Small countries can blaze a trail in central banking. New Zealand was an early adopter of inflation-targeting, which has become a global norm. Now Sweden has the chance to begin breaking the stranglehold of this orthodoxy.
Sweeping reforms of its central bank, the Riksbank, are recommended in a parliament-commissioned report written by former Bank of England Governor Mervyn King and US economist Marvin Goodfriend. They say the Riksbank needs more leeway to deviate from its inflation target if necessary, as well as greater powers to promote financial stability. They also criticise economic models used by the central bank and its overweening focus on delivering precise guidance on the outlook for rates even during times of high uncertainty.
These points apply well beyond Sweden. A member of the Bank of England's Monetary Policy Committee, Gertjan Vlieghe, said in a speech on Monday that shifts in debt levels, demographics and the distribution of income might have persistently changed the relationship between growth and interest rates. He too pointed out flaws in "workhorse models for monetary policy". When such important economic linkages are in doubt and the old models are breaking down, policymakers may be much better off taking a holistic approach to setting rates rather than focusing too narrowly on inflation goals.
Fans of targeting argue this would make inflation expectations for households and companies more volatile, with negative consequences for the economy. Axel Weber, chairman of the board of UBS and a former Bundesbank president, argues that stability in consumer prices doesn't guarantee economic, financial or monetary stability and that central banks would help discourage excessive risk-taking if they switched from simplistic inflation-targeting to an approach that emphasises risk management.
Rate-setters used to target measures of money supply but drifted away from such goals when the relationship between the quantity of money in circulation and inflation grew unpredictable. If inflation is no longer a good guide to the overall stability and health of the economy, another rethink may be useful. Sweden has a chance to lead the way.
