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1. To the Point
Discussion on the economy, by the Chief Economist November 2, 2010
Cecilia Hermansson
Group Chief Economist
Economic Research Department
+46-8-5859 1588
cecilia.hermansson@swedbank.se
No. 7
2010 11 02
Central banks face difficult choices
Sweden’s Riksbank has given up its zero interest rate policy. For major central
banks, it will take longer, even though this will increase the risk of future
imbalances.
Exit strategies have been put on hold. Instead more quantitative easing is
planned. The costs, however, would seem to exceed the benefits. Too much
responsibility is being placed on monetary policy to speed up the recovery.
Deflation fears are raising interest in price level targets as an alternative to
inflation targets. This could be a possibility for central banks that don’t already
have explicit inflation targets, but the question is whether the target can be
communicated to, and understood by, the public.
The financial crisis shows that central banks may have to lean against the wind
to fix bubbles in the credit and housing markets. In the complex monetary world
we live in, simple policy rules won’t work any longer.
Too early to relax
The Riksbank announced last week that it was raising its benchmark interest rate to
1%. On October 6, its last fixed rate loan expired. This means that monetary policy
will gradually normalise after the financial crisis. The key central banks (the Federal
Reserve in the US, the ECB in the euro zone, the Bank of England and the Bank of
Japan – G4) have reason to be envious of how much easier it is for the Riksbank to
climb itself out of the crisis. Raising interest rates from crisis levels is a sign of
strength. Of course, the G4 central banks are struggling with much bigger problems
than the Riksbank.
Among the difficult questions that need answers are: How long will policy interest
rates remain around zero and what would happen if they stay there too long? Is more
quantitative easing needed and what impact will it have on the economy, inflation
expectations and central banks’ independence? How are central banks influencing
global savings imbalances? What happens to monetary policy after the financial
crisis, i.e., which targets will best accommodate the risk of deflation, or at a later
stage high inflation? And is it time for new monetary targets that take into account the
credit expansion and asset prices? This “To the Point” discusses monetary targets, and
the advantages and disadvantages of quantitative easing. It also asks whether a major
paradigm shift is in order following the crisis now that economic policy has become
so complex from an international perspective. What have Western central banks
learned from the financial crisis and how will monetary policy change?
The G4 will maintain a zero interest rate policy
Thus far the central banks in smaller Western nations have been the only ones to raise
interest rates. This includes Australia and Norway (beginning in fall 2009) as well as
New Zealand, Canada and Sweden (beginning in summer 2010). Among emerging
economies, China and India have raised their rates. The common denominator among
these countries is that the financial crisis has eased faster and the economic outlook is
better than in the G4, where benchmark rates remain near zero. The lowest rate is in
Japan, which cut its benchmark rate from 0.1% to between 0 and 0.1% on October 5.
Here, the deflation problem is most visible. In the US, the benchmark rate remains
between zero and 0.25%. Deflation fears have increased, but for most of the members
of the Federal Open Market Committee (FOMC) deflation isn’t in their main
scenario. Kansas City Fed President Thomas Hoenig thinks it would be good to raise

2. To the Point (continued)
November 2, 2010
2
Chart 1: Policy Interest Rates in selected
countries (%)
Source: Reuters EcoWin
00 02 04 06 08 10
Procent
0
1
2
3
4
5
6
7
8
9
SwedenNorway
Euro Zone
UK
Japan
New Zealand
Australia
US
Canada
interest rates sooner than most other members of the FOMC. At the monetary
policy committee meeting of the Bank of England (BOE), one of the seven
members voted for a 0.25 bp hike in the benchmark rate, but the majority decided
to keep the rate at 0.5%. BOE Governor Mervin King noted that downward
pressure on inflation is at least as big as upward pressure. The European Central
Bank has maintained its key interest rate – the lowest fixed rate on refinancing
operations, or the refi rate – at 1%, but Eonia (the Euro OverNight Index
Average), i.e., the effective overnight interest rate on the interbank market, has
stayed below the discount rate during the crisis. As the ECB phases out support in
the form of fixed-rate loans to banks, Eonia will close in on the refi rate. The ECB
member most vocal about not waiting too long to raise interest rates is the
Bundesbank President, Axel Weber, who potentially stands in line to succeed
ECB President, Jean-Claude Trichet.
For the majority of G4 central bankers, the argument in favour of maintaining a
zero interest rate policy (ZIRP) is that economic prospects are weak. It will take
time for businesses and households to adjust their balance sheets. Credit
conditions have not yet normalised. Real interest rates remain too high
considering today’s weak growth and high unemployment. The risk of deflation
has increased. And there isn’t much room for another fiscal stimulus. Those in
favour of raising interest rates and gradually phasing out the ZIRP have several
arguments on their side as well. If there were another crisis, there wouldn’t be any
ammunition left, and there would be a greater risk that the US and Europe find
themselves stuck with ZIRP and deflation, just like Japan. Another question
concerns the effectiveness of monetary policy in a ZIRP environment versus more
normal conditions. Hoenig suggests raising the US benchmark rate to 1% and
letting it stay there for an extended period. He is worried that excessively low
interest rates will lead to an incorrect allocation of capital, disrupt the functioning
of the financial markets, and contribute to incorrect risk pricing and new asset
bubbles. While the US needs to focus on higher savings, ZIRP benefits those who
borrow rather than those who save. Although low interest rates weren’t the only
reason for the financial crisis in 2008-2010, monetary policy in 2002-2005
probably worsened the situation.
Another stimulus is on the way
While economic prospects have worsened and central banks’ policy rates are
already at or near zero, there are still a few monetary tools left. Below we discuss
the importance of good communication and a new round of quantitative easing.
There is also the option of cutting interest rates on the reserves banks keep with
the central bank in order to increase the incentive for them to lend the money
instead. These measures are not as potent as rate cuts, however, and the effects are
not as easy to measure. In G4 countries, another stimulus is on the agenda,
whereas the question of exit strategies has been put off.
Communication can make a difference
The first step to further stimulate the economy is to announce that ZIRP will
continue for an extended period and will be phased out at a measured pace. The
Japanese central bank has announced that it will keep rates at zero until price
stability is within reach and risks are under control: "BOJ will maintain the
virtually zero interest rate policy until it judges, on the basis of the 'understanding
of medium- to long-term price stability,' that price stability is in sight, on
condition that no problem will be identified in examining risk factors, including
the accumulation of financial imbalances."
The Federal Reserve has announced that under certain circumstances it will keep
its benchmark rate at a low level for an extended period: “The committee (FOMC)
will maintain the target range for the federal funds rate at 0 to ¼ percent and
continues to anticipate that economic conditions, including low rates of resource

3. To the Point (continued)
November 2, 2010
3
Chart 2: Central Banks’ balance sheets in
USD, EUR and SEK
Source: Reuters EcoWin
08 09 10
USD,EUR,SEK(thousandbillions)
0.00
0.25
0.50
0.75
1.00
1.25
1.50
1.75
2.00
2.25
2.50
ECB
Federal Reserve
Riksbank
utilization, subdued inflation trends, and stable inflation expectations, are likely to
warrant exceptionally low levels of the federal funds rate for an extended period.”
What central banks can do is to stress that they will keep interest rates low for
longer than the market expects to raise inflation expectations and to keep real
interest rates low. A change in monetary targets could also be part of the
announcement, i.e., that by introducing price level targets higher inflation will be
accepted for a period of time.
Quantitative easing: When no alternatives are available
The other available option is for the central bank to buy long-term securities, e.g.,
government bonds or mortgage bonds. The purpose would be to increase the value
of these securities (and reduce long-term interest rates) and to strengthen domestic
demand. Cranking up the printing presses could lead to higher inflation
expectations and lower real interest rates. The currency could also weaken, which
would contribute to higher export demand.
The Fed has bought mortgage bonds worth $1.45 trillion (10% of GDP) and
government bonds worth $300 billion (2% of GDP). The BOE has bought £200
billion in UK government bonds, or 14% of GDP. The Bank of Japan has bought
¥13 billion in Japanese government bonds, equivalent to 3% of GDP. These
measures are designed to improve the functioning of credit markets and to
stimulate the economy by easing monetary policy. Note that the ECB has not
wanted to change monetary conditions through quantitative easing; €60 billion in
covered bonds (0.6% of GDP) and an equal amount of distressed euro bonds have
been bought mainly to improve liquidity in certain markets. Now that the financial
crisis is abating, there is less need for such measures.
The US, Japan and UK are interested in quantitative easing as a way to further
stimulate their economies by easing monetary conditions (both interest rates and
currencies). Japan has decided to create a ¥5 trillion fund (slightly over 1% of
GDP), but the financial market feels this is too little to make a difference. The
BOE is discussing a further easing of around £50 billion, i.e., about 3.5% of GDP,
but no decision was made at its last monetary meeting. In the US, discussions
have focused on a new easing. Previously there were expectations of something
big happening in the financial markets, but that has been tempered somewhat. If
the Fed decides against another easing, there would be a lot of disappointment,
since the stock and bond markets would benefit from such a decision. To some
extent the market is now driving monetary policy through its expectations.
If the quantitative easing is as high as $1 trillion, e.g., $100 billion per month for
10 months, the entire budget deficit would be financed for a year by cranking up
the printing presses. At the most recent monetary meeting on September 21, the
Fed decided to use the repayments of previous bond purchases to buy new long-
term government bonds, keeping their value at around $2 trillion. Another round
of the easing that inflates its balance sheet could be warranted if the economic
recovery needs more support and to allow inflation to rise to levels more
consistent with the Fed’s implicit target (probably around 2% or just below).
Pros and cons with quantitative easing
Members of the US Federal Reserve have differing opinions about the benefits
and costs of quantitative easing. The majority seem to support another round of
easing if the economy needs it. The most negative member would appear to be
Kansas City Fed President Thomas Hoenig, who has opposed the central bank’s
decisions at recent meetings. The Fed’s discussions have been widely reported in
the media, so much so that some observers have jokingly called the FOMC the
“Federal Open Mouth Committee”. The advantages of a new round of quantitative
easing usually mentioned are as follows:
1. A quantitative easing will help to reduce long-term interest rates on the type

4. To the Point (continued)
November 2, 2010
4
Chart 3: Inflation in the OECD and the US
1972-2010 (%)
Source: Reuters EcoWin
72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10
Percent
-2.5
0.0
2.5
5.0
7.5
10.0
12.5
15.0
OECD
OECD trend
US Core CPI
of bonds that have been bought and also indirectly on other types of bonds.
2. The stimulus has given the financial markets a boost by adding liquidity
during the crisis.
3. Higher inflation expectations reduce real interest rates, which would
potentially stimulate the economy.
4. A weaker currency that increases export demand could also be a desirable
side effect.
Several studies carried out this year indicate that interest rates have fallen. Gagnon
state that altogether the US easing has lowered 10-year government bonds by 90
bp and 10-year agency bonds by 160 bp. Neely also mentions the international
impact as well as a 5% decline in the dollar. On the other hand, those measures
were bigger than the ones now being discussed and were adopted when the
financial crisis was at its worst and ZIRP wasn’t yet in the picture. The rate cut
could be as little as 10-25 bp in a programme worth $500 billion. Consequently,
the costs would very well exceed the benefits. The disadvantages include:
1. Quantitative easing seems to work best at the peak of a crisis, but has less
impact when a recovery is in progress. It is tricky at best to try to determine
the effects of quantitative easing, which also makes it hard to calibrate and
communicate monetary policy. Should the Fed announce from the beginning
how big the programme will be? Maybe today’s long-term interest rates are
low enough? It’s going to take time to clean out all the bad debts.
2. The monetary base increases, but not the money supply, when the financial
sector adjusts its balance sheets. This could change as the recovery continues.
There are tools that in theory could be used to shrink balance sheets if needed,
e.g., if inflation expectations rise too quickly, but it can be hard to implement
them at the right time and to the right degree.
3. The risks faced by central banks increase when their balance sheets shift from
focusing on short-term securities to long-term securities. Some agency bonds
are probably more or less worthless.
4. Buying various types of securities disrupts the financial market and makes
players dependent on what central banks do.
5. Financing the budget deficit by unleashing the printing presses means that it
wouldn't have to be financed through higher taxes. On the other hand, these
measures have to be phased out. This means that government bonds have to
be sold, which would affect the market as well as the independence of the
central bank vis-à-vis the administration.
6. A significant easing of US monetary policy would increase capital inflows to
emerging economies, with the risk of financial stability. A significantly
weaker dollar would adversely affect China's dollar reserves and force it to
further diversify its currency portfolio, causing other currencies to appreciate.
The risk of currency tensions increases when the Fed eases monetary policy,
also keeping in mind that key Asian currencies aren't market-based and are
pegged to US monetary policy.
Finding an optimal monetary target
Since the early 1980s inflation in OECD countries has trended lower. Central
banks have successfully met their goal of price stability. However, the risk of
deflation is now increasing. The question is whether central banks are competent
enough to fight off the dangerous combination of falling prices, wages and
demand. Which targets are available today and which ones should be? Among the
G4 nations, the BOE and ECB have announced fairly clear inflation targets. The
British target is symmetrical at 2%, but the central bank also has to support the
government's goals of higher growth and employment. The ECB’s inflation target
is below but close to 2%. Employment in the longer term is said to be driven by
structural reforms rather than monetary policy. The Bank of Japan’s goal is price

5. To the Point (continued)
November 2, 2010
5
stability and is quantified what seems to be symmetrically at between 0 and 2%.
Its aim is to stop deflation and instead reach the inflation target. There is no
similar goal for growth and employment.
The Fed has dual mandates for its monetary policy: full employment and price
stability. Since there is a connection between the two, the FOMC formulates
targets based on long-term unemployment (as a percentage of the labour force)
and the mandate-consistent inflation rate. Although it may seem that a central
bank can mainly impact the inflation rate, while unemployment is determined by
factors outside the Fed’s control, Fed Chairman Ben Bernanke has stated that
focusing exclusively on inflation could lead to more frequent and deeper
recessions. He has previously made it clear that he is interested in introducing a
clearer inflation target in line with other central banks, but opposition on the
FOMC seem to have been too great. The crisis showed that an inflation target
based solely on consumer prices can also contribute to imbalances. A growing
number of critics began to question the target, pointing to its one-sidedness. The
consensus, however, was that the target, if made more flexible by extending it for
a longer period, offered the advantages needed when it comes to finding an anchor
for monetary policy (greater clarity, easy to communicate and easy to understand).
There are two main reasons to introduce an inflation target in the US following the
financial crisis. One is that such a target creates expectations that could help it to
avoid deflation (it is possible, however, that such an anchor will not have much
impact if introduced too late). The second is that if inflation expectations rise too
quickly, an inflation target can create expectations that the central bank will not
jeopardise the price stability target in the longer term.
Lars E.O. Svensson, an influential economist specializing in monetary policy and
Deputy Governor of Swedish Riksbank, has noted that there is a disadvantage
with inflation targets in circumstances where the risk of deflation has increased.
He stated in one of his speeches: If firms and households consequently believe that
inflation will be very low in the short term and thereafter equal to the inflation
target, then the average expectations in the slightly longer term will still be low
and under the target. In such circumstances, with a zero interest rate, the real
interest rate may still be too high even if the inflation target is credible in the
longer term. One way to avoid this disadvantage is instead to have a so-called
price level target, or what may also be referred to as “average inflation
targeting”.
A number of central bankers are now urging the US to introduce a price level
target. See, e.g., Evans and Altig. Svensson explains price level targets as follows:
Unlike an inflation target, a price level target has a “memory” in the sense that
lower inflation or deflation during a period of time whereby prices fall below the
target path will be compensated for by a correspondingly higher inflation in a
later period to attain the price level target path once again.
Frederic Miskin notes in his book “Monetary Policy Strategy” that the economist
and Governor of the Central Bank of Israel, Stanley Fisher, in 1994 questioned
price level targets because they could lead to fluctuations in production, as crises
cannot be smoothed over and have to be compensated for. These targets probably
work better when there are deflation fears rather than inflation fears, since it is
easier to generate higher inflation than deflation. Research by the British and
Canadian central banks indicates that we could shift to a hybrid of inflation target
and price level target, as it is easier to communicate an inflation target, but that
central banks would also announce that any errors will be adjusted in the future.
Another question is whether the inflation target should be raised in order to
increase inflation expectations and that it is easier to avoid ZIRP in the event of
negative shocks. Blanchard of the IMF argued in favour of maintaining an
inflation rate of 3-5%, so that there is enough room for a stimulus if needed.
Those against raising the inflation target (e.g. Bernanke, Been) say that the costs

6. To the Point (continued)
November 2, 2010
6
Chart 4: US Current Account (billion US
dollars) and China’s Currency Reserves
(thousand billion US dollars)
Source: Reuters EcoWin
90 92 94 96 98 00 02 04 06 08 10
USD(billions)
-900
-800
-700
-600
-500
-400
-300
-200
-100
0
100
USD(thousandbillions)
-1.0
-0.5
0.0
0.5
1.0
1.5
2.0
2.5
3.0
3.5
4.0
US Current Account
(right hand side)
China's currency reserves
(left hand side)
probably outweigh the benefits. There are big risks in deviating from the
expectations of price stability that have already built up. It is usually difficult to
raise inflation “a little” without it getting out of hand. There is a risk of higher
nominal interest rates, which could complicate debt reduction. Slightly higher
inflation could also lead to higher volatility and, consequently, an undesirable
effect on living standards.
Effects of global savings imbalances
Monetary policy focuses on interest rates based on production/employment and
inflation. Free-floating currencies then become a balancing item based on
monetary policy, growth, trade, capital flows, psychology, etc. The problem is that
there are countries that peg their currencies to the dollar, which means that the
monetary policy they import is often too expansive. The currency is undervalued
and contributes to imbalances in the global economy. Although the Chinese
currency, the yuan, has begun to appreciate against the US dollar, it is still
considered undervalued. Imbalances are growing rather than shrinking, as evident
by the fact that the US current account deficit is increasing again and China's
currency reserves continue to grow. Despite that the financial crisis showed that
the savings surpluses that were built up in Asia helped to reduce real interest rates
in the West, there is no framework in place to govern currency tensions and
imbalances. The new round of quantitative easing in the US is launching a wave
of currency adjustments. China is trying to diversify its currency portfolio and
buying other currencies, in addition to real assets. The Bank of Japan is
intervening to avoid an overly strong yen. The Korean central bank is doing the
same thing, as is its Swiss counterpart. In Europe, deleveraging is impeded in the
PIIGS countries when the euro appreciates against the dollar. Some emerging
countries are introducing capital controls or taxes on capital inflows, but in all
likelihood such measures can easily be avoided by financial markets actors.
Leading up to the G20 Seoul Summit on November 11-12, expectations of greater
cooperation have been played down. It was easier to coordinate fiscal and
monetary policy. When many countries now seek to devalue their currencies in
order to gain an export advantage, there is a risk of increased protectionism, trade
wars, and weaker global demand. Small, export-centric European countries will be
the big losers.
The meeting of finance ministers in South Korea led to a debate on the US
proposal to place a limit of 4% of GDP on current account surpluses and deficits.
China didn't completely object, but Japan, Germany and Brazil did. In general,
countries with large current account surpluses must accept that their currencies
will rise in value, while countries with deficits need to see theirs weaken. For
Japan, a stronger yen is a problem in that it could worsen deflation. What are
needed are more structural reforms. This applies to the majority of Western
countries in response to the crisis. The US proposal opens a debate that could
continue and where proposals are taking shape. The most positive thing that can
be said at this point is that the door remains slightly open.
Should central banks lean against the wind?
Central banks have claimed for some time that it is better to clean up after a burst
bubble than to try to prevent one from arising. On the other hand, the Bank of
International Settlements (BIS), thought it would be more effective to lean against
the wind, i.e., raise interest rates slightly earlier to stop the credit expansion and
housing bubble. The argument for not doing anything about bubbles seem rather
convincing as it is 1) hard to determine whether or not there actually is a bubble,
2) hard to prick a bubble with the help of monetary policy because of how the
transmission mechanism works, 3) not enough to raise interest rates a little, and
significant hikes could threaten the economy, 4) hard to accept as the short-term
costs aren't necessarily outweighed by the long-term benefits of avoiding a bubble,
and also 5) Higher interest rates can create problems if the debt ratio has been

7. To the Point (continued)
November 2, 2010
7
Chart 5: House Prices in selected Countries,
Index 2000 = 100)
99 00 01 02 03 04 05 06 07 08 09
75
100
125
150
175
200
225
250
S
DK
SP
US
UK
N
IRL
Economic Research Department
SE-105 34 Stockholm, Sweden
Telephone +46-8-5859 1000
ek.sekr@swedbank.com
www.swedbank.com
Legally responsible publishers
Cecilia Hermansson
+46-8-5859 7720
allowed to rise, since it becomes harder to settle debts and the debt burden would
be higher than if funding had been allowed to continue without the impact of
monetary policy. On the other hand, this crisis shows that it can be fairly costly
not to take financial stability seriously. It is a question of effectively regulating
financial markets and introducing alternative measures that can limit credit
expansion, e.g., amortisation requirements, mortgage ceilings. Is there still any
reason to lean against the wind if these alternative measures have been called
upon? Maybe not all the time, but keeping interest rates unusually low for an
extended period is likely to create anomalies in the financial market, leading to
incorrectly priced risks and incorrectly allocated capital. It can be more important
to lean against the wind when raising interest rates slightly from an extremely low
level of around zero than when interest rates are being changed from 3.5% to 5%.
It is true that it is hard to determine when there is a bubble and what the
fundamentals are, but as Ray Barrell from the British National Institute of
Economic and Social Research (NIESR) said, “When you usually think there is a
bubble, there is a bubble …” Sweden may not have a housing bubble right now,
but tensions are clearly building and could create problems in a few years, leaving
it more vulnerable to the next crisis. It is reasonable therefore that Sweden now
raises its policy interest rate despite that relatively low inflation and prospects that
it will remain low would seem to indicate that the Riksbank could have waited a
little longer. A lower interest rate probably would not have created quite as many
jobs as econometric models predict. On the other hand, it is reasonable to expect
large imbalances if the ZIRP had continued longer than necessary. If global
developments and a stronger krona allow, the policy rate can then be raised more
slowly next year, but it makes sense from a risk management perspective to raise
it from the low level we had during the financial crisis.
In recent decades central banks have successfully reduced inflation. Econometric
models are partly to thank for why monetary policy could be set more or less
automatically based on some Taylor rule or similar assumption derived from the
output gap and inflation gap. At the time you didn't need many members to push
in one direction; it might have been enough with one person and a computer.
Today the world is more complex: China and India’s growing roles in the global
economy, savings imbalances, low consumer prices but high asset prices. There is
a risk of deflation and a risk of new asset bubbles. Regulation of the financial
sector is also a focus: what will be regulated and how much?
In such a world, greater flexibility will be needed when applying monetary policy.
Simple policy rules are no longer at our disposal. Instead greater “maturity” is
needed from those who set monetary policy and from actors in the financial
market who interpret the decisions. Monetary policy has now become as much art
as science.
Cecilia Hermansson
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