Why leaning against the wind is the wrong monetary policy for Sweden

[English translation of Ekonomistas post.]
Vox column

In a new paper, ”Why Leaning Against the Wind is the Wrong Monetary Policy for Sweden,” which was presented at an NBER conference in Tokyo, June 20-21, I explain and summarize why leaning against the wind is the wrong monetary policy in Sweden.[1] According to the Riksbank’s own calculations, the benefit of this policy, in the form of lower risks from household debt, is completely insignificant compared to the cost in terms of higher unemployment and lower inflation. Since inflation has fallen much below the inflation target and households’ inflation expectations, the policy has instead actually increased households’ real debt burden and, if anything, increased any risks from the debt. Thereby, it has made more difficult the work of Finansinspektionens (FI, the Swedish FSA) to reduce any such risks. 

“Leaning against the wind” is a monetary policy that is tighter than what is justified in order to achieve the inflation target and also to support Swedish economic policy’s most important goal, full employment. It thus leads to lower inflation than the inflation target and higher unemployment than a long-run sustainable rate. The Riksbank has rather aggressively been leaning against the wind the last few years, with the purpose of reducing household indebtedness and thereby any risks from it.

Leaning against the wind would be justified in Sweden under two conditions: (1) The macroprudential policy of FI is insufficient in reducing any risks from household debt. (2) A higher policy rate leads to benefits in the form of lower risks of a future crisis; benefits that are larger than the costs in terms of higher unemployment and lower inflation the next few years.

Regarding condition (1), the FI has already taken several actions, which have reduced any risks from household debt. It has introduced a loan-to-value cap for mortgages, increased risk weights on mortgages, increased capital and liquidity requirements for systemically important banks, and proposed that banks suggest individually adapted amortizations plans to their borrowers. The FI considers these actions sufficient at present, but is monitoring the developments and is prepared to take additional action if justified. It is difficult to maintain that macroprudential policy in Sweden would be insufficient.

Regarding condition (2), I show in some detail in the paper that the Riksbank’s own calculations imply that the benefit of a higher policy rate, in the form of possible both lower probability and less depth of a future crisis, instead of exceeding the cost is completely negligible compared to the cost. Expressed in terms of a lower expected future unemployment, the benefit is only about 0.0038 times the cost in the form of higher unemployment during the next few years. That is, the benefit is only about 0.4 percent of the cost.

Thus, none of the conditions that would together justify leaning against the wind in Sweden are satisfied. Without any noticeable benefits, the Riksbank’s leaning against the wind the last few years has led to high costs in the form of a higher unemployment rate, arguably about 1.2 percentage points higher than necessary, and an inflation rate around zero, that is, 2 percentage points lower than the inflation target and household inflation expectations.

That inflation the last few years has fallen much below the target and household expectations has actually implied that the households’ real debt burden has increased substantially. The real value of a given loan has in two and half years become 5 percent larger than if inflation had equaled the target. This has, if anything, increased any risks from household debt rather than reduced them. Thereby it has made the FI’s work to reduce any such risks more difficult. As the FI writes in its latest stability report (p. 12 of the full report in Swedish, so far only a summary of the report is available in English; hence my translation from Swedish here):

A lower inflation rate than expected contributes to increasing the real debt burden, that is, debt relative to the general price level. This may in turn contribute to the building up of financial risks and make it more difficult for households, firms, governments, and countries to manage their balance sheets. If inflation becomes negative during a longer period, there is deflation, in which case a further increasing debt burden and expectations about falling prices may lead to falling aggregate demand and thereby even lower prices. As the experience of Japan since the 1990s has shown, such a spiral may be difficult to break out of.

Thus, it is difficult not to conclude that the Riksbank’s leaning against the wind is the wrong monetary policy for Sweden.

[1] The paper was presented with the working title “Inflation Targeting and Leaning Against the Wind: A Case Study.” A shorter version, with the title “Inflation Targeting and ‘Leaning against the Wind’,” has been published in International Journal of Central Banking (June 2014).