Deflation in Sweden: Questions and answers

New Ekonomistas post (in Swedish). This is an English translation.

Sweden has deflation, that is, negative inflation. According to Statistics Sweden, CPI inflation in March was minus 0.6 percent. As we can see in the figure below, CPI inflation has been around zero since November 2012, and since January 2014 it has been negative. CPIF and HICP inflation i March was zero and minus 0.4 percent, respectively. We see that CPIF and HICP inflation has been on a downward trend since the summer of 2013. The inflation rate in Sweden is now among the lowest in the world. What has caused the deflation, what are its consequences, could Sweden end up in a similar situation as Japan, and what can be done about the problem?


Green is CPI inflation, black is HICP inflation, yellow is CPIF inflation, and blue is HICP inflation in the European Union.
Source: Statistics Sweden

What has caused the deflation?

The deflation has been caused by the Riksbank’s tight monetary policy since the summer of 2010. The majority of the executive board chose in the summer of 2010 to start increasing the policy rate, which was then at 0.25 percent. The policy rate was increased at at steady and fast rate to 2 percent in the summer of 2011. The increases started, in spite of the forecast in the summer of 2010 for inflation the next few years lying below the inflation target and the forecast for unemployment lying far above a long-run sustainable rate. (See figure 2 in this post.) The policy-rate increase caused the real policy rate (measured as the repo rate less HICP inflation, in order to be comparable across countries) to increase from minus 2.5 percent to plus 1 percent. This is a very large increase of 3.5 percentage points and was a very dramatic tightening of monetary policy. (See figure 3 in this post.)

With such a strong tightening of monetary policy, it would be very strange if inflation would not fall far below the target, and even become negative, as it indeed has done. It would also be strange if unemployment would not increase and stay high above a long-run sustainable rate, as it also indeed has done. Without the tightening that started in the summer of 2010, inflation would most likely now have much closer to the target and unemployment might have been about 1.2 percentage points lower. (See this post.)

What are the consequences of deflation?

Deflation implies that real debt increases. Thus, households’ (and firms’) debt burden increases, especially compared with if inflation had been 2 percent. Inflation has fallen far below inflation expectations the last few years, and this means that the price level has become considerably lower than anticipated. This in turn means that real debt has become considerably larger than borrowers had anticipated and planned for. The real value of each borrowed SEK million has increased by more than SEK 40 000 since the fall of 2011, compared with if the Riksbank had kept inflation on target. (See this post.)

If one, as the majority of the Riksbank’s executive board, is concerned about household debt, it is completely wrong to cause too low inflation, and even deflation. (For the comments of Governor Stefan Ingves on this, see this post.)

Deflation also means that real wages, for given nominal wages, increase. This is good for people with safe jobs and a given nominal wage. But lower inflation than anticipated in wage negotiations leads to higher real wages than anticipated. This in turns leads to many people without safe jobs losing their jobs and becoming unemployed. Low inflation and deflation thus have very uneven effects, and has large negative welfare effects.

Could Sweden even end up in a situation similar to that of Japan?

Deflation increases the risk of falling into a long period of a so-called liquidity trap, a situation with a zero policy rate, deflation, and expectations of low inflation or even deflation, as in Japan. Then, in spite of a zero policy rate, the real rate is too high, with continued deflation and high unemployment as a result.

An extremely large bubble in commercial property was burst in the beginning of the 1990s by policy-rate increases by Bank of Japan. After this, the Japanese economy stagnated, with low growth, deflation, and expectations of continued deflation as a result. Many economists, including at Princeton Ben Bernanke, Paul Krugman and me, criticized Bank of Japan for blaming deflation on other things than monetary policy and to conduct a too cautions and too tight monetary policy, instead of introducing a positive inflation or an upward-slopiong price-level target and do whatever it took to stimulate the economy and break the deflation tendency. With “abenomics“, after the election in December 2012 of Shinzō Abe to prime minister, monetary and fiscal policy has changed to become much more expansionary. It is too early to tell whether this policy change will succeed, but now no one can now accuse Bank of Japan of not trying very hard to break the deflation tendency.

If the Riksbank does not conduct a sufficiently expansionary policy, it can probably not be excluded that falling inflation expectations, continued deflation or too low inflation, a high real policy rate compared with rest of the world, and too strong krona, could push Sweden towards a long period of a liquidity trap.

What can be done about the problem?

The most important thing is that the Riksbank takes the inflation target seriously and stops neglecting it. In order to get inflation back to target soon, the policy rate has to be lowered quickly to 0.25 percent or even zero. If this does not help, the Riksbank – as other central banks at the zero lower bound with too low inflation and too high unemployment – will have to use unconventional (but by now frequently tested) policy measures. These include a negativ policy rate, large-scale asset purchase to lower long interest rates (quantitative easing), a low policy-rate path for a longer period with different variants of “forward guidance”, foreign-exchange interventions to depreciate the currency or at least (as in Switzerland) prevent it from becoming too strong, and to aim to overshoot the inflation target for a few years. (This speech from the spring of 2009 discusses some of these policy measures.)

The executive board majority’s argument against a lower policy rate is, as is well known, that it  would increase risks associated with household debt. But the Riksbank’s own calculations does not support that view. According to these calculations, lowering the policy rate by 1 percentage point, that is, to minus 0.25 percent, would have miniscule effects on such risks. (See this post.)

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