## REVOLUTIONARY CENTRAL BANKING

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### Challenges for central bankers
- The 2021 upsurge in inflation "took many central banks by surprise."
- Federal Reserve Chairman Jay Powell: “We now understand better how little we understand about inflation.”
- Enhancements in central banking over the past three decades—specifically advances in inflation targeting—helped central banks respond to major shocks including the financial crisis of 2007 and the 2021 inflation surge.
- Lars E. O. Svensson is identified as a leading figure in those enhancements.

### Svensson’s background and path
- Education and early career:
  - MS in physics and applied mathematics, Royal Institute of Technology in Stockholm, 1971.
  - Doctorate in economics in Stockholm; spent a year at the Massachusetts Institute of Technology where professors included Paul Samuelson, Robert Solow, and Peter Diamond, and fellow students included Paul Krugman and Olivier Blanchard.
- Academic and advisory roles:
  - First job at the Institute for International Economic Studies at Stockholm University.
  - External advisor to the Riksbank in the early 1990s.
  - Moved to Princeton University by 2001.
  - Returned to the Riksbank as deputy governor in 2007.
- Personal note: At age 75, Svensson remains active in research.

### Inflation targeting: adoption and outcomes
- Historical context:
  - Reserve Bank of New Zealand adopted inflation targeting in 1989–90.
  - Bank of Canada adopted inflation targeting in 1991 and “successfully reduced inflation to 2 percent.”
- Riksbank adoption:
  - In early 1993, the Riksbank adopted inflation targeting with a 2 percent long-term goal to be achieved by 1995.
  - The Riksbank “undershot” the 2 percent goal in the years that followed.
- Svensson’s contributions:
  - Argued for targeting “a narrow range for the inflation rate.”
  - Advocated flexible inflation targeting that balances inflation and full employment and cautioned against being “inflation nutters.”

### Inflation forecast targeting (IFT)
- Core idea:
  - Central banks should select a path for current and future policy interest rates so that the central bank’s own forecasts for inflation and employment “looked good” for achieving the inflation target and full employment over time.
- Rationale:
  - Monetary policy actions affect the economy with a long lag; transparency about the planned path of future policy is crucial.
- Adoption and practices:
  - Some central banks (for example, the Norges Bank, the Riksbank, and the Czech National Bank) began publishing their interest rate paths.
  - Many others adopted practices that went “considerably in that direction.”
- Illustration:
  - Scott Sumner: likened prior practice to a ship captain setting a course expected to be “200 miles off course” upon arrival; IFT aligns policy path and forecasts to the target.

### Going negative: negative interest rates as a tool
- Policy problem after the Great Recession:
  - With policy rates lowered to zero and forward guidance indicating “low for long,” central banks sought additional tools.
- Svensson’s advocacy:
  - Recommended moving to negative interest rates—levying fees on deposits to push banks into making loans and encourage spending.
  - Financial Times: “The most vocal advocate of the policy is Deputy Governor Lars Svensson.”
- Implementations:
  - The Danish central bank adopted negative interest rates in 2012, followed by the European Central Bank and several others.
- Views on effectiveness:
  - Former IMF Chief Economist Ken Rogoff: “if done correctly ... negative rates would operate similarly to normal monetary policy, boosting aggregate demand and raising employment.”
- Riksbank experience:
  - By July 2009, the Riksbank had cut rates to 0.25 percent.
  - The Riksbank cut rates to zero by 2014 and ventured into negative interest rate territory in 2015.
  - A subsequent IMF working paper by Rima Turk deemed the Riksbank’s negative interest rate experiment successful.

### Different and separate: monetary policy vs. financial stability
- Svensson’s position:
  - Monetary policy should focus on inflation and output goals.
  - Financial stability considerations should be left to macroprudential policy.
  - He argued that the benefits of raising interest rates to enhance financial stability are “small and uncertain,” while the costs in terms of higher unemployment and deflationary pressures are “high and far more certain.”
- Debate and influence:
  - Svensson’s cost-benefit calculations were featured in a 2015 IMF staff paper on “Monetary Policy and Financial Stability,” which concluded that in most cases the costs are higher than the benefits.
  - Philip Turner: Svensson “decisively won this debate” by rigorous logic using favorable empirical magnitudes for the opposing case.
- Riksbank disagreement:
  - In 2010 the Riksbank started raising rates; Svensson opposed the 2010–2011 rate hikes and “leaning against the wind.”
  - Svensson left the Riksbank at the end of his term in mid-2013, stating he had “not managed to get support for a monetary policy” he preferred.
  - Paul Krugman called the 2010–2011 rate hikes “possibly the most gratuitous policy error” of the global financial crisis.
  - By 2014 it became clear the 2010–2011 rate hikes were not taming housing price inflation and were leading to deflation and economic weakening.

### Continuing research and challenges to conventional indicators
- Recent focuses:
  - Demonstrating that commonly used indicators of housing price overvaluation—such as the house-price-to-income ratio—are misleading and can lead to poor policy actions by financial agencies.
  - Challenging the view that households cut back more on spending in a crisis when they have higher levels of outstanding mortgage debt.
- Impact:
  - Turner: “Wherever he goes, economists are forced to raise their game.”

*Profile by Prakash Loungani, assistant director of the IMF’s Independent Evaluation Office.*

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_Source: https://www.imf.org/-/media/files/publications/fandd/article/2023/march/pie-central-banking-revolutionary.pdf_