New Ekonomistas post (in Swedish). This is an English translation.
The Riksbank has recently delivered an account of monetary policy in 2013 to the Riksdag for the Finance Committee’s annual assessment of the monetary policy. This account is clearly a biased account from the majority of the Riksbank’s executive board, since it hides that the Riksbank’s own calculations support the minority.
Monetary policy in Sweden has resulted in very bad target achievement in the last few years, with inflation far below the target and unemployment far above a long-run sustainable rate. A lower policy rate and policy-rate path would have led to better target achievement for both inflation and unemployment. The majority of the executive board has resisted this, arguing that a lower policy rate would have increased long-run risks associated with household debt.
But a minority of the executive board, consisting of Karolina Ekholm and first me, up to May 2013, and then Martin Flodén, has argued in favor of a more expansionary monetary policy. This with reference to that “monetary policy would have far too slight an effect on the risks associated with household indebtedness compared to the costs associated with a longer period of inflation below target and low resource utilisation” (the account, page 33).
The strange thing is that the Riksbank’s account is silent about the fact that the Riksbank’s own calculations support the minority. These calculations make it possible to quantify the costs and benefits of a higher policy rate and to compare those.
The cost of a higher policy rate
A higher policy rate would result in higher unemployment. A 1 percentage point higher policy rate during 4 quarters would, according to the Riksbank’s own calculations in Riksbank (2014a, kap 2), lead to a 0.5 percentage point higher unemployment rate during the next few years (the red line in figure 1). This represents the cost of a higher policy rate. [1]
Figure 1. The effect on the unemployment rate of a 1 percentage point higher policy rate during 4 quarters. Source: The Riksbank.
The benefits of a higher policy rate
A higher policy rate might reduce household indebtedness. The reduced indebtedness might lower the probability of a future crisis and its bad macroeconomic outcome with low inflation and high unemployment. The reduced indebtedness might also, conditional on a crisis occurring, make the macroeconomic outcome less bad, for instance with a lower increase in unemployment. This constitutes the benefits of a higher policy rate.
What are then the benefits of a higher policy rate, according to the Riksbank’s own calculations?
How does a higher policy rate affect the probability of a crisis?
So what is the effect of a higher policy rate on the probability of a crisis? According the Riksbank’s own calculation, a 1 percentage point higher policy rate during 4 quarters results in 0.25 percent lower real debt within 5 years (the red line in figure 2 for quarter 20).[2]
Figure 2. The effect on real household debt of a 1 percentage point higher policy rate during 4 quarters. Source: The Riksbank.
Regarding how real debt in turn might affect the probability of a crisis, Riksbank (2013) refers to Schularick and Taylor (2012). According to that paper, 1 percentage point lower annual growth of real debt during 5 years (that is, 5 percent lower real debt in 5 years) would, everything else equal, reduce the probability of a crisis by 0.4 percentage points. [3]
Altogether, this would thus lead to a reduction of the probability of a crisis by 0.25*0.4/5 = 0.02 percentage points. This is of course an insignificant reduction of the risk. [4]
As can be seen in figure 2, in the long run, the policy rate has no effect on real debt, according to the Riksbank’s calculation, and thus, according to this calculation, no effect on any long-run risks associated with real debt.
The benefit of a higher policy rate, in the form of a reduced probability of a crisis, is thus completely insignificant, compared to the cost in the form of a 0.5 percentage point higher unemployment rate the next few years.
How does a higher policy rate affect the consequences of a crisis?
So what is the effect of a higher policy rate on the consequences of a crisis? According to Riksbank (2014b, figure A22), a 1 percentage point higher policy rate during 4 quarters would lead to a 1.4 percentage points lower debt ratio in 1 year and 0.44 percentage points lower debt ratio in 5 years (the red line in figure 3 for 4 and 20 quarters, respectively).[5]
Figure 3. The effect on the household debt ratio of a 1 percentage point higher policy rate during 4 quarters. Source: The Riksbank.
According to Flodén (2014), a 1 percentage point lower debt ratio might, all else equal, result in the increase in the unemployment rate in a crisis being 0.02 percentage points lower.
Altogether, this means that the increase in the unemployment rate might be 1.4*0.02 = 0.028 or 0.44*0.02 = 0.009 percentage points lower, depending on whether the crisis occurs after 1 year or after 5 years. If the crisis occurs with the probability 4 percent (the average probability of a crisis according to Schularick and Taylor (2012)), the expected lower increase in unemployment is only a 25th of 0.028 and 0.009 percentage points, respectively. It is clearly completely insignificant.
In the long run, the policy rate has no effect on the debt ratio, according to the Riksbank’s calculation, and thus, according to this calculation, no effect on any long-run risks associated with the debt ratio.
The benefit of a higher policy rate, in the form of a lower expected increase in the unemployment rate in a crisis, is of course completely insignificant, in comparison with the cost, in the form of a 0.5 percentage points higher unemployment rate the next few years.
Thus, the Riksbank’s own calculations support the minority. Monetary policy has such a small effect on any risks associated with household indebtedness, compared to the costs of too low inflation and too high unemployment, that monetary-policy decisions do not need to take household debt into account. Wouldn’t one think that the Riksbank, in its account of monetary policy, should have informed the Finance Committee about this fact, for the Committee’s coming assessment of the Riksbank’s monetary policy?
References
Flodén, M (2014), “Should We Be Concerned by High Household Debt?“, English translation of blog post on Ekonomistas, 20 february 2014.
Riksbank (2013), ”Financial imbalances in the monetary policy assessment”, Riksbank, Stockholm.
Riksbank (2014a), Monetary policy report february 2014, Riksbank, Stockholm.
Riksbank (2014b), ”The effects of monetary policy on household debt”, Riksbank, Stockholm.
Riksbank (2014c), Account of monetary policy 2013, Riksbank, Stockholm.
Schularick, M, and A M Taylor (2012), ”Credit Booms Gone Bust: Monetary Policy, Leverage Cycles, and Financial Crises, 1870-2008”, American Economic Review, vol 102, s 1029–1061.
Svensson, L E O (2014a), ”The Riksbank: The effect of the policy rate on the debt ratio is neither economically nor statistically significant”, English translation of blog post on Ekonomistas, 14 february 2014.
Svensson, Lars E O (2014b), ”The end for the Riksbank’s ’leaning against the wind’?”, English translation of blog post on Ekonomistas, 21 february 2014.
[1] The figure is constructed from the numerical data for Riksbank (2014a, chapt. 2). The effect on the unemployment rate of a 0.25 percentage point higher policy rate during 4 quarters has been multiplied by 4 to correspond to the effect of a 1 percentage point higher policy rate during 4 quarters, in the same way that figure 1 in this post has been constructed.
[2] The figure uses the numerical data for Riksbank (2014b, figure A20) with the opposite sign. We see that a 90-percent probability interval is not below the zero line, so the effect on real debt is not statistically significantly different from zero, and it may be positive. The policy rate behind figures 2 and 3 returns to zero after 4 quarters somewhat quicker than in figure 1, but this does not affect the conclusions.
[3] See Table 3, Sum of lag coefficients, Column (1)-(3). The coefficient 0.4 is probably too high, because data for a number of reasonable control variables are not available. A lower coefficient results in even less effect on the probability of a crisis.
[4] The average probability of a crisis is almost 4 percent, according to Schularick and Taylor (2012). A probability of 4 percent corresponds to a crisis on average every 25th year. A reduction of the probability by 0.02 percentage points to 3.98 percent means that the average time between crises increases by 1.5 months to 25 years and 1.5 months.
[5] As noted in Svensson (2014a), the increase in the debt ratio is not statistically significant from zero, and it cannot be excluded that it has the opposite sign.