Bäckström: Earlier assessments still largely apply

Governor Urban Bäckström spoke on Wednesday at a seminar in Halmstad on the topic of "Interest rate policy and economic developments". He talked about monetary policy in a historical perspective and commented on current economic developments and monetary policy.

"The timing of interest rate adjustments and also their pace almost always evokes a discussion, as is only natural and welcome. In the present context I want to consider some issues I believe should be borne in mind when discussing monetary policy. In an environment where people believe in the central bank's long-term commitment to the inflation target, along with such matters as inflationary impulses via import prices and the exchange rate it is to a large extent domestic resource utilisation that determines the prospects for inflation one to two years ahead and how the repo rate will move. If the economy is heating up or cooling down, the repo rate will normally by raised or lowered, respectively. How promptly or slowly the Riksbank needs to respond and the size of the adjustments are matters to decide from case to case. If, for example, resource utilisation and inflation are already high initially and activity is expected to turn upwards, a repo rate increase may be called for at an early stage. If there are plenty of unutilised resources and inflationary pressure is currently low, on the other hand, the central bank can wait somewhat longer," Mr Bäckström said.

"Our 2 per cent inflation target, introduced in 1993, gained increased credibility in the light of the tight monetary policy and the consolidation of the government finances in the mid 1990s. This meant that the inflation assessments and monetary policy could focus to a greater extent on resource utilisation. During the second half of the 1990s economic growth in Sweden was strong and employment rose by several hundred thousand persons without leading to an acceleration of price and wage increases. One explanation for this was the low initial level of resource utilisation after the crisis early in the decade. In this situation, monetary policy could be comparatively expansionary, with a low repo rate," he said.

"In the late 1990s and in 2000 it became increasingly evident that demand in the Swedish economy was rising too rapidly, so that the pace of growth needed to be adjusted to what the economy could manage in the longer run. When the global economy slowed at the end of 2000, the Riksbank did not lower its instrumental rate as much as other central banks. Due to the high level of activity in Sweden, the gap between the available production resources and the utilised amount had quickly closed. In that, as the Riksbank has pointed out in recent Inflation Reports, the underlying rate of price and wage increases is now somewhat too high; it now seems that resource utilisation may even have become too strained. There is nothing very dramatic about that but future growth at as rapid a rate as in the favourable years in the latter half of the 1990s does not now seem to be feasible without risking a development of prices and costs that is at odds with the inflation target. This is the relevant background - together with the international economic situation, which seems to have stabilised and even begun a cautious recovery - to the two repo rate increases totalling 0.5 percentage points that the Riksbank made this spring," Mr Bäckström continued.

"Turning to the current situation, as expected inflation has fallen back recently and there are grounds for believing in a further fall in the coming months. The economic slowdown in the past year has played a part here by leading to an increase in unutilised resources, and so have the signs that the transitory price effects we talked about last year are beginning to fade. But as the slowdown has been relatively moderate, resource utilisation has remained relatively high. As economic activity picks up in the coming years, there is reason to count on some gradual renewed increase in inflation unless something is done" he said.

"If the economic recovery continues as we expect in the forecast period and there is no reason to alter the assessment of inflation prospects, it is likely that repo rate increases may be needed. In my opinion, however, at present it is rather difficult to tell what will be a suitable pace. Particularly when the repo rate increase is taking into account, it seems today that on the whole, our assessment in the March Inflation Report still holds. As usual we must be alert to the course of developments. The situation can change quickly, particularly in the light of the economic upturn" Mr Bäckström concluded.