The dilemma facing Sweden’s Riksbank

Swedish monetary policy currently operates at extreme levels.

The policy rate remains at -0.5 per cent with a clear easing bias despite very strong GDP growth and an undervalued currency. The Riksbank has bought nearly 35 per cent of currently outstanding Swedish government bonds and is likely to extend its existing quantitative easing programme this week, bringing its programme to SEK 275bn of the approximately SEK650 bn government bond market by the middle of next year.

With a strong banking system and well-functioning credit creation, this policy is aimed at using the weak krona to raise inflation through higher import costs - a policy former Bank of England governor Mervyn King was critical of in a report earlier this year that evaluated Swedish monetary policy.

However, inflation remains below the Riksbank’s 2 per cent target and, importantly, this policy comes with costs. Since the introduction of unconventional monetary policy in February 2015, foreign investors have lowered their exposure to the Swedish government bond market substantially.

Market participants and even the National Debt Office are now concerned over the effects of QE on bond market liquidity and functionality. The negative repo rate signals a “state of crisis” and yields unintended consequences for savings and investments.

The majority of Swedish mortgages are at variable rates, contributing to strong growth in household lending and house prices that are unsustainable in the long term. These “externalities” from the current policy set-up must be taken into consideration and evaluated in a longer-term perspective and beyond the goal of reaching the inflation target in 2017-18.

The most troubling outcome, however, is that it is debatable whether the Riksbank’s expansionary policies will really have the intended effect on inflation. Sweden is a small and open economy. In the past decade, traditional manufacturing has been supplemented by a greater dependence on services.

IT developments, with Sweden as one of the very fast and early adopters of new technologies, together with integrated EU labour markets, have opened up a previously regulated economy and labour market.

It is questionable to speak of a “national” labour market. Several sectors including IT, construction and public services are seeing surging growth, but very little wage pressure. Global competition from a growing share of e-commerce clearly makes importing companies think twice before raising prices and wages, despite a weak krona.

Low inflation is not only the result of globalisation and IT, but also a result of the successful institutional changes Sweden made after the last domestic financial crisis in the early 1990s.

Sweden introduced an inflation target and floated the krona in 1992, adopting a fiscal policy framework, mandating a 1 per cent surplus in public finances over the business cycle and initiating a process of gradual de-regulation and opening up of the public sector. Meanwhile employers and trade unions worked successfully together to secure decent real wage growth, at levels that would still enable companies to compete and simultaneously secure a continued demand for labour.

Hence, what the Riksbank is fighting today is partly the success of policies introduced after the last crisis in order to keep Sweden competitive and maintain domestic cost discipline. The irony is that it is potentially building a foundation for a new crisis. And although it is a very remote and small possibility, a domestic crisis would be the main and probably only trigger for a prolonged period of deflationary price pressures.

The Riksbank needs to redefine the goal for price stability, allow for greater flexibility and room for manoeuvre, explain why inflation is below target. Tht would enable the bank to admit reaching 2 per cent inflation is not achievable in the short term.

Normalising policies − including raising the repo rate back to a positive level − will surely strengthen the krona, a reasonable and logical outcome that would be viewed as a sign of economic and financial strength.

Carl Hammer is chief Currency Strategist, head of global macro and currency Research at SEB.