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

Lars E.O. Svensson

Sweden has pursued a tighter monetary policy than is necessary to achieve the inflation target in order to reduce risks associated with household indebtedness. The net benefit to ‘leaning against the wind’ has been hotly debated; this column argues strongly against it. By reducing inflation, the Riksbank has in fact increased household debt, and contractionary pressure has worsened the employment situation. The author estimates that the benefits to leaning are worth only 0.4% of the costs.

There is a lively ongoing debate about whether raising interest rates beyond the level needed to stabilise prices – ‘leaning against the wind’ – is a justified modification of flexible inflation targeting (as discussed in Smets 2013). In a new paper, I explain why leaning against the wind is the wrong monetary policy for Sweden (Svensson 2014).

According to the Riksbank’s own recently published 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 (Sveriges Riksbank 2014). 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 the Finansinspektionen (FI, the Swedish FSA) to reduce any such risks.

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

Leaning against the wind would be justified in Sweden under two conditions, as discussed in a paper by Smets (2013):

The macroprudential policy of the FI is insufficient to reduce any risks from household debt.

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 over the next few years.

Regarding the first condition, the FI has already taken several actions that have reduced 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 amortisation 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 the second condition, I show in the paper, in some detail, 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 – is negligible compared to the policy’s cost (Sveriges Riksbank 2014). 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% 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 over 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 of around zero; that is, two percentage points lower than the inflation target and household inflation expectations.

That inflation over the last few years has fallen much below the target and household expectations implies that the households’ real debt burden has increased substantially. The real value of a given loan has (in two and half years) become 5% larger than if inflation had equaled the target. This has, if anything, increased the risks from household debt rather than reducing them, thereby making the FI’s work to reduce any such risks more difficult. As the FI writes in its latest stability report:1

"A lower than expected inflation rate 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 over a longer period, there is deflation and 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.

References

Finansinspektionen (2014), “The Stability of the Financial System”, (“Stabiliteten i det finansiella systemet,” in Swedish).

Smets, F (2013), “Financial Stability and Monetary Policy: How Closely Interlinked?” Sveriges Riksbank Economic Review 3: 121-160.

Sveriges Riksbank (2014), “The Effects of Monetary Policy on Household Debt,” box in Monetary Policy Report February 2014.

Svensson, L E O (2014), “Why Leaning Against the Wind is the Wrong Monetary Policy for Sweden,” working paper.

Footnote

Finansinspektionen (2014, p. 12), so far only available in Swedish (hence my translation from Swedish here).