself that it would
be wary of lowering the repo rate over the coming years even if the economic
outlook and inflation prospects were to deteriorate. My view is that, as a result of
this, there may be a risk of several people starting to make the interpretation that
we have indeed taken our eye off the ball to a certain extent, or at least don't
have it as sharply in focus as we usually have.
Too low average inflation creates problems
Let me elaborate a bit on this. If the repo rate were to be raised as soon as around
the turn of the year, the serious aspect is not in itself that the interest rate would
then be 0.25 percentage points higher, although for someone who prefers an
unchanged rate, there is of course no advantage in this either. The problem is
instead that it might be perceived as the Riksbank deviating from what it normally
does: designing monetary policy so that it is always very clear that the inflation
target is the point of departure. This is of course particularly important in
situations where there is a risk of confidence in the inflation target starting to
evaporate. Consequently, it is not "the tenths" themselves that are important - and
they are of course even less important under more normal circumstances. But
when confidence in the inflation target is at stake, even tenths can send signals
and this is something I think one is well advised to consider.
Let me stress that I of course believe that my colleagues on the Executive Board
also take arguments like these into consideration. However, it can certainly be the
case that we make different assessments of how important they are. This is
natural and in a way the whole point of an executive board. What I am presenting here
is my way of looking at things and my personal assessments.
A necessary condition for maintaining confidence in the inflation target is, as I see
it, that the monetary policy we conduct and plan to conduct means that we
anticipate inflation being 2 per cent at least at the end of the forecast period we are
considering. If the inflation forecast is not 2 per cent even in this time perspective,
the monetary policy, on which our inflation forecast is based, is wrong and we
must adjust it. But as I was just discussing, this is not always enough - it is not a
sufficient condition. Even though our inflation forecasts are in line with the target,
but we act and communicate in a way that can make it unclear how important we
consider the inflation target to be - and in the worst case do this on repeated
occasions - economic agents will sooner or later start to doubt our intentions. If
such doubt takes hold, inflation expectations in the economy may start to fall.
Economic agents may start to expect lower inflation than 2 per cent even in the
long term, and ultimately also begin to incorporate this into their economic
decisions. In this case, a self-reinforcing process arises leading to average inflation
"getting stuck" at too low a level.
But would this really be so problematic? Yes, I think it would be. That I am such a
committed advocate of the inflation target is not about me considering the
2-percent target to be "holy", just for the sake of it. It is about it not only being
important from an economic perspective that inflation does not rise too high, but
also that it does not fall too low. I have often discussed the arguments for this, but
they are worth repeating.
There are above all two aspects that I think make it important to maintain
confidence in the inflation target of 2 per cent and which indicate that the target
should not be lower. One is that, when average inflation is too low, it becomes
more difficult for wage formation to distribute the resources in the economy
efficiently. The reason is that it has proved difficult in practice to lower nominal
wages. If inflation is low and nominal wages cannot be lowered, then it becomes
difficult to adjust real wages between different professions, companies and
sectors. This can ultimately lead to both higher unemployment and poorer
productivity growth in the economy. A moderate level of inflation mitigates these
problems. It functions as grease in the wheels of the economic machinery.
Another advantage with an inflation target of 2 per cent, which has come to the
fore in recent years, is that it creates at least some scope for lowering the policy
rate before it reaches its lower bound. If the inflation target, and hence average
inflation, were to be lower, then the nominal rate would also on average be
lower. This would be particularly problematic in a world where real interest rates
are very low, as is currently the case. The scope for lowering the rate before it
reaches its lower bound would then be more limited than it is today, which would
make it more difficult to counteract future recessions. Therefore, if one does not
like negative interest rates, one should not advocate a lower inflation target, as
that would imply that the policy rate would have to be negative for longer
periods. In the international debate, moreover, there are several economists who
think that not even an inflation target of 2 per cent provides sufficient scope to
conduct as expansive a monetary policy as is sometimes necessary. So there are
sound economic arguments for an inflation target that is not lower than 2 per
cent.
To sum up, it is these considerations I have in my mind when I talk about the
importance of keeping our eye on the ball. Basically, it is a question of constantly
being very clear about the guiding role of the inflation target in the design of
monetary policy.
The lower bound of the repo rate is less than
zero
Regarding negative interest rates, I presented my own view on the matter in a
speech around this time last year.6 I think that the difficulties with negative rates
are not so much a question of purely economic aspects, but rather of what is
feasible according to social conventions and possible to create understanding for. For
example, the biggest problem is probably not the one that is commonly
highlighted, namely that the general public would choose to empty their bank
accounts and only hold cash, as soon as the interest rate is negative. Holding savings
in cash is, when it comes down to it, both troublesome and costly and given that
most people in Sweden have started to abandon cash, it is not something that
would seem particularly natural. The pain threshold here is probably relatively
high, from a purely economic perspective.
On the other hand, I strongly suspect that it would be difficult to gain
understanding for a policy that involves private individuals also encountering negative rates
on their deposit accounts; in other words having to "pay to save". This is perhaps
a limitation that simply has to be accepted. Ultimately, the legitimacy of, and
confidence in, an independent institution like the Riksbank is based on the general
public understanding the policy conducted, or at least not considering it to be
illogical and unjust. But it is exactly this that I think constitutes the limitation. That
zero per cent should be some magical limit for the repo rate is for me more
difficult to understand, however.7
During the almost three years that the repo rate was -0.5 per cent, normal
banksaver deposit rates never became negative, so there seems nevertheless to be
some scope for negative interest rates. And bearing in mind that monetary policy
resources are not inexhaustible, I think it is good to be able to make use of this
scope if it can thereby help to avoid major costs to the economy.
If it were to take longer to reach the target, it
does not mean we would give it up
I made the point earlier that it is very important how monetary policy is
communicated. Before I go on, allow me to discuss a hypothetical case that makes it
particularly clear how central this point is. It is no secret that very low real interest rates
have reduced the scope for managing cyclical fluctuations with the help of
monetary policy. In a speech three years ago, I said it could not be ruled out that we
might at some stage reach a point at which we consider it no longer desirable to
make monetary policy more expansionary.8 If we were to find ourselves in such a
situation - and I say if - we may as a consequence have to accept that it takes
longer than it normally does to attain the inflation target.
The advantages I just described of an inflation target of 2 per cent would of course
still apply and we would continue to do our best to attain the target. The
difference would be that we open up for the possibility that it could take longer than
we normally expect, and we accept this without making monetary policy more
expansionary.
In such a hypothetical case, we would thus not "give up the inflation target" and
suddenly start conducting an entirely different policy and, for example, raise the
interest rate. There would still be reason to conduct a policy that is as
expansionary as we deem possible, to avoid taking longer than necessary to attain the
target. However, one consequence might be that the Riksbank's communication
becomes even more central. The damage in a situation where monetary policy is not
made more expansionary, despite inflation being expected to undershoot the
target for a long time, will be much less if the general public can be convinced that
the target has not been abandoned, but that it is merely a question of taking
longer than normal to attain it. Clarifying this would be a difficult but hopefully
not impossible task.
Often unclear whether the criticism applies
to monetary policy or the target
Having gone through how I view the current situation and discussed a few related
aspects, I would now like to widen the perspective a little and talk about more
fundamental issues. More specifically, I thought I would go into why we have the
framework we have, with an inflation target and a floating exchange rate, and
what benefits this system provides. This is not the first time I have done so, but I
believe it is useful and important to remind people of this now and then. Having
lived with a monetary policy framework for a long time, it is easy to start taking
the benefits of it for granted and to focus on the drawbacks. The debate in recent
years suggests that this is what has begun to happen, at least in some quarters.
The debate has had slightly different angles. One line of reasoning criticises the
policy conducted by the Riksbank, although it is not always clear, to me at least,
the extent to which this criticism is directed at the policy as such - i.e. that we
have taken the wrong action given the target we have - or at the target definition
itself. The monetary policy mandate given to the Riksbank by the Riksdag is in
short to keep inflation over time close enough to 2 per cent so that long-term
inflation expectations in the economy are anchored at that level. More or less all
central banks in western countries with a floating exchange rate have the same
main task and the same target level, for example Norges Bank, the Bank of
England and the Federal Reserve.
Broad support for the inflation target
Before continuing, allow me to digress a little on the subject of the Riksbank's
mandate. Those who follow the current debate can certainly gain the impression
that the Riksbank has unilaterally adopted a monetary policy target that it thinks
is appropriate - 2 per cent inflation - but that is quite controversial in the rest of
society. In other words, the inflation target is the Riksbank's and only the
Riksbank's. This interpretation is, however, both incorrect and unfortunate.
So whose is the inflation target, then? The decision to introduce an inflation
target of 2 per cent was taken in 1993 by the General Council of the Riksbank. At that
time, the General Council had a different role to the one it has today and was the
Riksbank's decision-making body. The then Governor, Bengt Dennis, has described
the prevailing regime as follows (Dennis, 2003, p. 182): "The General Council
consisted of eight members. Seven members were elected by the Riksdag while the
eighth, the Governor of the Riksbank, was appointed by the General Council. It
was a council elected on political grounds and the majority of its members were
active politicians".
At the outset, the inflation target received a fair amount of criticism, even from
politicians. But quite soon, when the advantages of the target had become
clearer, broad support emerged for it. For many years now, the Riksdag
Committee on Finance has performed a review of monetary policy and every few years
has also tasked two foreign economists to review monetary policy. These reviews
largely concern the policy that the Riksbank has conducted but there is of course
nothing in principle to prevent framework issues being addressed, which has also
happened on occasion. If the Committee on Finance or the foreign reviewers had
considered the inflation target of 2 per cent to be inappropriate, it is reasonable
to assume that this would have been communicated at some point over the
twenty-five years or so the target has been in force. But this has not happened.
Thus, elected representatives played a key role in the introduction of the target,
they have always supported it, at least a majority of them, and there is nothing to
suggest that this is no longer the case.9 As I see it, this is approximately the
criterion for being able to call the inflation target "Sweden's" inflation target. So it is
not just the "Riksbank's" target, even though it is of course the Riksbank's task to
try to attain it.
Good target attainment in recent years
With that, I will return to the debate on the monetary policy framework. The
Riksbank has performed its task rather successfully in recent years. In terms of the
target variable CPIF, inflation has been very close to 2 per cent over the past two
years as well as during the first half of 2019, albeit with some help from an
increase in energy prices. It is only in the most recent months that inflation has
fallen back somewhat and it has done so largely as a result of a lower contribution
from energy prices.
Many who have been critical of the policy conducted by the Riksbank claim they
support the monetary policy framework and the inflation target. But bearing in
mind the aim of monetary policy having been to keep inflation around the target
and to maintain confidence in it, and that the Riksbank has had to work quite hard
to achieve this, it does not seem far-fetched to conclude that the criticism is
implicitly nevertheless that the target itself should have been different. This is true
at least if one believes that monetary policy could have been very different to
what it has been. And this is exactly the opinion many critics must be perceived to
have; otherwise it is difficult to understand at all why the discussion is so lively.
In this context, it can be worth emphasising that the expansionary policy
conducted by the Riksbank has been just enough to bring up inflation to 2 per cent.
Inflation has never been excessively high in recent years, but on the contrary has
recently fallen back somewhat and is now once again below the target. It is
therefore difficult to see how we, so to speak, have gone too far in view of our target. I
think it is reasonable that those who claim they support the monetary policy
framework and the inflation target, but nevertheless have been critical of the
policy conducted, take this into consideration.
The inflation target has had considerable
benefits...
Apart from this criticism, there is also a line of reasoning that states more clearly
that the target definition should be different. It is above all this part of the debate
that I will concentrate on in my discussion going forward. I would like to go
deeper into two specific areas: wage formation and the exchange rate. It was
failures in these two areas in particular that caused, or rather forced, Sweden to
switch over to the monetary policy regime we have today with a floating
exchange rate and inflation target. To provide some background to my continued
discussion, allow me to describe the situation prior to inflation targeting.
Since the early 1970s, Sweden had been stuck in what could be called a
devaluation cycle. Pegging the exchange rate, at least in theory, is the same as setting a
target for domestic inflation. The idea is that the domestic rate cannot exceed (or
fall below) inflation in the countries to which the domestic currency is pegged, at
least not for any longer periods of time. But in order to make the commitment of
maintaining a fixed exchange rate credible, it must be supported by other policies.
This was not the case in Sweden. As there were expectations of continued high
inflation and of the Swedish krona being devalued, in other words of the target for
the exchange rate being abandoned sooner or later, the wage inflation trend in
Sweden was stronger than it was abroad. As the exchange rate was fixed, the
competitiveness of Swedish companies weakened and a cost crisis arose. To
rectify this, no other solution than to devalue the krona was thought to be available,
which meant that the expectations of the krona's devaluation were met. This in
turn meant that the inflation trend could continue, competitiveness gradually
weakened again, the exchange rate was once more adjusted downwards, and so
on. What is normally referred to as "the nominal anchor" - the benchmark for
inflation expectations and thus for price-setting and wage formation - did not
function as intended.
It was far from obvious that inflation targeting, introduced in 1993, would succeed
in achieving what the fixed exchange-rate policy had failed to - to re-establish the
anchor for price-setting and wage formation. Today, we know that it did succeed
and furthermore did so relatively quickly. If I was to pick out the most important
contribution made by inflation targeting, it would be precisely this - providing a
nominal anchor for the economy. As far as Sweden is concerned, it is quite clear
that the inflation target has helped provide greater orderliness by playing this
role, and this has probably been an important explanation for the Swedish
economy having developed so favourably since the crisis at the beginning of the 1990s.
... but these benefits seem to have begun to
fall into oblivion
As I noted earlier, there is broad support for the inflation target. But as regards
wage formation, there is currently an opinion, at least in some quarters, that the
inflation target has played its part and become irrelevant: It was important when
bringing down wage inflation from its high levels of the 1970s and 1980s, but once
this has been achieved, the target no longer fulfils any function and might as well
be abolished. For several reasons, I see this as a historically questionable and
myopic argument, and it would be unfortunate if this view were to gain a firmer
foothold.
First, it is always sensible to not let oneself be influenced too much by the
prevailing situation when discussing the design of frameworks that are expected to be
stable and be in place for a long time. It is of course true that the kind of inflation
and wage surge seen during the 1970s and 1980s does not seem likely in the
foreseeable future. But at the end of the day, what do we really know about how the
situation will be a few years in the future? Even if inflation has been subdued in
recent years, it is not likely that we have arrived at "the end of inflation" for all
eternity. Inflation has always varied and never been constantly high or low for any
particular length of time (see Figure 1). It is difficult to see how society could have
changed so fundamentally that this historical regularity now no longer applies.
Assume that inflation, for reasons we cannot currently identify, will be, say, 4 per
cent a few years ahead. Even those who now consider the inflation target having
become irrelevant would probably then see the benefits of a credible anchor at 2
per cent. A credible inflation target stabilises wage formation, both when inflation
is unexpectedly high and when it is unexpectedly low.
Second, it is very unclear what might replace the inflation target as the anchor for
prices and wages in the economy. One possibility is of course for Sweden to revert
to a fixed exchange rate. This is something I will return to shortly. My
interpretation, however, is that those who think the inflation target has run its course for
wage formation are not predominantly advocating a return to a fixed exchange
rate. Instead, they seem to be relying on the wage formation reforms themselves
being sufficient. According to these reforms, which are collectively known as the
Industrial Agreement, industry has, for over twenty years, been setting the
benchmark for wage negotiations and is thereby steering wage growth in the entire
economy. In this way, international competitiveness is taken into account when
Swedish wages are set.
The Industrial Agreement has definitely fulfilled an important function as regards
bringing about more controlled wage formation with restrained wage increases.
But from a broader economic perspective, it is difficult to see how an agreement
between labour market parties could constitute a sufficiently stable anchor for
prices and wages in the entire economy, in order to be able to replace the
inflation target. As far as I am aware, Sweden would then be the first country in the
world to abandon inflation targeting in order to rely on such a system instead. The
ways of trying to provide an economy with a nominal anchor that are currently
employed are either directly via an inflation target or indirectly via a fixed
exchange rate.
Important to discuss the conditions for wage
formation
In recent years, a number of challenges with regard to the system whereby
industry sets the benchmark for wage negotiations in the rest of the economy are being
increasingly discussed. One aspect addressed is that this standardisation makes it
more difficult to change relative wages, which might be called for from the
perspective of fairness and distribution. For example, it can be an obstacle to
reducing wage gaps between women and men. But the problem has also been
highlighted from a macroeconomic perspective. If relative wages are not flexible
enough, it could counteract an economically effective distribution of the labour
force among professions and sectors. This could in turn create imbalances on the
labour market. Many analysts argue that, instead of the most important aim of
wage formation being to safeguard the international competitiveness of industry,
it should be to achieve balance in the labour market as a whole.10
Another important aspect highlighted in the discussion is the extent to which this
wage standardisation is always compatible with an inflation-targeting regime. The
reason for highlighting this issue is the strikingly low overall nominal wage growth
in the economy despite a healthy economic situation and more or less on-target
inflation. That wage agreements in Swedish industry have been restrained is due
to a large extent to modest wage growth in our European competitor countries,
probably because many of these countries have been hit very hard by the
international financial crisis and subsequent European debt crisis. As the agreements in
industry also set the standard for wage agreements in other sectors that are only
partly or not at all exposed to competition, these agreements will also be low.
From a theoretical perspective, this type of wage standardisation should not be
incompatible with inflation targeting in the long term as the euro area's inflation
target is very much in line with Sweden's. But in periods when wage growth in the
euro area is unusually low, standardisation based on the industrial sector
contributes to low wage growth in the Swedish economy as well. Even though the
Riksbank would make monetary policy more expansionary in such a situation, the
inflation target may take longer than normal to attain. During these periods, there is
a risk of inflation expectations falling and of confidence in the inflation target
weakening. This would not be good for the Swedish economy. We could then get
stuck in a situation with too low average inflation and nominal interest rates,
longer periods of negative rates and greater difficulties in counteracting
recessions via monetary policy.
A more general challenge is the fact that the constantly ongoing structural
transformation is changing the playing-field. It has already been highlighted in the
debate that there are labour shortages in parts of the labour market, primarily
publicly funded activities, which will also increase in the years ahead for demographic
reasons. Substantial real wage increases will be necessary there in order to meet
staffing requirements. Another aspect is that a new exposed sector is gradually
emerging, above all with more service companies. The longer-term consequences
of a relatively limited and probably decreasing part of the economy setting the
benchmark for the enti