Monetary policy

Stefan Ingves

Monetary policy implementation with inflation target

The world’s oldest central bank

1668

Sveriges Rikes Ständers Bank

1830s

Commercial banks are established

1904

Monopoly on issuance of banknotes

1661

Palmstruch first banknotes

1701

The Riksbank issues “transport” notes

1866

Sveriges Riksbank

1999

New legislation makes bank independent

An authority under the Riksdag

The Government The Ministry of Finance The Swedish National Debt Office The Riksdag

Sveriges Riksbank

Finansinspektionen (the Swedish Financial Supervisory Authority)

Economic policy

Fiscal policy Economic policy Monetary policy The Riksdag and the Government The Riksbank

The Riksbank’s governing

The Riksdag General Council 11 members Executive Board 6 members

The executive board of the Riksbank

Stefan Ingves Svante Öberg Karolina Ekholm Lars Nyberg Lars E.O. Svensson Barbro Wickman-Parak



The Riksbank’s tasks

To safeguard the value of money (=price stability) - Oversee and analyse monetary stability - Conduct monetary and exchange rate policy measures - Manage the foreign exchange reserve  To promote a safe and efficient payment system - Oversee and analyse stability in the payment system - Responsibility for the RIX system - Ensure the supply of banknotes and coins

CPI-inflation and historical mean Annual percentage change 18 16 14 12 10 CPI-inflation Historical mean 4 2 8 6 1971-1992 M ean 8,3% Standard deviation 3,0% 1993-2009 M arch M ean 1,6% Standard deviation 1,4% 0 0 -2 71 73 75 77 79 81 83 85 87 89 91 93 95 97 99 01 03 05 07 09 -2 4 2 8 6 18 16 14 12 10 Sources: Statistics Sweden and the Riksbank

Different monetary policy regimes 15 10 5 30

Fixed exchange rate

25 20

Inflation target

Short term interst rate, 3-month Treasury Bill (left scale) SEK measures as TCW (right scale) 120 110 100 150 140 130 0 89 91 93 95 97 99 01 03 05 07 09 90

Note. The vertical line marks the date for the shift in monetary policy regime, 19 nov 1992.

Source: The Riksbank



An independent Riksbank

Up to 1999: Conducted monetary and exchange rate policy.

 After 1999: Price stability General Council 4 years General Council 4 years Riksbank Governor 5 years Executive Board 6 years

The Riksbank’s organisation

Executive Board

Internal Audit Department General Secretariat

International Secretariat

Administration Department

Financial Stability Department Market Operations Department Monetary Policy Department Research

IT Department



Monetary policy theory Why a price stability target?

Monetary policy can

not

run affect employment in the long  Establishing inflation expectations  High and fluctuating inflation increases uncertainty and affects investment  Costly to hold back inflation  High inflation leads to redistribution of income and wealth  One instrument – one target

Inflation expectations by money market agents Per cent 5 4 3 2 1 0 -1 -2 94 Jan -95 Feb-97 Inflation expectations CPI Jun-08 Feb -96 Apr-08 Jan -08 Oct -07 Feb -98 Nov -05 Nov -06 Oct-08 Jan-09 96 98 00 02 04 06 08 10 12 5 4 3 2 1 0 -1 -2 Sources: Statistics Sweden and Prospera Research AB

Why one to two years ahead?

 Uncertainty over the transmission mechanism  Reduce fluctuations in the real economy

Forecasts

 6 monetary policy meetings per year (2008) 3 Monetary Policy Reports 3 updated assessments 2 public hearings before the Riksdag Committee on Finance

2 1 0 04 3 4 5 6 Repo rate with uncertainty bands Per cent, quarterly averages 90% 75% 50% Repo rate 05 06 07 08 09 10 11 12

Note. Broken lines represent the Riksbank’s forecast.

Sources: The Riksbank 6 2 1 0 5 4 3

CPI with uncertainty bands Annual percentage change 6 5 2 1 4 3 0 -1 -2 -3 04 90% 75% 50% CPI 05 06 07 08

Note: Broken line is the Riksbank’s forecast

09 10 11 12 Source: Statistics Sweden and the Riksbank 6 5 0 -1 -2 -3 2 1 4 3

4 2 0 -2 -4 -6 -8 04 GDP with uncertainty bands Annual percentage change, seasonally-adjusted data 6 6 90% 75% 50% GDP 05 06 07 08 09 10 11 12 4 2 0 -2 -4 -6 -8

Note. Broken lines represent the Riksbank’s forecast.

Sources: Statistics Sweden and the Riksbank

Optimal monetary policy

 Within a theoretical framework: Minimize quadratic forecast loss function

L t

=     0 ( 

t

  ,

t

        0 (

y t

  ,

t



y t

  ,

t

) 2 

t

  ,

t

, mean inflation forecast at t for period

t

 

y t

  ,

t



y t

  ,

t

mean output gap forecast,  constant relative weight on output-gap stabilization 20

Modified Taylor curves (ex-ante) and optimal monetary policy choice

    0 (

y t

  ,

t



y t

  ,

t

) 2 D A B C E 0     0 ( 

t

  ,

t

  * 2 ) 21

Estimated inflation and GDP gap Percentage deviation from the target and HP trend 5 4 3 0 -1 2 1 -2 -3 -4 -5 00 01 Inflation gap (CPI) GDP gap 02 03 04 05 06 07 08 09 10 11 12 -2 -3 -4 13 -5 2 1 0 -1 5 4 3

Note. Broken lines represent the Riksbank’s forecast.

Sources: Statistics Sweden and the Riksbank

Production as a Cobb-Douglas function

Y t



A t K t



H t

1   and

H t

 

H L t A



H

= Technology,

K

= Capital ,

H

= average hours per worker = Hours worked,

L

= Labour and α = constant

Y t Y t

 

A t K t

  (

H A t



H t

1  

K t



L t

) 1  

L t

1   23

Estimated gaps Percentage deviation from the HP trend -1 -2 -3 -4 -5 80 6 5 4 1 0 3 2 GDP Hours worked Employment 85 90 95 00 05 10

Note. Broken lines represent the Riksbank’s forecast.

Sources: Statistics Sweden and the Riksbank 6 5 4 3 2 -3 -4 -5 1 0 -1 -2

Signalling – influencing expectations

 Monetary Policy Reports  Policy rates and policy rate forecasts  Minutes of monetary policy meetings  Speeches – clearifying standpoints afterwards, signalling in advance just in exceptional cases

Signalling - Policy rate and 3 month treasury bills Procent 5,0 4,5 4,0 3,5 3,0 2,5 2,0 1,5 1,0 0,5 0,0 97 98 99 Repo rate 3 month treasury bill 00 01 02 03 04 05 06 07 08 09 5,0 4,5 4,0 3,5 3,0 2,5 2,0 1,5 1,0 0,5 0,0 Source: The Riksbank

Summary

     The Riksbank is an authority under the Riksdag Reasonably low inflation is beneficial (target of 2% +-1%) Repo rate change achieves full impact after 1-2 years Independent from 1999 Openness => a tool that creates legitimacy

Monetary policy implementation

Monetary policy repo

      Repos are implemented weekly  Term of one week Liquidity forecast in the morning Repo announcement on Tuesdays 09.30-09.45

Allocation at 10.00

Liquidity flow on Wednesday  lending/delivery of collateral Daily fine-tuning operations at 16.20-16.40

10 8 6 Policy rates & deposit rates Per cent Deposit rate Lending rate Lending overnight Repo rate 10 8 6 4 4 2 2 0 96 97 98 99 00 01 02 03 04 05 06 07 08 09 0 Source: The Riksbank

The overnight market

In both examples Bank A and B have two possibilities. 1) They can use the overnight market or 2) They can use the standing facilities offered by the Riksbank Example 1 Bank A + 50 Bank B - 50 1.25

The Riksbank O/n interest rate 2.75

The position of the banking system 0 Example 2 Bank A -+100 Bank B - 50 1.25

The Riksbank O/n interest rate 0 2.75

The position of the banking system

The overnight market – MPU April-09

In both examples Bank A and B have two possibilities. 1) They can use the overnight market or 2) They can use the standing facilities offered by the Riksbank Example 1 Bank A + 50 Bank B - 50 0.00

The Riksbank O/n interest rate 0.50

The position of the banking system 0 Example 2 Bank A -+100 Bank B - 50 0.00

The Riksbank O/n interest rate 0 0.50

The position of the banking system

Carrying out the main refinancing operation

 Calculating the net position of the banking system  Banknotes and coins in circulation        +Deposit facility +Other liabilities +Capital ./.Gold and foreign exchange reserve ./.Marginal lending facility ./.Other assets =Net position of the banking system, i.e. the level of the repooperation or issuing of certificates

Schedule for the main refinancing operation

The Riksbank announces a monetary policy repo or certificate at 9.30 a.m.

The banks tender their bids at 9.45 a.m.

at the latest The Riksbank announces the allot ment at 10.00 a.m. REPO The Riksbank buys securities and transfers funds to the banks (the banks borrow from the Riksbank) The Riksbank sells securities and receives the funds plus interest (the banks pay back their loans) Monday Tuesday Wednesday Thursday Friday Saturday Sunday Monday Tuesday Wednesday CERTIFICATES The Riksbank issues certificates (the Riksbank borrows from the banks) The certificates mature (the Riksbank pays back the loan plus interest)

The Riksbank steering of the O/N Rate

Over Night Interest Rate, % Lending Facility (ceiling) (2.75%) Fine tuning Operations +/- 10 bp (1.25%) Deposit Facility (Floor) Repo Rate (2.00) and O/N Rate are within the corridor Liquidity surplus 0 Liquidity deficit The position of the banking system, i.e the need for the banks to deposit at or borrow from the Riksbank The Riksbank is carrying out a repo transaction and the liquidity need of the banking system is placed close to zero

The Riksbank steering of the O/N Rate – MPU April-09

Over Night Interest Rate, % Lending Facility (ceiling) (0.50%) Fine tuning Operations +/- 10 bp (0.00%) Deposit Facility (Floor) Repo Rate (0.50) and O/N Rate are within the corridor Liquidity surplus 0 Liquidity deficit The position of the banking system, i.e the need for the banks to deposit at or borrow from the Riksbank The Riksbank is carrying out a repo transaction and the liquidity need of the banking system is placed close to zero

Changes in the yield curve when the policy rate is altered 3,5 3,5 Before M onetary policy meeting After M onetary policy meeting 3,0 3,0 2,5 2,5 2,0 1,5 1,0 2,0 1,5 1,0 0,5 repo 3 mån 6 mån 12 mån 2 år 3 år 5 år 7 år 9 år 10 år 0,5

To sum up

  The banking system has always the possibility to deposit or borrow over night at predefined interest rates, thus the overnight interest rate will be between these two interest rates.

In order to stabilise the short term interest rate we carry out different monetary policy operations, above all a weekly repo operation and daily fine tuning.

Monetary Policy Repo

     Weekly Repo transaction  One week maturity Liquidity forecast in the morning Repo announcement / bids on Tuesdays between 9.30-9.45

Allotment at 10.00

Settlement on Wednesday  Loan/delivery of securities

Example : Repo operation (cont)

Terms and conditions published on Reuters, tuesdays at 09.30

REPO 070214-070221 FIXED REPO RATE 3.00 %.

ON FEBRUARY 14 2007, THE RIKSBANK SHALL PURCHASE GOVERNMENT SECURITIES AND OTHER VALID SECURITIES FOR RESALE ON FEBRUARY 21 2007. ALL MONETARY POLICY COUNTERPARTIES ARE INVITED TO SUBMIT BIDS TO THE RIKSBANK (08-6966970) BY 9.45 AM ON FEBRUARY 13 2007, AT THE LATEST. THE LOWEST ACCEPTED VOLUME IS SEK 200 MLN. THE HIGHEST ACCEPTED VOLUME IS SEK 5 BLN.

Example: Repo operation

  Bidding takes place between 09.30-09.45

Bank A bids 3 billion SEK Bank B bids 2 billion SEK Bank C bids 2 billion SEK

Total bids = 7 billion SEK

  Riksbank has forecasted the aggregated liquidity deficit of the banking system to 4 billion SEK on average during the repo period.

The allotment will therefore be 4 billion/7 billion = 0,5714 = 57,14 per cent

Example : Repo operation (cont)

   Bank A receives 57,14 % of bidding volume.

0,5714 x 3 billion = 1 714 billion SEK Bank B receives 57,14 % of bidding volume.

0,5714 x 2 billion = 1 143 billion SEK Bank C receives 57,14 % of bidding volume.

0,5714 x 2 billion = 1 143 billion SEK

Total amount allocated: 1 714 + 1 143 + 1 143 = 4 000 SEK billion

Example : Repo operation (cont)

Result of repo operation published on Reuters at 10.00

RESULT OF FIXED REPO 070207-070214 FIXED REPO RATE ACCEPTED VOLUME PERCENTAGE ALLOTTED DEPOSIT RATE LENDING RATE 3.00 % 4.0 billion 57.1400 % 2.25 % 3.75 %

The monetary policy landscape in a financial crisis

   The

macroeconomic

landscape The

financial

landscape

Regulatory

landscape

  The inflation target Stability in the payment system

Background to the crisis: The

macroeconomic

landscape

  Global imbalances built up over a longer period of time   Large current account surplus in the east Large current account deficit in the west Large capital flows and expansionary monetary policy pushed down interest rates

Current account as share of GDP

Per cent 12 10 8 6 4 2 0 -2 -4 -6 -8 -10 95 China Sweden USA 98 01 04 -2 -4 -6 -8 07 -10 4 2 0 8 6 12 10 Source: The IMF

Background to the crisis: The

financial

landscape

   Low interest rates led to hunt for investment with higher return    Increased indebtedness Sharp increase in asset prices Extremely low risk premiums Securitisation and many new instruments Special companies off the banks’ balance sheets  Implicit and explicit guarantees led risks back into the banks

Credit spreads* for corporate bonds in the USA basis points 2200 2000 1800 1600 1400 1200 1000 800 600 400 200 0 2000

Aaa Baa High-yield

2001 2002 2003 2004 2005 2006 2007 2008 2009

*)Difference between corporate bond rate and government bond rate, source Reuters EcoWin

Background to the crisis: The

financial

landscape (cont.)

     A complicated structure that was difficult to gain insight into Much uncertainty over where risks lay Fears caused trade to fade away on many markets Many banks experienced difficulty refinancing themselves When Lehman Brothers fell Swedish banks were also indirectly drawn into the crisis

Background to the crisis: The

financial

landscape (cont.)

  Fundamental failures in risk management   The banks’ incentives to monitor credit risks partly disappeared The credit rating agencies’ models were inadequate and credit ratings were used wrongly.

   Correlations were underestimated Liquidity risks were underestimated Risks were priced incorrectly Fundamental flaws in corporate governance

Background to the crisis: the

Regulatory landscape

    Gaps in the regulatory framework enabled regulation arbitrage    Investment banks OTC derivatives Banks could expand off balance sheet Too little focus on liquidity risks Insufficient links between supervision and macro factors and systemic risk factors respectively Too strong national focus in financial supervision

Massive and unusual measures by authorities

      Large increase in lending by central banks  Longer maturities, different collateral Special liquidity assistance to individual institutions Agreements on currency loans between countries Extended deposit guarantee Programme for guarantees and capital injections Large policy rate cuts

How monetary policy normally functions

 The transmission mechanism

The transmission mechanism

    Interest rate channel Credit channel Exchange rate channel Inflation expectations  Financial markets are not functioning normally => transmission mechanism becomes less effectives



Monetary policy and financial stability

The Riksbank has two main tasks:

Monetary policy

and

financial stability

Monetary policy Financial stability  Policy rate  etc.

  ”Moral suasion” Inject liquidity  etc.

 Normally separate tools are used for these tasks  During the crisis it has become increasingly clear how closely interwoven the two tasks are.

Monetary policy and financial stability are interlinked:

i t lending



i t



m



c t

,...



Monetary policy in a financial crisis

   Interest rates close to zero in many countries When the traditional monetary policy tools are no longer effective it is necessary to find new ways ”Unconventional methods”   Different ways of making the financial markets function better Improve the supply of credit

Unconventional monetary policy

A stylised balance sheet for a central bank

Assets

Foreign assets Domestic assets Lending

Liabilities

Banknotes and coins Bank deposits Equity

Central banks’ balance sheets

Percentage of GDP 25 ECB 25 BOE 20 20 Federal Reserve The Riksbank 15 15 10 5 10 5 0 jan-07 apr-07 jul-07 okt-07 jan-08 apr-08 jul-08 okt-08 jan-09 0 Sources: Bureau of Economic Analysis, Eurostat, Office for National Statistics, Statistics Sweden and the respective central banks

The Riksbank’s balance sheet on 30 June 2008 (prior to Lehman Brothers crash) Assets

Gold Foreign currency reserve Lending USD Lending SEK Other

TOTAL Liabilities

26 Banknotes & coins 158 Fine-tuning 0 Riksbank Certificates 4 Liabilities to Fed 4 Equity Other

192 TOTAL

108 0 0 0 59 25

192

The Riksbank’s balance sheet on 31 Dec 2008 (after Lehman Brothers crash) Assets

Gold Foreign currency reserve Lending USD

Liabilities

30 Banknotes & coins 200 Fine-tuning Lending SEK Other

TOTAL 196 262

Riksbank Certificates Liabilities to Fed 7 Equity Other

700 TOTAL

112

207 49 189

59 84

700

Monetary policy measures

   The banks’ access to means of payment is increasing The monetary base (the banks’ reserves + banknotes and coins in circulation) is increasing The Federal Reserve and the Bank of England have gone a step further than the RB and bought different types of domestic financial assets

Monetary base

SEK billion 400 000 350 000 300 000 250 000 200 000 150 000 100 000 50 000 0 jan-08 The banks' holdings of Riksbank certificates The banks' deposit at the Riksbank Banknotes and coins in circulations apr-08 jul-08 okt-08 400 000 350 000 300 000 250 000 200 000 150 000 100 000 50 000 0 jan-09 Source: The Riksbank

Credit easing

Federal Reserve:  Purchase of certain private financial assets   Aimed at   reducing risk spreads making it easier for companies and households to gain access to credit Focus on the asset side of the balance sheet

Quantitative easing

Bank of England:  Purchase of government securities   Focus on the liabilities side of the balance sheet Instead of

the price

, i.e. the policy rate, the

quantity

of the banks’ borrowing, the monetary base, is affected directly

Quantity equation:

M



V



P



Y

Unconventional measures

   Both Quantitative Easing and Credit Easing are only used under special circumstances The situation is new for most central banks It may be wise to exercise a good portion of humility with regard to what these measures entail

Are similar measures needed in Sweden?

    We do not know yet Inflation expectations and the credibility of the inflation target are crucial The Riksbank’s established monetary policy framework is a strength The Riksbank does what is necessary, when it is necessary

How do we prevent crises in the future?

By bursting bubbles with interest rate policy?

 Difficult and important question, but not easy to reach a general conclusion   In one way or another, substantial increases in asset prices will affect monetary policy in the future However, probably more important to have suitable rules and supervisory functions for financial companies

How do we prevent crises in the future?

Financial supervision functions?

National level:  Important to have coordination between the Riksbank and Finansinspektionen (Swedish financial supervisory authority) International level – de Larosiére group:   

European Systemic Risk Council (

27 central banks + ECB) monitoring systemic risks Supervisory committees in Europe strengthened A step in the right direction – and not a day too soon!

How do we prevent crises in the future?

A Taylor rule for capital adequacy?

Knut Wicksell (1898): 

i

 

The Taylor rule for monetary policy

i t

 

t



r t

*     

t

  *   

Y Y t

 

A ”Taylor rule” for capital adequacy

c t



c

 

L



L t



L

*   

Y



Y t



Y



The link between monetary policy and financial stability

i t lending



i t



m



c t

,...



Concluding reflections

    Financial crises are nothing new The scope and complexity of this crisis makes it more serious than previous crises Deglobalisation in the wake of the crisis is worrying We must find tools to attain a more balanced development in the future

How do we ensure that confidence is restored?

  The international banking system requires a purge    All problems must be brought to light Only when we see the scope of the losses can confidence be restored This is a more difficult process than during the Swedish bank crisis of the 1990s Meanwhile the Riksbank is prepared to do whatever is necessary!