Infocus - The Riksbank has a problem

Looking ahead to its policy meeting on 26 April, the Riksbank is in a difficult situation. Inflation is already much above the 2% target and is being fanned further by a depreciating krona, both of which call for higher interest rates. But a weakening economy and the fact the Swedish economy is extremely sensitive to interest rates urge caution. In this issue of Infocus, EFG Chief Economist Stefan Gerlach reviews the situation.

The world’s oldest central bank going back to 1668, the Swedish Riksbank, is facing difficulties. With double-digit inflation, a weakening economy and an unfortunate combination of massive household mortgage borrowing that is highly sensitive to rate changes, the policy meeting on 26 April will not be easy.

The key task for the Monetary Policy Committee is to find a level of interest rates that is high enough to lower inflation, but not so high as to cause difficulties for households facing large mortgage bills.

Surging inflation

Measured by the consumer price index (CPI), prices rose by 10.6% year-on-year in March. This measure of inflation will be boosted by the fact that the Riksbank has raised interest rates: looking at the CPI with a fixed interest rate (CPIF), which the Riksbank uses to express its inflation target, prices rose by 8.0% over the same period. To understand the broad-based nature of inflation it is useful to look at the CPI net of energy with a fixed interest rate (CPIFXE). By this measure, prices rose by 8.9% year-on-year in March (see Figure 1).

The inflation problem is reflected in the behaviour of the exchange rate. Looking at the last decade of data, Figure 2 shows that the exchange rate against a basket of currencies has depreciated very sharply since 2013 by a cumulative 23%. While the CPI in Sweden has risen marginally faster than the tradeweighted CPIs of its trading partners, the increase in relative prices, 3%, is much smaller than the change in the exchange rate, implying that the real exchange rate has also depreciated.

This unfortunate combination of an exchange rate that depreciates much beyond what is suggested by price level differentials has been more pronounced since January 2022: while the trade-weighted exchange rate has depreciated by 7%, inflation in Sweden has been 3% lower than in its trading partners.

Of course, the Riksbank targets inflation and therefore only responds to the exchange rate to the extent it has implications for inflation. But by that standard, monetary policy appears to have been too expansionary in Sweden, at least in recent years.

The surge in inflation and the depreciation of the exchange rate has occurred despite the Riksbank having raised interest rates by 300 basis points since May 2022. The first increase came in May 2022 when rates were increased by 25 bps (see Figure 3). Policy was tightened again in July, this time by 50 bps as the Riksbank realised its rates were far too low and had to raise them substantially. In September, it doubled up and raised rates by 100 bps. In November rates were raised again, but by 75 bps, and in February 2023, by 50 bps.

In December 2022, the Riksbank also ended its asset purchase programme, which it had started in March 2020 as the Covid pandemic started. However, purchases had been very limited from July 2022 onward (see Figure 4).

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