Winner of the New Statesman SPERI Prize in Political Economy 2016

Thursday, 14 December 2017

The advantage of a central bank not being ‘ahead of the curve’

Imagine the following economy. Growth has been strong for a number of years: 2.7% 2014, 3.8% 2015, 3.1% 2016 and is expected to be above 3% again in 2017. The OECD also think the output gap is positive i.e. output is above the sustainable rate. Inflation was bobbing around zero for a few years, but since 2016 has gradually crept up to the target of 2%. It was just over 2% in the summer, but dipped just below target in the last two months. Fiscal policy is broadly neutral, and is expected to remain so. The unemployment rate is still slightly above 6%, but the average rate since the crisis in the early 1990s is over 7%.

We are talking about the very healthy Swedish economy. An economy where inflation is at target and some experts think the economy is running hot. What level do you think the Riksbank, Sweden’s independent central bank, has set its interest rate at? The answer is -0.5%. What is more the general expectation (the Riksbank publishes its interest rate forecast) is that rates will not start rising above -0.5% before min-2018. In addition, the Riksbank is undertaking its form of QE.

What can explain this dovish behaviour? Central banks are supposed to be inflation averse, and elsewhere they talk about the need to ‘normalise’ rates the moment the economy starts recovering, so that they are ‘ahead of the curve’. Part of the answer lies in the past. I have told the story in real time (here, then here, then here), so just a short synopsis this time. The Riksbank started raising interest rates from its then lower bound of 0.25% towards the end of 2010, because they were worried about a potential housing bubble. Rates continued to rise to 2%, but inflation began to fall, and did not stop until it hit zero at the end of 2012. There was no growth in GDP in 2012. The eminent macroeconomist Lars Svensson resigned from the Riksbank in protest at this departure from inflation targeting.

Sweden: Consumer Price Inflation and Short Interest Rates, plus forecast (from OECD Economic Outlook)

In 2012 the Riksbank admitted their mistake, and started lowering rates to the new lower bound of -0.5%, where they have been since the beginning of 2016. Having made the error of prematurely raising rates once, they are in no hurry to risk doing so again.

The Swedish experience I think illustrates a number of points that could also be applied to other central banks.

  1. Macroprudential policy is the way to deal with financial instability like housing bubbles. Using the interest rate instead can be very costly. Controlling inflation should be the only thing short term interest rates are used for.

  2. Low, below target, inflation can be very sticky. Swedish interest rates went below zero at the beginning of 2015, but inflation only went above 1% just under 2 years later, and this despite growth in GDP of 3.8% in 2015.

  3. Inflation went above target in July, August and September of this year. But the central bank, looking at the basic determinants of inflation like wage growth relative to productivity growth, held their nerve and kept rates at -0.5%. Inflation fell back to 1.7% in October, and has stayed below 2% in November.

  4. The argument that interest rates must be raised above their floor so that central banks are ‘ahead of the curve’ has not been as influential in Sweden as it has been elsewhere.

It could still go wrong for Sweden, but if it does not then the Riksbank's 2010/11 mistake may have a silver lining. By making the central bank extremely dovish, they have allowed the Swedish economy to grow strongly and unemployment to fall substantially. Perhaps the mantra adopted by other central banks of needing to be ahead of the curve in terms of early ‘normalisation’ is not such a clever idea.


  1. The idea that interest rates should return to “normal” is one of the most fatuous ideas of all time. In Galileo’s day it was “normal” to claim the Sun revolved around the Earth, which of course proves the Sun really does revolve around the Earth. And in ancient Rome is was “normal” to have lions eat Christians, which proves it’s a jolly good idea to have lions eat Christians.

  2. You seem to have ignored the influence that 7% unemployment (17% unemployment for adults < 25 yrs) may have had in Sweden.
    They will get inflation (imported from China) in 2018, what then?

  3. It will be interesting to see whether interest rates can be kept at zero (or perhaps even -0.5%) for ever as MMT people advocate. If that turns out to be the case, then perhaps the central bank doesn't have much to do, there simply needs to be an ample excess of reserves and that's the job done?

    1. That will not happen unless fiscal policy is used as a countercyclical tool at all times. That is not current policy.

  4. With the exception of some details of the historical description the conclusions in this post are very much in line with those in a speech held last week by the Riksbank Deputy Governor Per Jansson. Did you happen to read it? If not, it can be found here:

  5. With the exception of some details of the historical description the conclusions in this post are very much in line with those in a speech held last week by the Riksbank Deputy Governor Per Jansson. Did you happen to read it? If not, it is available on the Riksbank’s web site. [Realised that it probably wasn’t a good idea to include a link in the comment.]

  6. I wonder if an element of hysteresis could be at work. By overshooting inflation with a high-pressure labor market, the nairu may get pulled down a bit, reducing the pressure on inflation.

  7. I am not sure about your argument.

    If you have the output gap is positive and the inflation is close to 2%, then you should have positive policy interest rate no less than 4%, assuming that real short rate being around 2%.

    European economies like Japan's economy may be in a aggregation trap, in which a central bank can not raise its policy rate in fear of appreciation of the currency.

    I suspect a small open economy uner floating exchange rate system could easily face asset bubbles and bursts if you continue to keep such an ultra easy monetary policy.

    Question remains when the realty comes true as we saw in the so-called Leman shock a decade ago.

    Tomo Nakamaru

  8. if the economy were truly "above potential" or "over heated" then one would certainly expect inflation

    perhaps workers are not experiencing much increased bargaining power

    or there is less monopoly power in their economy that one might expect

    those are the two main elements causing excess inflation

    it is possible we just have "sticky inflation" and the onset of excess inflation is brewing and just around the corner

    but perhaps they are not really overheated at all

    at any rate, what is your explanation for this "sticky inflation" if that is truly what we have going on here


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