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Difficult path ahead for Riksbank

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In common with several other European countries, Swedish inflation in December ticked up a little, with CPI rising from November’s 1.4% to 1.7%. Producer prices rose 6.5%. What makes Sweden different is that, whereas across much of the rest of Europe rising inflation is being accompanied by accelerating economic growth, in Sweden the boom generated by the Riksbank’s aggressive monetary policy (the repo rate has been minus 0.5% since February 2016) started to fade last summer. GDP in Q3 2016 grew at an annualised rate of 2.8%, down from the previous quarter’s 3.6%. 

Meanwhile, the housing market, which has seen prices increase by more than 125% since 2005, received a blow in June last year when high-value interest-only mortgages were effectively banned. Loan capital must now be paid off at a minimum rate of 1% per annum on properties with a loan to value (LTV) of more than 50%, and at 2% for properties with an LTV of more than 70%.
 
While few would disagree that Sweden’s booming housing market is an unfortunate side-effect of the Riksbank’s ultra-low interest rate policy, and that a slowdown would be no bad thing, it will have to be carefully managed. The risk is that a sharp slowdown – or even actual falls in house prices – could adversely affect consumer confidence and lead to something more serious.

Meanwhile, the exchange rate is not helping. Having weakened sharply last Autumn against the euro, the krona has, in little over a couple of months, retraced from 9.9600 to 9.4400.This is a result of the market pricing in some sort of increase in interest rates. With rates remaining so very low virtually everywhere, very small changes in relative yields can make a big difference to foreign exchange rates. 

What is worrying the market is not so much Sweden’s headline rate of inflation but its core rate, which increased from 1.6% to 1.94% between November and December and is now running 0.24% higher than the headline rate. This is very different from the situation in the eurozone, where headline inflation rose from 1.1% in December to 1.8% in January but core inflation remained at 0.9%. While there is no chance of the ECB raising rates with core inflation at such a benign rate, markets have started to believe that, with Swedish core inflation running at more than double the eurozone rate, the Riksbank will be moving first. 

In the same way as the ECB is often described as being between a rock and a hard place, so it is with the Riksbank. The ECB is currently wrestling between setting monetary policy to achieve an equilibrium between the opposing demands of Germany (which is showing signs of overheating, particularly in the housing market) and Italy (which is still suffering from powerful deflationary forces associated with, but not limited to, its banking sector). 

The Riksbank, for its part, must make the difficult choice between prioritising price stability, while gently deflating the property bubble – and running the risk of rate rises strengthening the SEK and causing economic pain through reduced exports – or prioritising growth, continuing with loose monetary policy and running the risk that the property boom continues unabated. It is an unenviable task that is made somewhat easier by the restrictive measures on mortgages – so-called ‘quantitative restraint’. 

However, it is most certainly made more difficult by the illiquidity of the SEK market and the FX market’s clear view that Swedish interest rates must now rise as core inflation appears to be taking off. If the Riksbank finds itself unable to control the property market through monetary policy, without adversely strengthening the SEK and slowing the real economy, then we must surely expect more quantitative restraint. 

High prices in Stockholm and Gothenburg are forcing property investors to seek yield outside the main centres, suggesting that the easy money may already have been made, particularly given that the Swedes are second only to the Danes in the household indebtedness stakes. However, the acute sensitivity of the EUR/SEK exchange rate suggests that even the most gentle movement on the tiller – a move in the repo rate from -0.50% back to -0.35%, for example – would have a leveraged effect on the real economy, on account of the inevitable impact on the exchange rate. In short, investors have more to fear from the indirect effect of interest rate rises, when they arrive, than from a moderate change in policy per se. The Riksbank is certain to recognise this too and therefore we expect it to look through the uptick in inflation in the near term in order to avoid the negative impact on the real economy of further strengthening of the SEK.

All views expressed here are the Author’s own and are based on information available at the time of writing  

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