SPEECH
SVERIGES RIKSBANK
DATE:
08/12/2020
SE-103 37 Stockholm
SPEAKER: (Brunkebergstorg 11)
Governor Stefan Ingves
VENUE:
Business Arena
Tel +46 8 787 00 00
Fax +46 8 21 05 31
registratorn@riksbank.se
www.riksbank.se
Monetary policy in a changing world∗
We have had a dramatic year in 2020, when a lot has changed in our lives. For
members of staff and for us in the Riksbank's Executive Board, the year has
brought intensive work to manage the effects the coronavirus pandemic has had
on the Swedish economy.
Our focus has been on ensuring that there is good access to liquidity and keeping
interest rates low. We have wanted to provide the economy with the best
conditions possible to recover after the coronavirus pandemic and, as usual, to get
inflation to develop in line with the inflation target.
In many ways, our measures have resembled those of other central banks.
However, compared with the period before the financial crisis, just over ten years ago,
monetary policy has changed radically, above all because the monetary policy
toolbox today looks very different. Back then, adjustments of the policy rate were
seen as the only monetary policy tool. These days, most central banks work with
several tools, some of them modern iterations of older approaches, both in times
of crisis and in more normal times. Monetary policy and the way we 'do'
monetary policy has changed, but the objective of attaining the inflation target still
remains. And all the time, we need to stand ready to develop new tools and make
new kinds of analysis - so that we can reach our inflation target. If the world
changes, we need to change with it.
International changes affect monetary policy
There is good reason to look back and see what lies behind this development. This
has certainly been done before. Both the Riksbank and other central banks have
published and discussed a great deal about various international changes that
have led to changes in monetary policy. But I believe we need to continue the
discussion, partly because this makes it easier to understand current monetary
policy, and partly because it forms a necessary basis for a conversation on what the
monetary policy of the future might look like.
Today, I would like to address some of the most important international changes
that have a bearing on monetary policy. I am thinking specifically of how the
financial sector has developed in recent decades, both globally and in Sweden, and
of the fact that global real interest rates have fallen. This has tangibly affected
Sweden, which is a consequence of the Swedish economy being increasingly
integrated with the global economy. I will then present my view of what these
changes have entailed, both for how Swedish monetary policy is conducted, and
for how we need to develop how we discuss and perceive monetary policy in
general.
Crises affect monetary policy
The three unusually large crises we have experienced over the last decade or so
can be added to these long-term structural and global changes. Over ten years
ago, the global financial crisis started in the financial sector, when the excessive
risk-taking that had built up over many years finally came to the surface. Shortly
thereafter, the sovereign debt crisis broke out in Europe. The pandemic in the
midst of which we currently find ourselves is another kind of crisis. It started as a
health crisis before developing into an economic crisis.
During these crises, central banks around the world implemented different kinds
of measure to stabilise the situation. But the episodes remind us that the future is
always uncertain and that preparedness for crises needs to be a central element
of monetary policy. Twenty years ago, a different view prevailed and the
approach developed then, which continues to set the tone in today's discussions of
monetary policy, was based on a fairly stable macroeconomic environment. This
obviously affects our view of how monetary policy should be designed, whether
we believe that it is primarily a matter of counteracting small and regular
fluctuations in the economy or whether we believe that it is important for policy to be
able to prevent and counteract crises.
Over the last decade, we and other central banks have had to redevelop older
approaches that give greater weight to uncertainty and the understanding that the
world is constantly changing. We have had to develop our preparedness, capacity
and flexibility to innovate, sometimes with the help of old insights, as the
circumstances have demanded it of us. The Riksbank is not unique; rather, this
development of monetary policy can be seen at most other central banks.1
The financial markets are constantly
changing - central banks need to adapt
As mentioned above, today I intend to address two main changes. The first of
these concerns the development of the financial sector in recent decades.
Globally and in Sweden, the financial markets have grown larger, both in terms of the
volumes traded and in terms of the number of financial instruments. The second
change is that the global level of interest rates has fallen. This is having a
substantial effect on the scope for policy rate adjustments to stimulate the economy, and
there has been lively discussion in recent years of how this should be managed. I
therefore do not intend to discuss this specific issue today, but refer to the
comprehensive academic literature.2 Many analysts would argue that both of these
changes, at least partly, share a basis, namely higher global saving, which, in turn,
is a result of the world having become richer.3 But I would like to separate them,
as the discussion has primarily come to focus on the lower level of interest rates.
The fact that the financial sector has also changed in several respects is something
that needs to be given more attention, considering that the conditions on the
financial markets steer how monetary policy is designed and acts. Allow me,
therefore, to make a brief digression on the subject.
In the 1970s and 1980s, the world's capital markets were gradually deregulated.
This, combined with good global growth, which is to say a richer world, and the
development of information technology, led to strong development on the global
financial markets in terms of outstanding volumes, turnover and new instruments.
The development had major advantages. With less regulation, the financial
sector's basic functions - executing payments, allocating savings to investments and
managing risk - could be better managed, at the same time as the strong growth
on the financial markets contributed to the strong growth in the global economy.
But a larger financial sector has also led to greater potential risks, as exemplified
by the financial crisis twelve years ago. Demands on supervisory authorities and
central banks have therefore increased in recent decades - demands that they
monitor, oversee and regulate, when necessary. For monetary policy, the changes
in the financial markets have had an effect that has received less attention, as
they have affected the channels and markets through which monetary policy
measures act. A Swedish example, to which I will return, is the emergence of the
market for corporate bonds. These days, one-third of companies' loan financing
takes place on this market, and the functioning of this market has therefore come
to affect how changes in the repo rate spread to the interest rates that companies
are facing de facto.
The same target for monetary policy but the
way there looks different
The environment in which the Riksbank acts has thus changed in a way that
affects monetary policy on several levels. And our way of thinking about monetary
policy, what it is and how it should be conducted, has also changed along with our
environment.
The objective of monetary policy is unchanged and remains price stability, often
more concretely defined in terms of stabilising inflation around 2 per cent. In
other words: the same target but our way of attaining it - which is to say the tools
at our disposal and also how we can be expected to act and react to events in the
economy - has had to change. The international changes I have described affect
most other central banks. Looking abroad, we can also see great similarities at
various central banks in how monetary policy has changed.4 In other words, the
Riksbank is part of an international development.
Monetary policy - then, now and in the future
Until the financial crisis, it was most common to analyse and discuss monetary
policy on the basis of a relatively simple model with a small number of variables.
Inflation was primarily assumed, in a fairly simple way, to be affected by real
economic activity (which was usually described in terms of measures of resource
utilisation, unemployment or some other measure of capacity utilisation). One tool
that the central bank had perfect control over, the policy rate, was assumed to
have a clear effect on inflation via real economic activity. The transmission
mechanism, which is to say the chain of events from changes in the tool (the policy rate)
to the final effect on the target variable (inflation), was assumed to be stable and
to have few details. And monetary policy worked in that when the interest rate
was cut, demand was stimulated, meaning that capacity utilisation rose and thus
so too did inflation. Of course, when such models were used to compile
background material at central banks, larger models with more variables became
necessary. But the transmission mechanism remained very clear and simple, and
details on how the financial sector works were not explicitly included. However, as
instructional tools to illustrate important points about inflation targeting (for
example, the balance between real economic stability and how quickly inflation can
be brought back to the target after a shock), the models worked well.
The financial crisis showed that more complex models were
needed...
For a more thorough and detailed discussion of monetary policy in practice,
models like this were insufficient and this became obvious in conjunction with the
financial crisis over ten years ago, if not sooner. There were several reasons for
this.
The first reason was that, as the financial markets had a subordinate, or almost
non-existent, role in the models, the consequences of shocks on the financial
markets could not be described. The models certainly included households that save
and companies that invest, but in some way, these were assumed to find each
other without financial intermediaries like banks or somewhat developed financial
markets. It was basically assumed that all saving and lending took place in the
form of a certain kind of bond and it was also the interest rate on this that the
central bank could directly steer. This might not be such a bad simplification if the
financial markets were relatively frictionless and various actors on the financial
markets were easily able to make deals with each other. In such a world, interest
rates with longer maturities would depend, to a great extent, on expectations of
the policy rate in the future. It also assumes that the information needed by
households and companies to take decisions is free and evenly spread (which is to
say information is not asymmetric).
...and that the view of the financial markets was oversimplified
Precisely this assumption that the financial markets were frictionless was one
reason why it was difficult to understand the driving forces behind the global
financial crisis of 2007-2009, as well as which measures the central banks should take
and, for example, to discuss asset purchases as a further monetary policy
instrument.5 When the central banks nevertheless started to purchase assets on a large
scale in conjunction with the financial crisis, this was done as it was an old, tried
and tested measure - that is, not anything particularly unconventional. There
were still enough people in central banking who remembered how monetary
policy was conducted 'in the old days'.6 Older theories from the 1960s (portfolio
balance theories, for example) went through a renaissance. The financial crisis gave
rise to new research and, subsequently, new models with a richer representation
of the financial markets, but these were not circulated until after the financial
crisis. However, this newer approach has not actually changed the way monetary
policy is discussed in Sweden. I will return to this a little later, when I comment on
the Riksbank Inquiry.
The simplified view of financial markets meant that the financial parts of the
transmission mechanism were neglected in the analysis of monetary policy. The
focus lay on the central bank's policy rate, and questions concerning how changes
in the policy rate actually affected other interest rates and lending to companies
and households did not receive the same attention. As long as economic and
financial development were reasonably stable, this may not have been such a great
problem, even if there were voices that argued that the central banks were not
following events on the financial markets closely enough and that the imbalances
accumulating in the financial system were thus being missed.7
But then the financial crisis arrived and the transmission mechanism broke down.
The expression 'pushing on a string' was coined, meaning that policy rate
adjustments from the central bank did not spread to other interest rates as expected, if
at all. An established approach became significantly less useful in that it said
nothing about what should be done if the transmission mechanism stopped working.
This required another kind of analysis, based on the understanding that the
financial markets were not functioning without friction or normally, and that was able
to use this diagnosis as a starting point to suggest appropriate measures. I will
come back to this later.
Preparedness and flexibility - a new, yet familiar, way
of thinking
The last decade has been turbulent and the Riksbank and other central banks
have several times had to act in situations where uncertainty is considerable.
When the transmission mechanism broke down during the financial crisis, the
central banks took measures to maintain the functioning of the financial system.
And now, during the coronavirus pandemic, the Riksbank has taken a number of
different measures to ensure that there is no doubt that there is plenty of liquidity
in the economy. Thanks to measures by central banks and governments around
the world, the pandemic has not turned into a financial crisis.
As I mentioned earlier, these measures entail a different way of conducting
monetary policy compared to the one that was part of the prevalent approach from the
time before the financial crisis. Instead of one tool, the policy rate, central banks
now use several different tools. Previously, the focus lay on influencing the
financial conditions via a short-term, risk-free interest rate that primarily affects the
banks' funding. Now, central banks also introduce measures that directly affect
more long-term and even non risk-free interest rates. These too can lead to the
intended effects on the interest rates and other credit conditions that households
and companies face, and thereby to the desired effects on capacity utilisation and
the rate of inflation.
Another way of describing the menu of monetary policy measures that are now
being used is that they concern both sides of the Riksbank's balance sheet. When
the policy rate is adjusted, this entails changes for a part of the Riksbank's
liabilities.8 And when the Riksbank purchases different types of assets, this means that
the asset side changes. In other words, today's monetary policy works with the
entire balance sheet.
Crisis preparedness - part of monetary policy
Another change is that the central banks have been reminded of the importance
of not just being able to stabilise normal economic cycles but also being prepared
to act rapidly and broadly to restrain the effects of crises affecting both the
development of the real economy and the financial system.
Preparedness to act rapidly and in several different ways has now become part of
ordinary monetary policy in Sweden and other countries. During the financial
crisis, the Riksbank did not carry out asset purchases. Monetary policy was instead
primarily broadened by new forms of, and conditions for lending to the banks. But
in 2012, the Riksbank purchased government bonds for SEK 10 billion, a relatively
small amount in the context, to create operational preparedness in the event that
large-scale asset purchases would later become necessary. And in 2015, when
inflation had been too low for too long and the ECB was initiating large-scale
purchases of bonds, the Riksbank was able, in a relatively simple way, to make
monetary policy more expansionary - that is, to hold down the general level of interest
rates in Sweden - via large purchases of government bonds. Correspondingly, this
year, we have decided on the purchase of corporate bonds to a value of SEK 10
billion to strengthen monetary policy preparedness. We are thus building up an
operational capacity in the event a highly unfavourable scenario arises and more
comprehensive purchases, for example of corporate bonds, become necessary to
ensure that lending and the financial conditions do not deteriorate too much.
In this context, I need to address the Riksbank Inquiry. Previously, in its
consultation response, the Riksbank has questioned the actual starting point for the
Inquiry's way of looking at monetary policy. It wishes to divide the Riksbank's
toolbox into different parts and micro regulate which tools should be used when,
where and how.
The effect will be a narrowing of the concept of monetary policy, less
independence and freedom of action for the Riksbank, and an impaired ability to adjust
monetary policy to changed conditions. In this event, Sweden will have its own
definition of monetary policy that deviates markedly from the rest of the EU and
the world. As I have explained above, monetary policy is so much more than just a
short-term adjustment of the interest rate and purchases of government
securities. The Riksbank Inquiry is not characterised by this insight.
According to my way of seeing things, the Inquiry is far too attached to the simple
model used at the start of the 2000s. Despite the lessons of a global financial
crisis, the Inquiry has chosen to cling to a model typical of this earlier period. It is
extremely important for the Riksbank that we have a Sveriges Riksbank Act that
allows leeway for a changing world and that accepts that monetary policy, not just
in Sweden but internationally too, now looks different compared to twenty years
ago. And what will the world look like in twenty or thirty years? If the Riksbank is
to continue to function for many decades, it needs to focus more on principles
and combine clarity over the Riksbank's tasks with flexibility over how this can be
achieved. Now it is time to think again and make a new attempt.9
Of course, principled regulation must be balanced by democratic control. Here,
evaluation, transparency and insight into operations are key elements that ensure
that monetary policy is being conducted efficiently and appropriately for the
public good.
New demands for analysis - both in theory and in practice
The financial crisis entailed new demands being placed on the monetary policy
analysis. The old models have been further developed over the last ten years and
supplementary approaches have been given a more prominent role in central
banks' internal discussions.10
One way of describing the implications of the new analysis is that it is more
disaggregated. If focus, prior to the financial crisis, was on a single policy rate that
was to carry the entire burden of monetary policy, as it were, the analysis is now
more detailed. Partly this is because it places greater emphasis in how policy rate
changes spread through the financial system, via various markets to other interest
rates, all the way to the interest rates faced by companies and households. And
partly it is because the analysis focuses on describing how measures other than
policy rate adjustments, for example various types of asset purchase, affect the
financial conditions, economic activity and inflation. To link back to a part of the
reasoning above, it could be said that the new analysis has its starting point in the
financial markets not being as 'frictionless' as the earlier models assumed.11
New and old tools can be combined, depending on the
situation
The general level of interest rates in the world has fallen in recent decades, policy
rates have fallen to zero or thereabout and new versions of old tools such as asset
purchases have had to be used to provide monetary policy stimulation. But shocks
in the transmission mechanism have also justified the emergence of new
monetary policy tools. To an increased extent, companies are obtaining funding directly
on the market, and not just via loans from the banks. This is the reason that
central banks have gone in and purchased corporate bonds to thereby support
lending in the economy and maintain a functioning transmission mechanism.
The policy rate will probably be in focus again, once times and the financial
conditions have normalised. The level of the policy rate specifies a kind of foundation
for short-term risk-free interest rates, as well as other interest rates in the
economy. But how policy rate changes spread to interest rates with longer maturities,
non risk-free interest rates and the interest rates faced by companies and
households can vary, depending on the situation in the economy, conditions on the
financial markets and the structure of the financial sector. Consequently, other
tools than the policy rate will continue to be needed to ensure that other interest
rates and lending develop in such a way that capacity utilisation in the economy is
maintained and the inflation target is met.
How far can the policy rate be cut?
At present, the Riksbank's policy rate is at zero per cent and, according to the
Monetary Policy Report from November 2020, the Executive Board's best
assessment is that it will remain there over the entire forecast period, which is to say
until the end of 2023. At the same time, we have emphasised that the policy rate
may be cut to below zero, should the circumstances justify it.
We have done this before - cut the policy rate to slightly below zero, that is.
Between February 2015 and December 2019, the policy rate lay in the range of -0.1
to -0.5 per cent. Our experiences of this period were mainly positive, as the low
policy rate contributed to inflation again rising towards the target without any
major negative side effects.
Cutting the repo rate 'deeply' is another thing, however. There is an international
debate on the importance of being able to make large cuts, down to -5 per cent
or more, for instance.12 Would this be possible in Sweden? Purely technically, it is
probably possible. But if such a measure were seriously to be considered -
perhaps in a situation where the pandemic was having much greater negative effects
on growth and unemployment - we would have to carefully consider a number of
questions, not all of which would be strictly economic.
The economic questions include the effects of negative interest rates on the
functioning of the banks and on their profitability, something that is perhaps more
important in countries other than Sweden. The idea is that there is a boundary
beyond which interest rate cuts de facto become counterproductive in that lending
becomes impeded.13 Another economic question concerns the well-known
reasoning that there is a point at which the general public decides to withdraw all its
savings and convert them to cash or go over to using some other currency so as to
avoid a negative interest rate.
A question of public confidence
The classic objection to negative interest rates may need to be complemented by
other, less macroeconomic reasoning that concerns public confidence in the
central bank and the country's currency.
The central bank is an important institution in most countries and its remit means
that it takes responsibility for confidence in the means of payment, the country's
own currency. This can be expressed as the central bank having responsibility for
price stability, but, just as much, it is a matter of ensuring that there is an efficient
payment system in the country. As I said, there is an international debate on the
importance of being able to cut policy rates to far below zero, and it is being
discussed how this could be achieved in practice with various technical solutions.
Something possibly missing from this discussion is how the general public's
confidence in their country's own currency/means of payment would be affected. If
one unit of saved currency suddenly gives less than one unit of currency back,
what would happen to the public's willingness to hold that currency? Negative
real interest rates are certainly nothing new, and this phenomenon has not been
linked to any undesired effects on behaviour. Consequently, according to
economic theory, negative nominal interest rates should not be any different as it
usually assumes that it is real interest rates that are important to our decisions to
consume or invest. However, this assumption is not undisputed, and there are
plenty of examples to indicate that people often think in nominal terms. In such
cases - is it self-evident that the general public will consider that the economic
advantages of cutting the interest rate to far below zero justify the nullification of
old rules on for example saving - that you will at least get back what you saved?
In a small, open economy, it may be even more complicated, as there are
alternative means of payment. It could be said that the local currency is exposed to
competition. So if the central bank in a small, open economy were to cut the level of
interest rates far below zero, there would not only be a risk of large capital
outflows (the traditional macroeconomic analysis), but also a risk that the general
public would start to use other currencies for its savings and transactions.
Reasoning like this may seem very foreign to us in Sweden. We associate events
like this with poorly-functioning countries a long way away. But my argument is
that we also need to take account of public confidence in the currency, payments
and the central bank when the suggestion of deeply negative interest rates is
being discussed. The advantages need to be weighed up against the disadvantages.
And alternative measures also need to be considered, for example fiscal policy.
This discussion becomes even more relevant when new digital currencies, such as
the Facebook currency Libra, are waiting round the corner.
New times place new demands on the
Riksbank's balance sheet
Requirement to be able to absorb risks...
The asset purchases that are now part of the ordinary monetary policy toolbox
involve various kinds of risk being transferred from society at large to the central
bank's balance sheet.14 This is why the risks have increased on the Riksbank's
balance sheet. But the risk buffer that the Riksbank has in the form of equity and
revaluation accounts has not grown at the same rate. This means that we need to
take measures to ensure that the Riksbank has enough of a buffer for the risks
that exist on the balance sheet.
Generally accepted accounting principles indicate that the Riksbank may make
provisions for the risk of losses existing on the balance sheet. The Riksbank has
previously had a relatively small balance sheet, associated with small financial
risks, and has therefore not needed to make provisions to complement the
existing loss-absorbing buffer. However, risks have increased in recent years as new
assets have been purchased and the balance sheet has grown.
As from this year, the Executive Board is therefore starting to make provisions to
strengthen our buffer, so that it can be used if the Riksbank should make losses.
The provisions will thus form a complement to the existing equity and revaluation
accounts.
Purely practically, we do this by allocating parts or the whole of the result for the
year, meaning that the dividend-qualifying result becomes lower than would
otherwise have been the case. The dividend to the state is thus affected. However,
the dividend model used by the General Council of the Riksbank spreads this
effect out over five years and, due to last year's high profit, the dividend for this
year will be relatively high, even if we make a large risk provision.
... and requirements for our foreign exchange reserves
The Riksbank, like most central banks, has foreign exchange reserves. Today,
these amount to almost SEK 400 billion. Almost half of the foreign exchange
reserves, SEK 181 billion, are funded through loans of foreign currency on the
international capital market via the Swedish National Debt Office. This currency
borrowing arose when the Riksbank, on a couple of occasions, needed rapidly to
strengthen the foreign exchange reserves. This first happened in 2009, during the
financial crisis, after which the Riksbank decided to do it again in 2012. How large
the foreign exchange reserves need to be is basically based on an assessment of
how much foreign currency we need to retain to be able to fulfil our
commitments. The Riksbank regularly reviews this assessment.
It is unusual for central banks to fund the foreign exchange reserves by borrowing
foreign currency and it is also unusual for central banks to borrow from their
countries' debt offices, such as the Swedish National Debt Office. Most central
banks in small, advanced economies instead have completely self-financed foreign
exchange reserves in the magnitude of 10-12 per cent of GDP. Our borrowing of
foreign currency has been criticised from time to time for raising the official
measure of national debt, as well as the measure known as Maastricht debt, which is
often used in international comparisons. This borrowing thus leads to a conflation
of the Riksbank's foreign exchange reserves and the public finances.
Large-scale borrowing for the foreign exchange reserves is also a disadvantage
from the perspective of preparedness. As foreign exchange reserves funded by
loans involve refinancing risks, self-financed foreign exchange reserves could
strengthen the Riksbank's ability to act in a financial crisis.
In light of this, it is reasonable to review the available alternatives for funding the
foreign exchange reserves. One possibility would be to replace currency loans via
the National Debt Office with self-financing through purchases by the Riksbank of
foreign currency, paid for in Swedish kronor. In this case, however, it would have
to be done in a way that minimises the effect on the krona exchange rate.
Equipping ourselves for the future
Let me now round off. These days, monetary policy does not only involve
adjustments of the policy rate but also changes to the Riksbank's holdings of various
financial assets and the composition of the liabilities held by the Riksbank. This is
something that characterises monetary policy in many countries and the reasons
for this are primarily international, with specific Swedish conditions playing less of
a part. My assessment is that the root causes are connected to long-term
structural changes in the financial system around the world. It is therefore not just
connected to temporary crises. Consequently, I also consider that changes in the
central bank's holdings of various assets will be an important part of monetary policy
for a long time to come, even if the policy rate will remain an important
instrument.
One lesson from the last few decades is that central banks need to pay attention
to how the financial sector transforms over time and to be well prepared to act
rapidly and broadly in times of crisis. With the broader range of monetary policy
tools developed over the last decade - which, in many ways, are reminiscent of
how monetary policy was conducted in times past - the Riksbank is better
equipped to fulfil its tasks. And considering the Riksbank's long history, this is
nothing new - we have to move with the times!
References
Adrian, Tobias (2020), "'Low for Long' and Risk-Taking", IMF Monetary and Capital
Markets Department, departmental paper series no. 20/15, November.
Andersson, Björn, Magnus Jonsson and Henrik Lundvall (2020), "The new
macroeconomic environment after the global financial crisis", Sveriges Riksbank Economic
Review, no. 1, Sveriges Riksbank.
Bailey, Andrew, Jonathan Bridges, Richard Harriso