I’ve seen some fairly odd decisions made by various central banks in my 30 odd years in the markets. But they normally have some sort of explanation, even if you don’t agree with it. But in the case of the Riksbank decision last week, I honestly cannot understand the rationale for not only leaving rates and asset purchases unchanged, but also leaving projections for future policy unchanged, with the first rate hike not expected until 2018. It is frankly utterly bizarre, and smacks of an ill-conceived desire to maintain a weak currency – a desire that has no justification whatsoever given Sweden’s macroeconomic circumstances.
Even at the July meeting, it was quite hard to justify the super easy stance of the Riksbank. The economy has been growing at 3% +, the employment rate was at record levels, and inflation was only modestly below target. But despite having the strongest economy in the G10 Sweden was running one of the easiest monetary policies, with the repo rate at -0.5% and asset purchases continuing. At the September meeting the Riksbank had to consider the news that GDP growth had accelerated to 4% y/y in Q2, and inflation had risen to 2.4% on their targeted CPIF measure, above the 2% target for the first time since 2010. But the Riksbank decided not only to continue with their hyper-easy policy, but didn’t change the view that they wouldn’t raise rates until the second half of 2018. Why? Well according to the Riksbank:-
” For inflation to stabilise close to 2 per cent, it is important that economic activity continues to be strong and has an impact on price development. It is also important that the krona exchange rate does not appreciate too quickly.”
In their report the Riksbank accept that growth is stronger than expected, inflation higher than expected (and above target), resource utilisation is approaching historic highs, and the employment rate and household debt at record levels, but they still want to keep rates at historic lows. The only reason they appear to have is that they don’t want the currency to rise too fast as this would endanger the inflation target. This seems to me to be an incredibly short-sighted policy, which has been shown to be unstable and dangerous in many places in the past, the UK most notably.
Sweden is a very open economy, and the currency certainly will have a significant impact on inflation in the short-term. But in the end keeping interest rates at a level that is inappropriate for the economy in an attempt to prevent currency strength is courting disaster. The result will likely be continued strong growth in the short run, further rises in household debt and above target inflation. When the brakes do have to be applied they will have the be applied that much harder, sending the currency up that much quicker. Or if the Riksbank choose not to apply the brakes, perhaps because inflation doesn’t rise too much, they result will ultimately be that the excessive debt burden causes a crash.
This isn’t just about Sweden, it’s also about the weakness of the policy of inflation targeting. The inflation process may well have changed significantly in recent years, with wage growth failing to ignite despite low and falling unemployment in Sweden and the Anglo-Saxon economies. The path from policy to the economy to inflation has not only changed, it may be almost completely blocked. Inflation is being determined elsewhere by other factors. Setting interest rates to control inflation in the short to medium term is becoming a ridiculous endeavour, and attempts to control inflation by controlling the currency are taking huge risks with the economy.
But it’s not even the case that the Swedish krona is particularly strong. The Riksbank likes to use the nominal KIX index, which shows the SEK slightly on the strong side of recent averages, and they cite the recent rally as one of the reasons for their decision in September. But measures of the real exchange rate show it to be very much on the weak side of historical norms. Attempts by the Riksbank to stop it rising are ultimately futile. Sooner or later it will return to normal levels, and it is better to allow it when the economy is strong and running a substantial trade surplus. A strong currency is a good thing – it makes consumers richer. They will be able to spend more without increasing their debt, and the trade surplus might come down. Instead, the Riksbank are following an unsustainable and dangerous policy, tying their policy to a region (the Eurozone) which is years behind Sweden in its recovery.
Source: Riksbank, BIS