Bäckström: Currency interventions cannot be rouled out
Governor Urban Bäckström spoke about Sweden's economy at a dinner in Stockholm arranged by Inter-Alpha's Steering Committee, a forum for discussions comprising a number of international banks. The following is an extract from his speech.
"In the Riksbank's latest Inflation Report, presented on 31 May, the main scenario points to inflation one to two years ahead being approximately in line with the targeted rate of 2 per cent. At the same time, we noted that both CPI and UND1X inflation have recently risen more than expected. The increase is explained above all by a number of transitory factors that are calculated to affect inflation for just a limited period and then drop out next year. Consequently they do not affect the forecast development of inflation one to two years ahead.
"The composite picture of inflation expectations among economic agents points to inflation remaining around the target in the longer run. That witnesses to strong confidence in the Riksbank and the inflation target. We intend to take good care of that confidence.
"The spectrum of risks that was presented in the Inflation Report was considered to be more or less balanced; that is, the risks of lower and higher inflation, respectively, weigh the same. On the one hand there was the risk of international economic activity in general and in the United States in particular being weaker than foreseen, which would subdue inflation. On the other hand, there was the risk of inflation being driven upwards by a weaker exchange rate, as well as by rising domestic demand and a less favourable relationship between inflation and growth.
"Additional information has become available since we presented the Inflation Report. The uncertainty about the American economy is still there. In the financial markets, however, there is an increasingly clear view that the slowdown will not be particularly deep and that potential growth in the United States is still good. Thus, American stock markets have turned upwards during the spring, bond rates have risen and the dollar has appreciated markedly against most other currencies.
"The strength of the dollar partly explains the weakening of the Swedish krona in recent months. But it is not the sole explanation; the krona has depreciated more against the dollar than many other currencies, including the euro. This has happened even though the situation in the Swedish economy is good, with a stronger potential output than before, sound government finances, a surplus on the current account and low inflation expectations. The Riksbank considers that in a fundamental perspective, today's weak exchange rate is not reasonable.
"The weak exchange rate at present is a deviation from the path in the main scenario that served as the basis for the latest Inflation Report. This means that if the krona remains weak for a longer period, there may be risk of inflation being higher one to two years from now. If there are grounds for believing that the krona will continue to be weak - and nothing else happens to alter inflation prospects - that will have consequences for monetary policy. This will apply in particular if the view that is emerging in a number of financial markets around the world is correct, that is, if the slowdown in the United States and the international downturn in general are comparatively mild.
"In a regime that explicitly targets inflation, the formation of monetary policy is determined above all by inflation prospects. But that does not mean that the value of the krona is irrelevant. On the contrary, the exchange rate is an important factor in the assessment of inflation prospects.
"As the Riksbank has pointed out on a number of occasions, in recent years a weak exchange rate's impact on import prices seems to have diminished. There are limits, however, to the extent to which the krona can deviate from the initial values on which the Inflation Report is based without this calling for measures of monetary policy. Permanently large deviations could ultimately threaten price stability both through direct effects on import prices and via an increased demand for real exports that, with high resource utilisation, could lead to an increase in the rate of inflation. That, of course, must not be allowed to happen. Additionally, there is a risk of an increase in inflation expectations, as a consequence of a weak exchange rate, which cannot be tolerated.
"Currency market interventions are one of the instruments at the disposal of a central bank. For a central bank that targets inflation, the primary instrument is, however, the interest rate. But at a time when the exchange rate is a serious upside risk in the inflation forecast and deviates markedly from a reasonable value, a situation may arise where currency market interventions are motivated as an additional element in the work of continuously ensuring price stability," Mr. Bäckström concluded.
