Rosenberg: Monetary policy and energy prices

Irma Rosenberg gave a speech on Monday as part of the "Sydsvenska utbildningsdagarna" training days. One of the questions taken up by Mrs Rosenberg was how energy price fluctuations and other transient changes in the inflation rate affect the monetary policy stance.

"Just over one week ago the Riksbank published its third Inflation Report for the year. As in the two earlier reports, the outlook for inflation in the coming years is strongly affected by the substantial fluctuations in electricity and oil prices. If an adjustment is made for energy prices, inflation is expected to develop in line with the Riksbank's target a couple of years ahead. The Riksbank therefore decided to leave its key interest rate unchanged. Since the Inflation Report was published there has been some criticism of the Riksbank's monetary policy, with claims that it has become less clear and more difficult to interpret. There has in particular been discussion of which measure of inflation should be used as a base for monetary policy," said Irma Rosenberg.

 

"Let me begin by saying that the Riksbank's target is that CPI inflation shall be 2 per cent a year. Adjustments to the repo rate have their main effect on inflation via demand 1-2 years ahead. Monetary policy is therefore normally aimed at attaining the inflation target in this time horizon. However, there can be reasons for deviating from this simple rule and these were described in detail in a clarification in 1999 published by the Executive Board (1). One reason may be that CPI inflation is affected by shocks that are not anticipated to have lasting effects. However, when this is the case the Riksbank shall clearly state at the time of its monetary policy decision how inflation is expected to deviate from the target," said Mrs Rosenberg.

"Energy price fluctuations have now brought up the question of which inflation measure provides the best guidance regarding developments in the underlying inflation rate related to cyclical activity. Those who follow our activities and read our Inflation Reports should not find the Riksbank's reasoning on inflation measures surprising. Our Inflation Reports have contained discussions on several occasions regarding transient price effects and the need to identify the underlying inflationary trend more closely related to cyclical activity. These discussions have concerned, for instance, the introduction of maximum fees in the childcare system in spring 2000 and changes in property taxes, as well as oil price developments, in autumn of the same year. More recently the discussions have mainly concerned mad cow disease and foot-and-mouth disease and, most recently, electricity price fluctuations. Many of you may also remember that mortgage interest expenditure for households fell heavily and pushed down CPI inflation when the Riksbank cut the repo rate during the late 1990s. At that point the inflation measure UND1X (2) was emphasised, as this excludes such expenditure. You can read more about this in the box on targets and indicators in the most recent Inflation Report," said Mrs Rosenberg.
 
"Essentially, the reasoning is fairly self-evident. All central banks with the task of safeguarding price stability must make thorough analyses of the reasons for prices developing as they do and examine each individual situation. It's part of the job. A mechanical reaction to every event regarding a given measure of inflation would lead to substantial costs for the economy in that this would cause much greater fluctuations in both interest rates and consequently GDP growth and employment than is the present case. It is easy to understand that, for instance, a rise in inflation stemming from an unsustainably high rate of wage increase has a completely different significance for monetary policy than a rise due to a supply shock, such as hydroelectric power stations temporarily suffering water shortages in their reservoirs as a result of a hot, dry summer," pointed out Mrs Rosenberg.

"At the previous monetary policy meeting the Riksbank chose to base its decision on inflation measured by UND1X adjusted for energy prices. This does not mean that it will automatically be the measure that best captures demand-driven underlying inflation in future. The fact that the Riksbank from time to time must make an assessment of whether temporary price effects exist could mean that interest rate adjustments will be slightly more difficult to predict than if we mechanically followed one and the same measure. However, the macro economic outcome of the interest rate decisions will hopefully be better," said Mrs Rosenberg.

"Let me conclude by saying that since the changeover in policy at the beginning of the 1990s, it has not always been possible to conduct such a flexible policy, as it could have put our credibility at risk. It took time to erase the effects of the high-inflation economy and the poorly-managed stabilisation policy. During the period when our credibility had not yet been consolidated, it was also necessary to formally tie monetary policy to certain very simple principles. It was a question of making clear in every possible manner that we were serious about safeguarding price stability.  The fact that our credibility has now been established and we therefore have the possibility of conducting a more flexible policy is a strength of our monetary policy regime and something we should be pleased about," concluded Mrs Rosenberg.