So, why is inflation so low in Sweden? Svensson claims:
The deflation has been caused by the Riksbank’s tight monetary policy since the summer of 2010.In Sweden, the Riksbank's policy rate is the repo rate, which is set by the Executive Committee of the central bank, and has followed this path since 2008 (again, from the Riksbank's web site):
The Riksbank kept the policy rate at 0.25% well into 2010 and then, as the recovery proceeded at a normal pace and inflation increased, the policy rate went up, in typical Taylor-rule fashion. The policy rate reached a peak of 2% (not very high, right?) in late 2011, and then, as the Riksbank started to see real GDP growth below 3% and inflation below the 2% target, it quite promptly began cutting the policy rate. The policy rate is currently at 0.75%, and plans for its future path, conditional on the forecast, can be seen in the second chart. But what happens if the inflation rate stays low? From the Riksbank's last policy statement:
Monetary policy needs to remain highly expansionary to contribute to inflation rising towards the target. Although inflation has been somewhat lower than expected, only a minor revision has been made to the inflation forecast. The Executive Board of the Riksbank has therefore decided to hold the repo rate unchanged at 0.75 per cent. It is judged appropriate to begin gradually raising the repo rate in one year's time, when inflation has picked up.That's from a section titled "Low Interest Rate Until Inflation Picks Up." Clearly, if inflation remains low, the policy rate will remain low.
As economic activity strengthens, inflationary pressures are expected to rise. However, it is uncertain how quickly inflation will rise, particularly as it has been weaker than expected for some time now. The repo-rate path has therefore been adjusted down somewhat and reflects a greater probability of a repo-rate cut in the near term compared with the assessment made in February.
So, it seems to me that the Riksbank has been, and is, playing pretty much by the Old-Keynesian/New Keynesian book. Why Svensson doesn't like what the Riksbank was and is doing is not apparent from the data. We need to dig deeper to find out why he's so critical. Svensson was a Deputy Governor of the Riksbank from May/2007 to May/2013. At a critical juncture in June 2010, the Executive Board of the Riksbank voted to increase the policy rate 1/4 point to 0.5%. Svensson dissented:
Deputy Governor Lars E.O. Svensson entered a reservation against the repo-rate path and advocated a repo-rate path with a repo rate of 0.25 per cent through the fourth quarter of 2010, and thereafter a gradual return to the repo-rate path of the main scenario. Lars E.O.Svensson maintained that such a repo-rate path results in a better outcome for both resource utilisation and inflation, with both lower unemployment and CPIF inflation closer to the target.After leaving the Riksbank, in September 2013 Svensson wrote this post, in which he claims that, if the Riksbank had not only done what he had recommended in June 2010, but kept the policy rate at 0.25% until the current time, the inflation rate would be at the 2% target, and unemployment would be lower. In Svensson's September 2013 post, it is not clear to me what model he used to come up with his counterfactual, but suffice to say that, whatever the model is, it tells us that a short-term real interest rate of -1.75% can be sustained for 3 1/2 years, which seems goofy. One thing I would be interested in seeing is the output this model produces under the actual path for the policy rate. My guess is that it predicts inflation well above what actually occurred. Off the top of my head, I would say that, under Svensson's policy scenario, the inflation rate would currently be lower, and the unemployment rate would be about the same as what we're actually seeing in Sweden now.
Of course, this is just quibbling over history. What does Svensson think the Riksbank should do now if it wants to hit its 2% inflation target?
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 negative 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.By now, it should be well known that Taylor rules have some very undesirable properties. In particular, a central bank which follows a Taylor rule blindly can get stuck in a policy trap, in which the policy rate is at the zero lower bound, and inflation is low or negative. The central bank wants higher inflation, and thinks it will achieve this by lowering the policy rate, which is not feasible, so the policy rate stays at the lower bound and - given that the Fisher relation holds in the long run - inflation stays low or negative. This is the policy trap that Svensson's advice would lead the Riksbank into.
Once the Riksbank is stuck at the zero lower bound, what would Svensson have it do? Unconventional policy is the prescription. As Svensson notes, unconventional policy has been "frequently tested." So how did that work out? In the U.S., as you know, the Fed has been deeply into unconventional policy for the last five years - quantitative easing (QE) and forward guidance in particular. But apparently those experiments have not been so successful, as the inflation rate has been falling for the last two years or more: "Quantitative and Qualitative Monetary Easing Program," which began in April 2013.
In Sweden, the Riksbank cannot consistently meet its inflation target of 2% if the policy rate stays low or goes to zero. The Fisher relation guarantees that. In order to meet its inflation target, the Riksbank has to increase the policy rate - there's no other way to do it.
In addition to the standard Taylor-rule policy-trap problem, there are two elements of Svensson's unconventional policy recommendations that further exacerbate the problem, in terms of how Svensson looks at it. First, if QE works in the long run the way I've modeled it, then it will ultimately produce less inflation, not more, if the policy rate stays low or at the zero lower bound. Second, consider Svensson's "negative policy rate" recommendation. This appears to be a variant of the idea that, if our problem is a binding constraint on the nominal interest rate at zero, then we should relax the constraint by somehow taxing the liabilities of the central bank. Miles Kimball loves this idea. Basically, the central bank could tax reserve accounts, and there are schemes that might allow taxation of currency or its electronic replacement.
What would be the effect of taxing central bank liabilities? For simplicity, think about a world with perfect certainty. In the long run, standard asset pricing gives us the Fisher relation, which is
R = r + i,
where R is the short-term nominal interest rate, r is the real interest rate, and i is the inflation rate. If central bank liabilities are not taxed, then arbitrage gives us the zero lower bound, i.e. R cannot fall below zero. But if we tax central bank liabilities at the rate t per period, then the lower bound on R is -t. Therefore, in the long run, if R is targeted at its lower bound by the central bank,
i = - r - t
So, if we think that r is invariant to monetary policy in the long run, then if the central bank pegs the nominal interest rate at its lower bound, and central bank liabilities are taxed, this will make long-run inflation lower.
Basically, people who advocate for taxes on central bank liabilities as a means for increasing inflation are making the same error as are people who are concerned that the currently large stock of reserve balances in the United States might ultimately produce more inflation (a group of people that may or may not have once included yours truly). For example, you might think that, if you tax central bank liabilities, then people have less inducement to hold those liabilities, and inflation results due to some kind of hot-potato effect. Similarly, you might think that, as assets other than money become more attractive (as the economy recovers and real returns rise), that inflation might rise, for a similar reason. Well, that logic is wrong. To induce people to hold central bank liabilities when the nominal interest rate has been at its lower bound for a long period of time, the inflation rate must be sufficiently low, so that the real return on money is sufficiently high. If we tax central bank liabilities, or the real returns on alternative assets are higher, the inflation rate must be all the lower in the long term, in order to make central bank liabilities sufficiently attractive that people will hold them.
***Addendum: I made an error in the chart by including a March observation which was a preliminary estimate for something that was not in fact the national CPI. Here's the chart that (correctly) drops the last observation: