Villy Bergström: Monetary policy in an uncertain world Speech by Mr Villy Bergström, Deputy Governor of the Sveriges Riksbank, to the Sparbanksstiftelsen Nya, held at the Gävle concert hall, 14 May 2001. *  *  *  Following several years of very strong GDP growth, we are now seeing a slowing down in the Swedish economy. It is necessary for the growth rate to slow down over the next few years to avoid a long-term threat to price stability. While there was a plentiful supply of free resources, GDP could grow more quickly than the long-term productivity growth and labour force supply allowed. Now, however, the resources are running out and production needs to be adapted to a slower rate that is more sustainable in the long term. When the Riksbank raised its repo rate by 25 points to 4 per cent in December last year, the decision was based on assessments that demand would continue to increase to such an extent that the shortage of resources would lead to the inflation target being exceeded. The interest rate was raised despite the fact that the inflation rate was then only 1.4 per cent. This shows the pedagogical and practical problems the Riksbank faces when making such decisions. Monetary policy decisions are based on assessments of the inflation rate a couple of years ahead and are aimed at achieving the inflation target in this time horizon.
In addition, the target that has been used to guide monetary policy has rarely been able to signal early enough that imbalances were being built up, regardless of whether monetary policy was aimed at a fixed exchange rate or towards a price stability target. To simplify, one can say that the result of an exaggerated optimism in countries with a fixed exchange rate has been that the build-up of financial imbalances was expressed in rising inflation without any depreciation pressure on the currency. It has not been possible to subdue inflationary pressure through raising interest rates while optimism regarding the country's economy and confidence in the fixed exchange rate regime have remained, as a more stringent monetary policy would have reinforced the nominal exchange rate. At the same time, increases in consumer prices have been kept down by the strong currency, temporary increases in productivity, or by demand being aimed towards, property, shares and land – assets whose prices are not included in the central bank's target function. There has thus been no reason for monetary policy to counteract the emergence of financial imbalances. When the financial bubble has actually burst, the country has often suffered a deep and long-lasting recession caused by adaptations to the imbalances that have been built up. A high level of indebtedness, falling asset prices and unprofitable investments have subdued demand for a long period of time. Households have chosen to increase their savings to reduce their debts.