Monetary policy

Stefan Ingves

Monetary policy

implementation with inflation target

The world’s oldest central bank

1668Sveriges Rikes

StändersBank

1661Palmstruch -

first banknotes

1701The Riksbank

issues “transport” notes

1830sCommercial banks

are established

1904Monopoly onissuance of banknotes

1866Sveriges Riksbank

1999New legislation

makes bank independent

An authority under the Riksdag

The Riksdag

The Government Sveriges Riksbank

The Ministry of Finance

The Swedish National Debt Office

Finansinspektionen (theSwedish Financial

Supervisory Authority)

Economic policy

Economic policy

Fiscal policy Monetary policy

The Riksdag and the Government The Riksbank

The Riksbank’s governing

The Riksdag

General Council11 members

Executive Board6 members

The executive board of the Riksbank

Stefan Ingves Karolina Ekholm

Barbro Wickman-Parak

Lars Nyberg Lars E.O. Svensson

Svante Öberg

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 meanAnnual percentage change

Sources: Statistics Sweden and the Riksbank

-2

0

2

4

6

8

10

12

14

16

18

71 73 75 77 79 81 83 85 87 89 91 93 95 97 99 01 03 05 07 09-2

0

2

4

6

8

10

12

14

16

18

CPI-inflation

Historical mean

1971-1992Mean 8,3%Standard deviation 3,0%

1993-2009 MarchMean 1,6%Standard deviation 1,4%

Different monetary policy regimes

Source: The Riksbank

0

5

10

15

20

25

30

89 91 93 95 97 99 01 03 05 07 0990

100

110

120

130

140

150

Short term interst rate, 3-monthTreasury Bill (left scale)

SEK measures as TCW (right scale)

Inflation targetFixed exchange rate

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

An independent Riksbank

Up to 1999: Conducted monetary and exchange rate policy.

General Council 4 years

Riksbank Governor 5 years

After 1999: Price stability

General Council 4 years

Executive Board 6 years

The Riksbank’s organisation

Executive Board

Administration Department

IT Department

Internal Audit Department

General Secretariat

Monetary Policy

Department

Market Operations Department

Financial Stability

Department

InternationalSecretariat

Research

Monetary policy theoryWhy a price stability target? Monetary policy can not affect employment in

the long run

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

Sources: Statistics Sweden and Prospera Research AB

-2

-1

0

1

2

3

4

5

94 96 98 00 02 04 06 08 10 12

-2

-1

0

1

2

3

4

5Inflation expectations

CPIJan -95

Nov -05Feb -98

Feb-97

Feb -96

Nov -06

Jan -08

Oct -07

Apr-08

Oct-08Jun-08

Jan-09

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

Repo rate with uncertainty bands

Per cent, quarterly averages

Sources: The RiksbankNote. Broken lines represent the Riksbank’s forecast.

0

1

2

3

4

5

6

04 05 06 07 08 09 10 11 12

0

1

2

3

4

5

690%75%50%Repo rate

CPI with uncertainty bandsAnnual percentage change

Source: Statistics Sweden and the RiksbankNote: Broken line is the Riksbank’s forecast

-3

-2

-1

0

1

2

3

4

5

6

04 05 06 07 08 09 10 11 12

-3

-2

-1

0

1

2

3

4

5

690%75%50%CPI

GDP with uncertainty bandsAnnual percentage change, seasonally-

adjusted data

Sources: Statistics Sweden and the RiksbankNote. Broken lines represent the Riksbank’s forecast.

-8

-6

-4

-2

0

2

4

6

04 05 06 07 08 09 10 11 12

-8

-6

-4

-2

0

2

4

6

90%75%50%GDP

20

Optimal monetary policy Within a theoretical framework:

Minimize quadratic forecast loss function

=

, mean inflation forecast at t for period

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

* 2 2, , ,0 0

( ) ( )t t t t t ty y

, ,t t t ty y

ttt ,

tL

21

2, ,0

( )t t t ty y

* 2,0

( )t t

B

C

A

0

E

D

Modified Taylor curves (ex-ante) and optimal monetary

policy choice

Estimated inflation and GDP gap

Percentage deviation from the target and HP trend

Sources: Statistics Sweden and the RiksbankNote. Broken lines represent the Riksbank’s forecast.

-5

-4

-3

-2

-1

0

1

2

3

4

5

00 01 02 03 04 05 06 07 08 09 10 11 12 13

-5

-4

-3

-2

-1

0

1

2

3

4

5

Inflation gap (CPI)

GDP gap

23

Production as a Cobb-Douglas function

and

A = Technology, K = Capital , H = Hours worked,

= average hours per worker L = Labour and α = constant

1)(ttttLHKAY

1

ttttHKAY

ttLHH

H

11

ttt

ttLKHAY

Estimated gapsPercentage deviation from the HP trend

Sources: Statistics Sweden and the RiksbankNote. Broken lines represent the Riksbank’s forecast.

-5

-4

-3

-2

-1

0

1

2

3

4

5

6

80 85 90 95 00 05 10

-5

-4

-3

-2

-1

0

1

2

3

4

5

6GDP

Hours worked

Employment

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

Source: The Riksbank

0,0

0,5

1,0

1,5

2,0

2,5

3,0

3,5

4,0

4,5

5,0

97 98 99 00 01 02 03 04 05 06 07 08 090,0

0,5

1,0

1,5

2,0

2,5

3,0

3,5

4,0

4,5

5,0

Repo rate

3 month treasury bill

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

Policy rates & deposit ratesPer cent

Source: The Riksbank

0

2

4

6

8

10

96 97 98 99 00 01 02 03 04 05 06 07 08 09

0

2

4

6

8

10Deposit rateLending rateLending overnightRepo rate

The overnight marketIn both examples Bank A and B have two possibilities. 1) They can use the overnight market or2) They can use the standing facilities offered by the Riksbank

Bank A+ 50

Bank B- 50

The Riksbank

1.25

2.75

O/n interest rate

The position of the banking system0

Example 1

Bank A-+100

Bank B- 50

Example 2

The Riksbank

1.25

2.75

O/n interest rate

The position of the banking system0

The overnight market – MPU April-09

In both examples Bank A and B have two possibilities. 1) They can use the overnight market or2) They can use the standing facilities offered by the Riksbank

Bank A+ 50

Bank B- 50

The Riksbank

0.00

0.50

O/n interest rate

The position of the banking system0

Example 1

Bank A-+100

Bank B- 50

Example 2

The Riksbank

0.00

0.50

O/n interest rate

The position of the banking system0

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 REPOcertificate at 9.30 a.m.

The Riksbank buys The banks tender securities and their bids at 9.45 a.m. transfers funds to the The Riksbank sells at the latest banks (the banks securities and

borrow from the receives the funds The Riksbank Riksbank) plus interest (the announces the allot- banks pay back theirment at 10.00 a.m. loans)

Monday Tuesday Wednesday Thursday Friday Saturday Sunday Monday Tuesday Wednesday

CERTIFICATES The certificates The Riksbank issues mature (the Riksbank certificates (the pays back the loan Riksbank borrows plus interest)from the banks)

The Riksbank steering of the O/N Rate

The position of the banking system, i.e the need for the banks to deposit

at or borrow from the Riksbank

Over Night Interest Rate, %

0Liquidity surplus Liquidity deficit

Repo Rate (2.00) and O/N Rate are within the corridor

Deposit Facility (Floor)

Lending Facility (ceiling)(2.75%)

(1.25%)

Fine tuning Operations +/- 10 bp

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

The position of the banking system, i.e the need for the banks to deposit

at or borrow from the Riksbank

Over Night Interest Rate, %

0Liquidity surplus Liquidity deficit

Repo Rate (0.50) and O/N Rate are within the corridor

Deposit Facility (Floor)

Lending Facility (ceiling)(0.50%)

(0.00%)

Fine tuning Operations +/- 10 bp

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

0,5

1,0

1,5

2,0

2,5

3,0

3,5

repo 3 mån 6 mån 12 mån 2 år 3 år 5 år 7 år 9 år 10 år0,5

1,0

1,5

2,0

2,5

3,0

3,5

Before Monetary policy meeting

After Monetary policy meeting

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 SEKBank C bids 2 billion SEKTotal 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 3.00 %

ACCEPTED VOLUME 4.0 billion

PERCENTAGE ALLOTTED 57.1400 %

DEPOSIT RATE 2.25 %

LENDING RATE 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 GDPPer cent

Source: The IMF

-10

-8

-6

-4

-2

0

2

4

6

8

10

12

95 98 01 04 07

-10

-8

-6

-4

-2

0

2

4

6

8

10

12China

Sweden

USA

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 USAbasis points

0

200

400

600

800

1000

1200

1400

1600

1800

2000

2200

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

AaaBaaHigh-yield

*)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

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

Financial stability

Policy rate etc.

”Moral suasion”Inject liquidityetc.

Monetary policy and financial stability are interlinked:

,...ttlendingt cmii

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 policyA stylised balance sheet for a central bank

Assets Liabilities

Foreign assets Banknotes and coins

Domestic assets Bank deposits

Lending Equity

Central banks’ balance sheetsPercentage of GDP

Sources: Bureau of Economic Analysis, Eurostat, Office for National Statistics, Statistics Sweden and the respective central banks

0

5

10

15

20

25

jan-07 apr-07 jul-07 okt-07 jan-08 apr-08 jul-08 okt-08 jan-09

0

5

10

15

20

25ECB

BOE

Federal Reserve

The Riksbank

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

Assets Liabilities

Gold 26 Banknotes & coins

108

Foreign currency reserve

158

Fine-tuning 0

Lending USD 0 Riksbank Certificates

0

Lending SEK 4 Liabilities to Fed 0

Other 4 Equity 59

Other 25

TOTAL 192

TOTAL 192

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

Assets Liabilities

Gold 30 Banknotes & coins

112

Foreign currency reserve

200 Fine-tuning 207

Lending USD 196 Riksbank Certificates

49

Lending SEK 262 Liabilities to Fed 189

Other 7 Equity 59

Other 84

TOTAL 700 TOTAL 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 baseSEK billion

Source: The Riksbank

0

50 000

100 000

150 000

200 000

250 000

300 000

350 000

400 000

jan-08 apr-08 jul-08 okt-08 jan-09

0

50 000

100 000

150 000

200 000

250 000

300 000

350 000

400 000The banks' holdings of Riksbank certificates

The banks' deposit at the Riksbank

Banknotes and coins in circulations

Credit easingFederal 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 easingBank 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:

YPVM

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

YYri tYtttt **

A ”Taylor rule” for capital adequacy

YYLLcc tYtLt *

The link between monetary policy and financial stability

,...ttlendingt cmii

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!