New Ekonomistas post. This is an English translation:
What is meant by “without prejudice to the objective of price stability” when the Riksbank has an inflation target? How do we know whether or not the Riksbank is neglecting the price-stability objective? Could it be that the Riksbank is not only neglecting the price-stability objective but is also counteracting the Riksdag’s and the Government’s high-employment objective as well as increasing household indebtedness?
What is the Riksbank’s mandate for monetary policy? The Riksbank Act states: ”The objective of the Riksbank’s activities shall be to maintain price stability.” The Government Bill (in Swedish) about the Riksbank Act and how it shall be interpreted states: “As an authority under the Riksdag, the Riksbank shall also, without prejudice to the objective of price stability, support the objectives of the general economic policy with the aim to achieve sustainable growth and high employment.” (Italics added.)
The Riksbank has specified the price-stability objective as an inflation target of 2 percent for the annual rate of change of the Consumer Price Index (CPI). High employment must be interpreted as the highest sustainable employment, which is determined by how the economy works and not by monetary policy. The highest sustainable employment is in practice (when the labor-market participation rate is independent of monetary policy) the same thing as the lowest sustainable unemployment. Then the Riksbank’s mandate is to stabilize inflation around the inflation target and unemployment around the (lowest) long-run sustainable rate.
What is meant by “prejudice to the price stability”, that is, “neglecting” the price- stability objective, when the Riksbank has an inflation target of 2 percent? How do we know if the Riksbank is neglecting the price-stability objective or not?
Since the Riksbank does not have complete control over inflation, any deviation of inflation from the target cannot be to neglect the price-stability objective. The best the Riksbank can achieve is inflation fluctuating moderately around 2 percent. This means that the average inflation over a longer period becomes a criterion of whether or not the Riksbank is neglecting the price-stability objective. If average inflation over a longer period exceeds or undershoots the inflation target, the Riksbank is neglecting the price-stability objective.
However, one could argue that, as long as the Riksbank, if inflation is deviating from the target, is trying to bring inflation back to the target within a reasonable time, the Riksbank is not neglecting the price-stability objective. The criterion could then be whether or not the Riksbank’s inflation forecast reaches the inflation target within a reasonable time. But, as is shown by the National Institute of Economic Research in a special study in The Swedish Economy August 2013, there are unfortunately good reasons to doubt Riksbank forecasts. Diagram 34 in the special study shows that the Riksbank forecasts for CPI inflation have systematically overestimated inflation and are therefore note reliable. To check whether or not the forecasts reach the inflation target within a reasonable time is therefore not at good way of checking whether or not the Riksbank is neglecting the price-stability objective.
In principle, it is of course doubtful to use forecasts or measures that the Riksbank has itself constructed to assess if the Riksbank is neglecting the price-stability objective. It is better to use measures and indices that some other institution, such as Statistics Sweden, has constructed. Average inflation over a longer period is easy to measure and, by comparing with other countries with inflation targeting, it is easy to see what is possible. The table below (part of table 1 in a paper of mine), shows the inflation target, what price index the target refers to, average inflation, and the average deviation from the target for a few countries that have had inflation targets as long as Sweden. (Click here for a larger table in a separate window.)
We see that Sweden stands out in comparison with the other countries. During 1997-2011, average CPI inflation has undershot the target by 0.6 percentage points. To this can be added that, during January 2012 – July 2013, average CPI inflation has only been 0.5 percent; thus undershooting the target by a full 1.5 percentage points.
With such a large deviation from the target compared to how other central banks have performed, it seems that one must conclude that the Riksbank is neglecting the price-stability objective, in particular when one observes how low average CPI inflation has been recently.
The figure below shows time series of the CPI for Sweden and Canada since 1997. The black line shows how the CPI if it would grow by 2 percent each year since 1997. The light blue line shows the CPI for Canada; in particular, that it closely follows the black line. It is thus fully possible to keep average inflation close to 2 percent over a long period. The red line shows the Swedish CPI and how it on average has increased at a slower rate than 2 percent, especially in the last few years. If the CPI had increased by 2 percent on average since 1997, it would now have increased by almost 40 percent. It has actually increased by just a bit above 20 percent.
What are the consequences of the Riksbank’s neglect of the price-stability objective? As I have shown in the paper mentioned above and is shown in the figure below (figure 11 in the paper), 0.6 percentage points average inflation below the target has caused about 0.8 percentage points higher unemployment, about 38 000 jobs, during 1997-2011. That unemployment has been higher is because inflation expectations have equaled the target during this period, in spite of average inflation falling below the target. When actual inflation falls below expected inflation, unemployment becomes higher. As shown in a previous Ekonomistas post (English translation here), currently unemployment may be as much as 1.2 percentage points higher (corresponding to about 60 000 jobs) compared to a situation where the Riksbank with more expansionary policy had kept inflation close to the target.
As I have also shown in the Ekonomistas post mentioned above, the Riksbank’s tight monetary policy has led to higher real household debt and a higher household debt ratio, measured relative to GDP or to disposable income. This is because the Riksbank’s policy has reduced the price level, nominal GDP and nominal disposable income faster than household nominal debt. Then real debt and the debt ratio increases.
One can show the long-run consequences for household debt in a different way. The figure below shows that the CPI would have increased by about 23 percent since 2003, if average inflation had equaled the target. In fact, the CPI has only increased by 13 percent.
Assume now that a household took out a mortgage of SEK 1 million in 2003. Assume for simplicity that the household has not amortized the debt but that it 10 years later remains equal to SEK 1 million. Assume the borrower like most others was expecting 2 percent inflation per year for the next 10 years. The black line in the figure below (the unit on the vertical axis is thousands of SEK) shows that the real value in 2003 prices of the mortgage would then have fallen to SEK 813K in 2013 (SEK 1million/1.23). But since the price level in reality has only increased by 14 percent, the real value of the mortgage has only fallen to SEK 878K (SEK 1 million/1.14). This means that the real value of this mortgage is 8 percent higher than it would have been if the Riksbank had kept average inflation on target. The lower price level has also led to lower nominal GDP and lower nominal disposable income, so the debt ratio is also at least 8 percent higher; it is actually more than 8 percent higher, since the Riksbank policy has led to lower real GDP and real disposable income than if inflation had been on target.
Thus, the Riksbank has neglected the price-stability objective by allowing average inflation to undershoot the inflation target. This has led to higher average unemployment. The Riksbank has thereby not supported the objective of the general economic policy of high employment. Lower average inflation has also led to higher real household debt, and to a higher debt ratio relative to GDP and disposable income. All this in spite of the Riksbank justifying its tight policy by the presumption that the policy would lead to a lower debt ratio than an easier policy would.
All in all, the Riksbank is apparently not only neglecting the price-stability objective; it is actually both counteracting the high-employment objective of the Riksdag and the Government as well as increasing household indebtedness.