Renowned monetary economist and then member of the Risbank’s board Lars Svensson vehemently opposed the tightening cycle back then and his views were subsequently vindicated when the Riksbank was forced to cut interest rates again over the course of 2012 because inflation rates declined dramatically. In fact, the Riksbank’s subsequent rate cuts fell initially far short from what was needed, thus leading to a de-facto tightening of monetary conditions. As a result, the Swedish economy experienced three years of roughly zero inflation from 2012 to 2015 as well as suboptimal growth rates in output combined with higher unemployment than necessary. Furthermore, the predominant aversion to monetary easing in the beginning only delayed the inevitable and actually led to the fact that much more aggressive steps had to be taken later on to make up for previous mistakes. Indeed, the Riksbank decided to cut its repo rate, the interest rate at which commercial banks can borrow or deposit funds, to negative 10 basis points in February 2015.
After the ECB and the Swiss National Bank, the Riksbank thus became the third central bank in Europe to test negative interest rates. The decision to go negative in Sweden was taken amidst the ECB’s initiation of its program of Quantitative Easing (QE) in early 2015. The introduction of this large scale asset purchase program for the eurozone led to a large depreciation of the euro vis-à-vis a basket of currencies. The monetary easing by the ECB thus led to immediate upward pressure on the Swedish Crown (SEK) and, given that the eurozone is Sweden’s largest trading partner, this directly translates into lower prices on imports, thus putting further downward pressure on the domestic inflation rate. In this respect, the Riksbanks’ hands were effectively tied by decisions from policy makers from abroad. Indeed, soon after the ECB started its asset purchase program, the Riksbank decided to cut interest rates twice again, moving even further into negative territory and ever since July of last year the repo rate has remained at negative 35 basis points.
Furthermore, the Riksbank also started to introduce its own program of QE in February 2015, deciding on the purchase of Swedish government bonds of a meagre ten billion SEK at first. This amount quickly proved to be highly inadequate, given the downward pressure on the domestic inflation rate, and the program was beefed up another four times over the course of last year. The latest decision to ramp up the purchases came this fall amidst the expectation that the ECB would increase its own QE, an expectation that was fulfilled mid-December when Draghi announced that another six months of asset purchases would be added to the program. Meanwhile, the Riksbank announced last October that their QE would be extended to June 2016 and increased to a total of 200 billion SEK with purchases of 120 billion SEK already executed over the first three quarters of 2015, meaning that by the middle of this year the Swedish central bank will own about 30 percent of the government’s outstanding stock of nominal debt.
Financial markets, however, did not consider this move newsworthy and mostly shrugged off the monetary easing. In fact, the Swedish stock market actually declined by roughly 10 percent since the beginning of November while the Swedish crown actually appreciated by about 1.5 percent (vis-à-vis the euro), thus moving in the opposite direction than presumably intended by the Riksbank. While its own forecasts suggest that inflation will return to its target of 2 percent by 2017, meaning six subsequent years of undershooting, financial markets are far more pessimistic. Five-year ahead inflation expectations suggest a yearly average inflation of merely 1.7 percent over the coming five years.
The recent expansion of the Riskbank’s QE will most likely prove to be insufficient and, just like other central banks, Swedish officials might have to turn to purchases of private sector assets. However, even such a move might turn out to be inadequate. The economists Lukasz Rachel and Thomas Smith have estimated that the global real interest rate has fallen by about 450 basis points over the past 30 years. This implies extremely low nominal interest rates and a very high probability of being stuck close to the zero-lower bound. There has been a growing consensus among prominent macroeconomists that central banks should target the level of nominal income instead because the outdated two percent inflation target is bound to fail in today's world of secular stagnation. However, public officials across the world have not yet accepted this view and seem to believe that current conditions are merely temporary. Institutional inertia seems to be a problem even in a well-governed country like Sweden. Unfortunately, this will imply that central banks are set up for failure as every minor adverse economic shock might throw them back to the zero-lower bound where their response depends on policy tools like Quantitative Easing, which might be politically hard to implement. Not a very bright outlook for the future.
Larry Summers on secular stagnation:
Lukasz Rachel and Thomas Smith on the decline of global real interest rates: http://www.bankofengland.co.uk/research/Pages/workingpapers/2015/swp571.aspxere to edit.