Sweden: The Mistake Yellen Wants to Avoid

  March 17, 2015

By Johan Carlstrom for Bloomberg


Women-friendly work laws. An inclusive social safety net. Beautiful bike lanes. While there's a lot to love about what Sweden's policy makers have done, here's one blunder the U.S. will want to avoid: Underestimating the dangers of too-low inflation. 

This  month, after one year of too-slow price gains and another two years of falling prices, Sweden's central bank was forced to take unprecedented action. The bank slashed interest rates into negative territory in addition to announcing its intention of buying government bonds.

Critics said the drastic move came too late and could have been avoided altogether had the bank just acted sooner. In the four years leading up to the historic stimulus, the central bank's board had bitter debates over the need to cut interest rates, leading to the resignation of Deputy Governor Lars E.O. Svensson. 

Critics such as Svensson say the Riksbank started raising interest rates too soon, then cut rates too slowly even though the economy rapidly plunged into deflation.

The Riksbank was once seen as the world's state-of-the-art inflation-targeting central bank. Now, with deflation on its doorstep, its credibility has been damaged.

The Fed's policy rate is still at zero, where it has been since December 2008. U.S. policy makers want to raise interest rates this year. The haunting fact behind that intent: They have missed their 2 percent inflation target for 32 months, and aren't likely to get back there anytime soon. Fed officials continue to say that as the unemployment rate falls inflation should move back to the target.

In Sweden, central bank Governor Stefan Ingves was also firm in his belief that prices would soon rise (they didn't, as the chart above shows) and that more aggressive stimulus would further fan an emerging housing bubble.

In Sweden, price gains slowed from 3 percent to 1 percent over the course of a single year, only to decelerate further and actually start declining by late 2012.

Minutes of the Fed meeting in January showed an intense debate about the course of inflation in the U.S. and the risks of raising interest rates too early. That may be a sign that Fed officials have learned the Riksbank's lesson.

"An earlier tightening would increase the likelihood that the committee might be forced by adverse economic outcomes to return the federal funds rate to its effective lower bound," the Fed minutes said.

To be sure, there are some important differences between the U.S. and Sweden. One is that the U.S., at least as of now, is still seeing price gains. And in the U.S., what's driving plans to tighten is more a strengthening labor market and not so much concerns about fueling asset bubbles -- even though some policy makers have been quite vocal about their concerns about excessive risk-taking in some sectors.

Right now, inflation rates in other Western democracies are low or negative too. In Germany, inflation is negative 0.5 percent; in the United Kingdom it is 0.3 percent; and in Canada it is 1.5 percent. No central banker today will raise interest rates without looking carefully at Sweden's example.

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