A speech, with several references to the Swedish experience, of John Williams, President of the Federal Reserve Bank of San Francisco, on May 27, 2015. Here is the part that refers to Sweden:
Despite the clear need to consider all potential tools to avoid a financial crisis, I am unconvinced that monetary policy is one of them. Three observations lead me to this conclusion. First, monetary policy actions offer unfavorable and costly tradeoffs between macroeconomic and financial stability goals. Second, using monetary policy in pursuit of financial stability could undermine the credibility of the central bank’s commitment to its inflation target and unmoor inflation expectations. Third, the great uncertainty about, and long lags between, monetary policy actions and risks to the financial system argue against their playing a meaningful role.
Taking these in turn: The first issue is the high cost, in terms of macroeconomic goals such as price stability and full employment, of using monetary policy to address potential risks to financial stability. Under normal circumstances, macroeconomic and financial stability goals are likely to be in harmony. However, in some circumstances, such as when the economy is weak but risks to financial stability appear to be growing, they may come into conflict. In such a case, the concern over financial stability may suggest raising interest rates higher than would be appropriate for macroeconomic goals, resulting in higher unemployment and lower inflation.
This problem is starkly illustrated by the real-world tradeoff that Sweden’s central bank, the Sveriges Riksbank, faced in trying to mitigate risks to financial stability using monetary policy. Let me set the stage. In recent years, Sweden’s economy has been in the throes of persistently high unemployment and low inflation. At the same time, household debt has grown rapidly. In response, the Riksbank undertook a tighter monetary policy stance than purely macroeconomic considerations would have called for. In effect, inflation and unemployment goals were subordinated to reduce the risks to financial stability that stemmed from Sweden’s high level of household debt. Lars Svensson has argued that the Riksbank’s monetary policy actions induced a significantly higher rate of unemployment and a sustained shortfall of inflation relative to its target.5 Sweden’s dilemma is not an isolated example; a similar set of issues has faced Norway’s central bank, the Norges Bank.6
The second, related, observation is that policy actions aimed at addressing financial stability could drive inflation far from its target for many years. This could undermine faith in the central bank’s commitment to its inflation target and affect inflation expectations, which have been known to slip when central banks emphasize the role of financial stability when deliberating monetary policy. Figure 1 shows survey data on longer-run measures of inflation expectations for the United States, the euro area, Norway, and Sweden.7 These have remained stable in the United States and the euro area throughout the tumult of the global financial and euro crises, as well as the aggressive monetary policy undertaken by the Federal Reserve and the ECB. In contrast, long-run inflation expectations in Norway and Sweden fell below target when their central banks were highlighting financial stability worries.8 This followed long periods of inflation averaging below target levels and central bank communication that financial stability concerns had been affecting policy decisions.
After the Riksbank reversed course in July 2014, inflation expectations rebounded, providing additional evidence to suggest a link between adherence to a financial stability mandate and inflation expectations. The Norges Bank, on the other hand, stayed the course and inflation expectations have remained depressed. So far, it’s unclear how durable this slippage will be. Nonetheless, it is an apt reminder of the potential long-run costs of losing sight of the price stability mandate. The steadfastness of the nominal anchor in most advanced economies has been, and continues to be, a key factor in many central banks’ ability to maintain low and stable inflation during and after the global financial crisis. If the anchor were to permanently slip, it would wreak lasting damage to central banks’ control over both inflation and economic activity, at considerable cost to the economy.
My third observation is that while the costs of using monetary policy to address financial stability risks are clear and sizable, the potential benefits of such actions are much harder to pin down. In part, this uncertainty is due to the difficulty inherent in analyzing and measuring tail risks that could develop in the future. But it also reflects the shortcomings of available economic models, which do not provide much guidance on how monetary policy may affect such risks.9 Moreover, monetary policy is likely to affect financial stability in myriad ways and even the direction of these effects may depend on the circumstances at hand. For example, Svensson argues that the Riksbank’s policies may have actually increased the already high household debt-to-income ratio, potentially exacerbating financial stability risks rather than mitigating them.10 More generally, once perceived risks to the financial system have begun to emerge, the implications for monetary policy are unclear. Take the current example of the purported effect of low interest rates on excessive risk-taking in financial markets. Does this argue for more rapid policy actions to discourage further risk accumulation? Or does it imply a more gradual course of action to minimize the risk of a sudden adverse market reaction? It’s not at all obvious. Based on the standard principle that highly uncertain policy actions should be used with caution, the ambiguous effects of monetary policy on financial stability are another argument for limiting use of this tool.11