US and UK central banks considering raising rates should look to Sweden, says Stewart Robertson.

November 2014

Key points

  • Riksbank raised rates in July 2010.
  • There are valuable lessons to be learned by other central banks.
  • Inflation hit zero in November 2012 and country has flirted with deflation since.
  • Growth has slowed and unemployment remains stubbornly high.
  • Riksbank backtracked and cut rates.

Sweden has frequently been in the vanguard of new trends, be they car safety, saunas or flat-pack furniture. The country also experienced a full-scale banking crisis, resulting in a state-aided rescue, almost 20 years before the collapse of Lehman Brothers. Since then Sweden has been held up as a paragon of economic virtue by many commentators, notably in the field of monetary policy during and immediately after the global financial crisis. The Riksbank responded promptly and by the middle of 2009 had not only slashed its main policy interest rate but had become the first major central bank with a negative interest rate.

But has Sweden now set another and far more unwelcome first? Recent developments suggest that in raising rates in 2010 the Riksbank may have committed a classic monetary policy error and that the economy is paying the price. As such, there are extremely valuable lessons to be learned by other central banks that are considering pulling the interest-rate trigger.

After a year with a repo rate at 25 basis points, the Swedish central bank raised rates to 50 basis points in July 2010. At that time headline inflation was 1.0 per cent and the ‘core’ measure was 1.7, both less than its 2.0 per cent target. Although economic output had grown rapidly in the first half of the year this should have been no great surprise given the magnitude of the downturn in 2008 and 2009. And while the unemployment rate, at 8.7 per cent, was falling, it remained well above its natural rate, which most commentators consider to be around six to seven per cent.

The justification given for the hike was that it would help ensure the inflation target was met in the future. Mention was also made of a recent sharp increase in household indebtedness, related to a bubbly housing market. The rate rise was followed by six others over the coming year, lifting the repo rate to 2.0 per cent by the summer of 2011. The same reasons for tighter policy were repeated with each decision, although more specific reference was made of higher headline inflation. This had reached 3.0 per cent by spring 2011, largely because of a sharp rise in oil prices. By contrast, core inflation had remained subdued.

Since then headline inflation has plunged. With core inflation on a downward trend, lower energy and food prices led to headline inflation, which the central bank targets, touching zero in November 2012. The country has flirted with deflation ever since. (See Chart 1)


Meanwhile growth has slowed to an average annual pace of just 1.5 per cent over the past two years compared with around 3.0 per cent in the previous two year period. Simultaneously, Sweden’s unemployment rate has remained stubbornly high at a little under 8.0 per cent. Nominal GDP growth – the lifeblood for avoiding deflation – is currently running at a paltry one to two per cent compared with a more normal pace of five to six. (See Chart 2)


As a result the Riksbank has reversed earlier rate hikes, although it has been somewhat reluctant to do so – the repo rate was left at 1.0 per cent throughout 2013 and at 0.75 per cent in the first half of 2014. The central bank finally gave in and reduced it to 0.25 per cent in July and finally to zero last month. Latest data shows core inflation at 0.5 per cent, a headline rate of -0.1 per cent and an economy that has hardly grown in the first half of the year.

Sweden’s recent economic history suggests the central bank was jumping at inflation shadows and got engaged in an ill-advised attempt to defuse what it perceived to be a housing bubble and an associated build-up of debt. Nominal interest rates are a blunt instrument in these circumstances and Sweden’s experience suggests that central banks which attempt to target asset prices, or at least those which are spooked by them, will not succeed, or will only do so with avoidable collateral damage. Other policies, such as altering the regulatory framework, may be a better way of mitigating the risk of asset price bubbles.

The lesson to be learned from Sweden’s experience is that central banks need to be especially careful about raising rates after the global financial crisis. There will come a time when extreme policy stimulus has to be slowly removed. But that needs to be done for the right reasons and central banks need to be aware of the possible adverse consequences of their actions.

The risk of Sweden experiencing an extended episode of sluggish growth and chronically low or negative inflation is greater now than it was in 2010. And the actions of the Riksbank are undoubtedly part of the explanation for this. Like all matters economic, we do not know the counterfactual – perhaps there would have been a real estate bubble and bust and a damaging buildup of debt, resulting in inflation.

But the burden of proof must lie with the central bank and not its detractors. Judging by their letter to the Financial Times, published on November 11, deputy governors Cecilia Skingsley and Per Jansson don’t think the central bank did anything wrong. Many would beg to differ.

Key lessons for other central banks:

1.   Consider inflation prospects over a long horizon – don’t get spooked by short-term developments.

2.   Be wary of hiking rates in response to rising asset prices and debt levels. This doesn’t mean ignore such things, but view them in a wider context.

3.   Take it slowly – raise rates in small increments and await their impact. Interest rates of just 2.0 per cent were sufficient to have major effects in Sweden.

4.   Do not assume that very low nominal policy interest rates imply easy monetary conditions. Other things to consider include real interest rates, the exchange rate, money supply and the health of the banking system.

5.   Above all, be aware that deflation tomorrow is a far bigger danger than inflation today. If allowed to take root, it can be tough to shift.

It will be anathema to those who experienced the inflationary 1970s and 1980s, but dealing with an inflationary overshoot, especially a mild one, is quite easy. Dealing with deflation once it settles in is not.


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