This is an English translation of a Swedish Ekonomistas guest post  by Stefan Palmqvist, PhD, who works as an advisor at Finansinspektionen (the Swedish Financial Supervisory Authority). The opinions expressed are his own and not necessarily those of anyone else at Finansinspektionen.

In a post on Ekonomistas (in Swedish), Mats Persson discusses if the Riksbank should use more weapons than the repo rate. Mats argues that such actions would not do any harm at present, but that they also would not do much good. I mean that they certainly can do harm. The Riksbank’s current interest rate path indicates that the repo rate will be increased, while the Riksbank at the same time buys government bonds to bring down interest rates in general and to weaken the krona. With such a contradictory monetary policy the Riksbank’s possibility to influence expectations is reduced, which in turn can make it difficult to achieve the inflation target. 

Let us start by studying a period in which the Riksbank instead used monetary policy in a clear and consistent way. During the acute phase of the financial crisis, 2008-2009, the Riksbank acted with both conventional and unconventional monetary policy. The conventional monetary policy consists of the repo rate and forecasts for this; what is known as the repo rate path. During the autumn of 2008 and spring of 2009 the Riksbank cut the repo rate from 4.75 to 0.25 per cent. It also gradually revised down the repo rate path, which in July 2009 indicated that the repo rate would be held at 0.25 percent for almost two years (see the solid orange line in Figure 1).

But the Riksbank’s repo rate path was not credible. The market instead believed that the Riksbank would soon raise the repo rate again and predicted much higher interest rates than the Riksbank’s repo rate path over the next 2.5 years (see the solid red line in Figure 1).

Figure 1. Repo rate, market expectations and the Riksbank’s repo rate paths during 2009-2010. (Percent)
Sources: “Monetary Policy Report”, July 2009 and February 2010, Sveriges Riksbank.
Note: Market expectations are measured by the forward rates as of 25 June 2009 and 4 February 2010.

To support the repo rate path, the Riksbank complemented conventional monetary policy with unconventional measures, mainly in the form of so-called fixed-rate loans. This meant that the Riksbank, on three occasions during the fall of 2009, lent a total of nearly 300 billion kronor to the banks. These fixed-rate loans had maturities up to 12 months. The interest rate amounted to about 0.4 per cent, which was lower than the market expected, and the demand for these fixed-rate loans was high. During the autumn, the market expectations shifted down and in February 2010 they largely coincided with the Riksbank’s repo rate path, at least for the period covered by the fixed-rate loans (see the dashed lines in Figure 1, which are very close to one another until the middle of 2011). Other interest rates fell as well.[1] During this period, the Riksbank hence backed their words (the repo rate path) with actions (fixed-rate loans) and thus obtained credibility for the repo rate path. Monetary policy was both clear and consistent.

How do things stand today? The Riksbank has again acted with conventional monetary policy. It has cut the repo rate by a total of 2.25 percentage points since the autumn of 2011. It has also gradually revised down the repo rate path, which in February indicated that the repo rate would remain at very low levels until the second half of 2016. Thereafter, the Riksbank predicted that it will begin to raise the repo rate (see the solid orange line in Figure 2).

However, contrary to in 2009, the Riksbank’s repo rate path for the next 1.5 years was already credible since it coincided with market expectations in February. The difference that existed was that the Riksbank expected it to raise the repo rate faster than the market thought from the second half of 2016 (compare the solid lines in Figure 2).

Figure 2. Repo rate, market expectations and the Riksbank’s repo rate path during the spring 2015. (Percent)
Sources: ”Market pricing of the Riksbank”, 2015-02-12 and 2015-03-30, SEB and “Monetary Policy Report, February 2015”, Sveriges Riksbank.
Note: Market expectations are measured by the forward rates as of 12 February and 30 March 2015.

But even though the Riksbank’s repo rate path in February already was credible, it began to use unconventional measures. In February it bought government bonds worth 10 billion kronor to push down interest rates in general. [2] As a consequence, market expectations for 2015 had fallen by roughly 0.05 percentage points about a week later. But if the Riksbank wanted to bring down interest rates in general, why did it not revise its repo rate path in order to clarify how low interest rates in general should be? That would have been clear and consistent.[3]

In addition to the cut in February, the Riksbank cut the repo rate by a further 0.15 percentage points in March. The Riksbank said then that it expects that the repo rate increases will occur at a slower pace than indicated by the repo rate path in February.[4] Exactly which path the Riksbank predicts right now is not known, but it’s hard to believe that it would have adjusted the repo rate path down so much that it isn’t still above market expectations. The Riksbank is also buying government bonds during the period March-May for an additional 30 billion kronor to drive down interest rates in general and to weaken the krona. In addition, the Riksbank has stated that it is prepared to launch a program of loans to companies via the banks, that it can intervene in the foreign exchange market (weaken the krona), and that it can buy other types of assets. Market expectations have also this time shifted down (see the dashed orange line in Figure 2). But if the Riksbank wants to lower interest rates in general and weaken the krona, why doesn’t it lower the repo rate path significantly to clarify how low interest rates in general , and how weak the krona, should be?

It is good that the Riksbank takes its inflation target seriously and tries to bring inflation back to target. But it is not good that the Riksbank says that the repo rate will be increased and simultaneously acts to bring down interest rates in general, since that makes monetary policy unclear and contradictory. This may in turn reduce the Riksbank’s possibility to bring inflation to the target. It would be better if the Riksbank coordinated their conventional and unconventional measures in a similar way as during the financial crisis.

[1] See Elmér et.al. “The Riksbank’s monetary policy measures during the financial crisis – evaluation and lessons learnt”, Economic Review 2012:3, Sveriges Riksbank.

[2] See “Purchases of government bonds”, Basis for decision, February 11, 2015.

[3] Martin Flodén entered a reservation against the decision to buy government bonds in February. His main argument was that it could make monetary policy unclear, see the minutes of the monetary policy meeting, February 11, 2015.

[4] See the Press release from March 18, 2015.