The Riksbank governor Stefan Ingves suggested this week that their are no limits in the law to their interventions providing they're for monetary policy. Their mandate is to maintain inflation at a low and stable level and in their eyes, that really does seem to be at all costs.
Chris Jeffery and I have been chatting through their approach - we think that it's doomed to ultimately end in tears, and quickly moved on to what the right approach might have been as an alternative. Here's our solution to the Swedish problem, but first, let's set the scene...
Imagine a country with over 5% nominal growth in 2015, household debt growing 3 years in a row and house prices up over 20% in the last two years. Chris suggested that if you didn't know the country and you were asked to guess the short-term policy rate it probably wouldn't be negative and I had to agree. Before 2012, negative interest rates were the stuff of fantasy until Denmark decided to give it a crack in 2012. Now of course, it's become quite in vogue; even Japan is finally getting in on the act and the UK Gilt curve is currently pricing in a cut too.
But in Sweden's case this feels like a very indirect tool for what the central bank wants to achieve. Their basic remit is to achieve low but stable inflation. So their argument for intervention is that people's expectations of inflation are falling.
The problem is that they're importing the deflation from the very low inflation in imports from Europe and elsewhere. The Word Bank estimates Sweden's imports at 40% of its GDP, making it the 30th most open economy in the world according to the Observatory for Economic Complexity. The idea seems to be that intervention will keep the Krone down
To understand why it will end in tears, it's easiest to draw a picture, so here's my best attempt (with the help of Powerpoint of course):
When I write it down on paper, it almost looks reasonable, but there are problems with it.
A key part of the plan is that very low (in this case negative) interest rates pushes the Swedish Krone down, pushing up the prices of imports bought from abroad. In addition the low interest rates encourage consumers and businesses to borrow, pushing up demand and increasing inflation on locally produced goods too. But there's really nothing wrong with the domestic economy except for low inflation expectations. To combat that one problem, the Riksbank is distorting the local economy by encouraging excessive borrowing and unintentionally pushing up house prices.
So unfortunately Sweden is storing up problems for tomorrow. The UK and Spain have both demonstrated how serious housing bubbles and excess consumer borrowing can be. It’s reached a point where even home owners in Sweden are getting a bit uneasy with how high prices have got. It’s unsustainable and in due course it’s very likely that Sweden will suffer a significant recession, caused by the explosion in house prices and rising consumer debt. And of course when that time comes, the Riksbank will have very few tools to help stabilise the economy, with interest rates already on the floor and their own form of quantitative easing reaching its limits already.
So the natural question Chris and I asked ourselves was whether there was an alternative that might have been more successful in achieving their goal of low but stable inflation. We think we struck upon one potential solution, though whether it would be acceptable under European law is another matter and one we’ve not looked into.
The idea is to address the problem of lower import prices directly at source, but stabilising import prices. It almost sounds too simple, but the idea is to have some sort of time varying VAT that smoothes import prices in periods like now, when import prices stay low for prolonged periods. Below is a diagram, showing how it would work.
It’s a much more direct transmission mechanism, which avoids destabilising house prices and consumer borrowing. Of course, it might somewhat undermine the principles of a single economic zone, as by stabilising prices it maybe could be seen as protecting local producers. However, given the specific problem Sweden has and such a simple alternative to deal with it, tackling the legality of the right answer seems better to us than ploughing in with the wrong one.
So, having returned from our thought experiment on the Swedish economy we need to go back to what that means for markets. Our general thesis is unchanged, which is that the Riksbank experiment with negative rates will probably be looked back on as a policy error, with impacts for Sweden that could last well into the next decade.