Consultation response (in Swedish) (Swedish summary)

I agree with Goodfriend and King’s criticism that the Riksbank majority, because of concerns about household debt, pursued too tight monetary policy after 2011 and deliberately used over-optimistic inflation forecasts to justify a higher policy rate. I reject Goodfriend and King’s claim that the majority’s large monetary tightening 2010-2011 was justified in the light of available information and the recovery after the crisis. I also reject Goodfriend and King’s claim that the tightening 2010-2011 was broadly accepted by the minority (Karolina Ekholm and me), because we at each policy meeting only voted for a moderately lower policy interest rate and policy-rate path.The minority followed a simple and robust policy rule. According to this, the policy rate and policy-rate path should be lowered one step at each meeting, as long as the inflation forecast was below the target and the unemployment forecast was above the long-run sustainable unemployment rate. This is clear from the minutes and speeches. The minority’s lower policy rate and policy-rate path at each policy meeting was thus just the first step, not the only step towards a well-balanced monetary policy. Goodfriend and King’s recommendations are commented in more detail in my consultation response, but I do not see that their recommendations would solve the problems with Swedish monetary policy. In order to solve the problems the Finance Committee should clarify that the Riksbank’s mandate, as formulated in the Riksbank Act and its preparatory works, is price stability and full employment. The Finance Committee should also strengthen the democratic control of the Riksbank and further clarify assignment of responsibilities in the current well thought-out framework for macroprudential policy. 

Summary

I agree with Goodfriend and King’s criticism that the Riksbank majority, because of concerns about household debt, pursued too tight monetary policy after 2011 and, by assuming unrealistically high future interest rates abroad, deliberately used over-optimistic inflation forecasts to justify a higher policy interest rate. I also agree with Goodfriend and King’s view that the majority’s strategy was problematic, because the concerns over financial stability held by the majority were never explained within a clear conceptual framework, it was not easy to reconcile the objective of “leaning against the wind” with the official mandate of the Riksbank to pursue price stability, and no empirical evidence was produced on the magnitude of the costs and benefits of pursuing such a strategy.

I reject Goodfriend and King’s claim that the majority’s large monetary tightening 2010-2011 was justified in the light of available information and the recovery after the crisis. The reviewers here seem to confuse rates of change and levels. GDP and export had started to grow in 2010, but the levels were very low. Goodfriend and King do not explain why a large tightening would be warranted when unemployment had reached a peak of around 9 percent, the level of GDP was well below its previous peak and even further below its trend, and export was still much lower than its previous peak. Importantly, the Riksbank’s inflation forecast was below the inflation target and its unemployment forecast was far above a sustainable rate of unemployment. A tightening in such a situation leads to an inflation even further below the target and unemployment rate even higher than its long-run sustainable rate. The problem with the majority’s strategy that Goodfriend and King note for the period after 2011 did also apply for 2010-2011.

I also reject Goodfriend and King’s claim that the tightening 2010-2011 was broadly accepted by the minority (Karolina Ekholm and me), because we at each policy meeting only voted for a moderately lower policy interest rate and policy-rate path. This misunderstanding may perhaps be explained by the fact that the review lacks a discussion of the principles of flexible inflation targeting, what is meant by a “well-balanced” monetary policy, and what simple policy rules will lead to a well-balanced monetary policy. Goodfriend and King do not mention that the minority followed a simple and robust policy rule, even though this rule is clear from the minutes and speeches: If the inflation forecast is below the inflation target and the unemployment forecast is above a long-run sustainable rate, monetary policy is not well balanced, because target achievement can be improved by lowering the policy rate and policy-rate path. The simple and robust policy rule is thus, in this situation, to lower the policy rate and policy-rate path, one step at each meeting, until eventually either the inflation forecast is above the target or the unemployment forecast is below a sustainable rate, and together represent a satisfactory target achievement. Because the starting position was so far from a well-balanced monetary policy, several steps and meetings would be required to get there.

The minority’s lower policy rate and policy-rate path at each policy meeting was thus just the first step, not the only step towards a well-balanced monetary policy. Furthermore, this simple policy rule did not demand any great precision in inflation and unemployment forecasts, since they so clearly were, respectively, below target and above a long-run sustainable rate, especially when they were corrected by more realistic assumptions about interest rates abroad.

Goodfriend and King’s recommendations are commented in more detail in my consultation response, but I do not see that their recommendations would solve the problems with Swedish monetary policy. The big problem is that the Riksbank’s majority, in an attempt to constrain household debt, deliberately pursued a tight monetary policy that neglected both the price-stability objective and the primary objective of Swedish economic policy, full employment. This despite the preparatory works of the Riksbank Act stating that the Riksbank, without prejudice to the price-stability objective, shall support the goals of the general economic policy with the purpose of achieving sustainable growth and high employment. The majority’s policy was pursued despite extensive theoretical and empirical research having shown already in 2010 that, as far as could be judged, the costs of such a policy by a margin exceeded the possible benefits. Empirically, the effect of the policy rate on household debt and risks of a crisis is too small for the benefits to exceed the costs in terms of high unemployment and low inflation. Later research has shown that the costs outweigh the possible benefits with an even greater margin and, given the current state of knowledge, are in most cases several times larger than any benefits.

In order to solve the problems of monetary policy and ensure a satisfactory target achievement the Finance Committee should further clarify that the Riksbank’s mandate, as formulated in the Riksbank Act and its preparatory works, can be specified as price stability and full employment. The Finance Committee should also strengthen the democratic control of the Riksbank by ensuring that the actual decision-making power rests with an executive board with six independent members and by a more thorough annual review of monetary policy, for instance by the Fiscal Policy Council receiving an expanded mandate to also assess monetary policy.

The Finance Committee should also clarify that the current well thought-out framework for macroprudential policy, which assigns the responsibility for macroprudential policy to the Swedish FSA, limits the Riksbank’s assignment regarding financial stability to liquidity support, particularly in crisis management. The Finance Committee should also clarify that a possible future need for coordination of monetary policy and macro-prudential policy should be handled by the FSA, not the Riksbank, judging whether the stance of monetary policy would pose a significant threat to financial stability that cannot be contained by the policy tools available to the FSA. If so, the FSA should warn about this in the Financial Stability Council. Then the Riksbank can decide whether monetary policy needs to be adjusted. This way the Riksbank’s independence is preserved. In the absence of such a warning from the FSA, the Riksbank should not deviate from the monetary policy objectives.

Read the consultation response (in Swedish)

See also “Two serious mistakes in the Goodfriend and King review of Riksbank monetary policy” and “Goodfriend and King misreport the monetary policy stance of the minority”