July 6, 2015    6 minute read

Sweden’s Battle with Deflation

   July 6, 2015    6 minute read

Sweden’s Battle with Deflation

The Riksbank have continued to undertake the use of expansionary monetary policy by reducing interest rates and increasing purchases of government bonds. On the 8th July 2015, the REPO rate in Sweden will effectively be lowered from -0.25 to -0.35%. The main objective for the Nordic nation has been to meet its inflation target of 2%, which they are still slightly off. The inflation rate in May 2015 was reported to be at 0.1% (CPI), which had significantly increased from -0.2% in April. However, Sweden’s objective may be harmed due to the value of the krona rising more than expected.

Sweden has relied on the depreciated krona to overcome the issue of deflation. When the value of a currency falls, the nations domestic goods become relatively cheaper compared to foreign goods. So, businesses in Sweden are likely to pass on the increase of their import costs to consumers, in terms of higher price levels. As a result, general prices levels, i.e. inflation, will rise. However, as the krona has appreciated, this will completely have the opposite effect to what has been observed in Sweden previously. Now, we would anticipate imports to be relatively cheaper compared to exporting goods and so lowering the inflation rate. Even though the change in the exchange rate will not impact Sweden’s inflation level straight away, it has been vital for the central bank to lower REPO rates. Following this, demand will begin to fall due to the appreciation and so slowing down economic activity and growth levels for the economy.

The purpose of the decreased interest rate will have two main effects. Firstly, a lower rate will stimulate demand in the economy and raising investment levels, so making it more likely for price levels to rise. Secondly, the value of the krona can depreciate due to lower interest rates. A greater outward level of hot money would occur, as foreign investors are likely to move their deposits to nations with higher rates, as the return levels will be relatively higher. For instance, investors moving from Sweden to the USA would sell their krona deposits and use it to purchase US dollars. As a result, the value of the krona would depreciate and thus continue to aid Sweden to hit their 2% inflation target. The positive effects of shifting hot money away from Sweden would occur swiftly.

Due to external factors such as uncertainty arising from declined economic activity from neighbouring nations, Sweden’s objective will become more difficult to obtain. A great level of uncertainty is being formed due to the issue of Greece and so creating issues for Eurozone members. As Sweden exports most of their goods to EU members such as Germany, UK and Norway, implications to these nations may lead to less demand for Swedish goods. For instance, if the recovery continues to be slow in Europe, then Sweden’s export levels would begin to diminish and so lowering the inflation level. The reason for this is due to business confidence in Sweden falling and so wage-levels decreasing as a result, which would hinder the nations chance of achieving 2% inflation.

Risks associated with expansionary monetary policy

Substantially low interest rates could pose threat to long-run economic objectives for Sweden. Firstly, the cost of mortgage payments will be reduced with lower interest rates and so increasing demand for houses. Consequently, house prices would rise, which is currently being observed in Sweden. Rising house prices and household indebtedness may lead to consumers reducing consumption and increasing saving levels, especially if uncertainty continues to loom in Europe. The final result would involve demand and price levels in Sweden deteriorating over time. As Sweden has some of the highest housing prices in the world and if household debt levels continue to increase, there is a possible danger of a future housing bubble.

Secondly, the central bank buying more bonds can also encourage consumers to increase their debts. Greater household debt-to-income ratios will make the household sector more vulnerable to any shocks. For instance, if weakened economic activity increases Sweden’s unemployment rate then households will struggle with debt repayments. In a worst-case scenario, households struggling with mortgage payments could default which would lead to distress selling. Prices of assets would in turn drop, i.e. downward spiral of prices and so making it more difficult for the nation to meet its target rate. However, this is unlikely to occur in Sweden as the nation has been enjoying a great fall in unemployment rates. The only major factors that could set off this risk are the high uncertainty levels from Greece and a possible declining economic recovery in neighbouring nations.

Following this, low rates of interest can encourage greater risk-taking. Investors will invest in much riskier assets when lending rates have been low for a significant time period. However, financial issues would arise once the central bank stops or reduces the amount of bonds purchased. For example, bond prices are less likely to accurately reflect the risk from high levels of debt. Also, as investors would have invested in riskier assets, the prices of equity would have increased unnaturally. Expansionary monetary policy can indeed place stress on financial markets in the long run.

Relaxed monetary policy will cause asset prices to rise as a result, but the prices are made vulnerable once monetary policy is restricted. As the discounted rate of cash flows are reduced and greater revenues are expected from assets, this would cause a heavy rise of asset prices. However, if the central bank decides to tighten its monetary tools once they’ve met their targets, asset prices would drop significantly and possibly collapse. Monetary policy is required to stay expansionary in order to prevent the collapse of asset prices. Furthermore, the use of expansionary monetary policy can negatively impact financial stability and growth in the long run.

Even though Sweden is likely to be successful with meeting their main objective through monetary eases, long-term implications need to be monitored. It is vital for Sweden’s central bank; government, policy makers and regulators to make sure the probability of future risks arising are reduced. The only major factors that could hinder Sweden’s battle with deflation are uncertainty in the euro area or if the growth of the economies it trades with begin to slow down.

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