Heikensten: Domestic inflation surprisingly low

The path of inflation

‘A year ago last May a strong economic upswing, in Sweden as well as elsewhere, was foreseen by all observers, including the Riksbank, and inflation was expected to pick up, though not quite as much as the strong growth suggested. It was foreseen that rising domestic price pressure would be countered to some extent by low price pressure internationally. Things have turned out differently. The economic upswing has been even stronger, particularly on the international front, than we counted on at that time, while inflation has been below the Riksbank’s forecast, even though this was low compared with other predictions. The latter is mainly due to a weak domestic price trend.’

‘So what lies behind the low domestic inflation? As regards the Riksbank’s forecasts, the discrepancies in the past two years consist mainly of larger effects from deregulations and depressed profit margins.’

‘The most natural explanation for the surprisingly low domestic inflation is that in recent years the economy has had more unutilised resources than we reckoned with. That in turn may be due, for example, to the labour market functioning more efficiently than expected. But is also conceivable that our economy’s potential growth rate is higher than we believed. The increased competition that is to be seen in many markets tends in various ways to keep price pressure down. This is particularly the case in an economy like ours, where the price level was comparatively high initially. The difficulty lies in determining to what extent the pattern in recent years is temporary.’

‘There are many indications that the growing competition, deregulations and so on may continue to aid the Riksbank in combating inflation. But even if they do, growth above the long-term potential will presumably generate rising inflationary pressure. With our present assessment of economic activity – an average growth rate in the coming years of over 3 per cent – it is thus natural to count on further interest rate increases.’

‘In the work on our next Inflation Report there are, as I see it, two matters that should be highlighted. One has to do with just the conjunctural aspect of activity. Could activity next year be stronger than this year, or weaker? The other matter is the economy’s inflation propensity. The Riksbank must continue to study conceivable reasons why domestic inflation has become surprisingly low.’

Monetary policy’s rule of action

‘The Riksbank formulates monetary policy on the basis of a forecast of inflation one to two years ahead. If inflation, measured as the annual change in the CPI, is expected to exceed the 2 per cent target within this horizon, then the interest rate is normally raised and vice versa. That is the rule of action the Riksbank has followed in recent years. The rule has helped make monetary policy more transparent. It has also contributed to a more focused analysis and made our internal discussion more structured.’

‘The reason why the Riksbank chose this particular time horizon of one to two years is that it corresponds to the period when an interest rate adjustment is assumed to have its greatest effect. But as interest rate changes also affect inflation in both the shorter and the longer term, there may still be reasons for also considering inflation’s forecast path in the coming year as well as beyond the target horizon.’

‘The Executive Board has clarified that without relinquishing our intellectual framework, there may be reasons for departing from the rule of action under special circumstances. This applies if inflation is affected by transient factors or if the economy is hit by such sizeable shocks that bringing inflation back to the targeted rate inside the time horizon might be hazardous. We have underscored, however, that we shall motivate deviations of this type.’

‘During the summer the market has discussed the Board’s meeting in June. The decision at that time was complicated in that the forecast indicated that inflation would not reach the targeted rate until right at the end of the time horizon, while there was a risk that it might accelerate after that. This was because a number of the factors – for example the introduction of the maximum day nursery charge – that were judged to hold inflation back in the coming two years could then be expected to stop acting. Apart from this, there were fears that separate bubble effects could arise in asset markets; although this risk was assumed to be slight, its effects on the economy might be serious in the longer run.’

‘Monetary policy decisions entail striking a balance between a variety of risks. An interest rate increase in June would have meant that we somewhat stretched the rule of action. The policy might then have been perceived as unclear and the question would have been raised as to whether the Riksbank really does act symmetrically. I therefore finally decided that the arguments for an increase did not quite hold and that there were grounds for waiting.’