Strategy and Macro Research – Large Corporates & Institutions 1 of 5

Title Macro analysis – 12 May 2014

Macro focus – Sweden

What is needed for a 50 basis point cut in July?

• Several events during May and June can in-crease the likelihood of a 50 basis point cut in July

• At present the likelihood of a 50 basis point cut in July is about 10 percent

• There is a strong economic case for a 50 basis point cut in July.

Inflation in Sweden shows a remarkable deviation from the inflation target. In March the CPI was -0.6 percent and the CPIF (consumer price index with a fixed mort-gage rate) year on year change was 0.0 percent. The average for the past 12 months also shows that the CPI is a long way from the Riksbank’s target of 2 percent. The market, and Swedbank, anticipates a repo rate cut of 25 basis points in July. Here we present a list of the most important leads prior to the Riksbank’s monetary decision in July. We suggest that the likelihood of a 50 basis point cut in present circumstances is 10 percent, but that the probability may rise if a number of events occur. The three main variables will be (1) the inflation outcome, (2) action by the ECB, and (3) the meeting of the Financial Stability Council in May.

What is required for the Riksbank to make a 50 basis point cut?

There are a number of events which together would increase the likelihood of a 50 basis point interest rate cut. In our judgment, at least three of these events should deviate sub-stantially from market expectations for a 50 basis point cut to become likely. In chronological order the most important events are as follows:

1. If actual inflation in April and/or May is a surprise on the downside (May 13 and June 12).

2. The Financial Stability Council makes clear, forceful recommendations for countering increased indebt-edness (May 23).

3. Weak GDP in 2014 Q1, and/or a downward revision of 2013 Q4.

4. A more expansive monetary policy from the ECB which weakens the euro and indirectly strengthens the Swedish krona (June 5).

5. The exchange rate strengthens more than the Riks-bank forecasts.

The fifth event, the exchange rate trend during the period until the Riksbank meeting in July, does not have a specific date but is an important variable. All events in the list above can affect the exchange rate, but the exchange rate can also

change as a result of other events around the world, which affect the Swedish krona exchange rate directly or indirectly. Graph 1 shows the trend of the Swedish krona in trade-weighted terms (the so-called KIX Index or Effective Ex-change Rate Index) and the Riksbank’s forecast.

DateDateDateDate EventEventEventEvent

May 13May 13May 13May 13 Inflation figure for April

May 23May 23May 23May 23 Meeting of the Financial Stability Council

May 30May 30May 30May 30 GDP, first quarter

June 5June 5June 5June 5 ECB interest rate announcement

June 12June 12June 12June 12 Inflation figure for May

July 3July 3July 3July 3 The Riksbank’s interest rate decision

The trend of the KIX since the last Riksbank meeting in April suggests that a cut is not likely. On May 9 the Swedish krona was 1.4 percent weaker than in the Riksbank’s forecast, in KIX-weighted terms. In the opinion of ECB, a 10 percent strengthening of the euro would contribute to a 40-50 basis point reduction in inflation. Recalculated for Sweden, the latest weakening of the exchange rate could increase infla-tion by just about 10 basis points, i.e. a 0.1 percent increase according to this rule of thumb. This however is too little to get close to the inflation target in a meaningful way. Higher than expected actual inflation, strong GDP growth and measures by the ECB could again contribute to an apprecia-tion of the Swedish krona and lower inflationary pressure.

Graph 1: The Swedish krona has weakened compared with the Riks-bank’s forecast

Macro focus – Sweden

2 of 5 Strategy and Macro Research – Large Corporates & Institutions

Remarkable deviation from the inflation target

Despite an upturn in economic activity in Europe and Swe-den, inflation continues to drop and unemployment remains at a persistently high level. In Sweden the year-on-year CPI was -0.6 percent in March. The year-on-year CPIF was 0.0 percent, the lowest figure recorded since the commencement of the series in 1988. Graph 2. Remarkable deviation from the inflation target

Falling inflation is not only a Swedish phenomenom. Graph 2 shows that inflation is below the inflation targets in a num-ber of developed economies. However, we can conclude that Sweden is further from its inflation target than, for example, Switzerland, the Eurozone and Canada. Also, Graph 1 shows a further drop of inflation in March compared with the average for the past 12 months in Sweden, the Eurozone and Nor-way. In the USA, Canada and Switzerland the latest outcome is marginally higher than the average for the past 12 months. The trend of falling interest rates in the majority of devel-oped economies can be divided up into three factors. First, a global decline in food and energy prices. Second, low capacity utilisation and a large surplus of unutilised resources in the labour market since the financial crisis are holding down wage increases. Third, structural changes are ongoing, lead-ing to greater competition in many sectors and making it difficult for companies to raise prices. This includes greater competition from e-commerce in the retail trade, lower mar-ginal costs, for example, in music, literature and journalism, and a larger international component in service sectors, pre-viously reserved for local markets. It is important to emphasise how difficult it is for the Riks-bank to achieve the inflation target, but it is economically very important that it actually happens. It is important for the Riksbank’s credibility. Well anchored inflation expecta-tions are central for the Swedish wage bargaining process. Accelerating urbanisation in combination with a low level of housing construction has led to a rise in household debt, pri-marily in the metropolitan areas. Statistics from the Riksbank show that the leverage of households with new loans is about 370 percent of disposable income. Low inflation will mean an additional burden for these households because the value of the debt will not decrease and might even increase if we have deflation. An inflation rate well below the inflation target will benefit those who do not have debt and have sub-stantial assets, primarily older, affluent households. House-holds with high debt levels will lose out when their debt does not decline in value.

Inflation which deviates from the inflation target over a long period has a negative effect on the real economy. It makes wage formation more difficult, the propensity of households to consume is weakened and incentives for companies to invest are reduced. There is a risk that the improvement in the economy will falter if the adverse effects of low inflation intensify. The case for a 50 basis point reduction in July

Swedbank’s forecast is that tSwedbank’s forecast is that tSwedbank’s forecast is that tSwedbank’s forecast is that thhhheeee Riksbank will cut the repo Riksbank will cut the repo Riksbank will cut the repo Riksbank will cut the repo rate by 25 basis points in Julyrate by 25 basis points in Julyrate by 25 basis points in Julyrate by 25 basis points in July. In our judgment, the likelihood of a 50 basis point cut is about 10 percent. It may become more likely if one or more of the events we list above actually occurs. However, there is a strong economic case for a 50 basis point cut, even on the basis of present information. Firstly, the remarkable deviation from the Riksbank’s inflation target puts the credibility of the Riksbank at risk and expec-tations of inflation will diminish. In the latest survey for Prospera, inflation expectations over five years are 1.8 per-cent (see Graph 3). Inflation expectations fell below 2 percent at the beginning of 2013, and since July 2013 the number has remained consistently below two percent. Two year in-flation expectations are 1.6 percent. The Riksbank’s credibil-ity is increasingly questioned in the economic-political debate in Sweden. There have even been calls for a less independent Riksbank. Graph 3: Inflation expectations drop

Secondly, it is reasonable to ask how much a 25 basis point cut will affect inflation and the real economy. A 25 basis point cut is already priced into the market and its effects on the Swedish krona should be limited. The effect on import prices would therefore be limited and thus not contribute to higher imported inflation. Interest costs for households and companies are already low and a 25 basis point cut will only produce a marginal increase in consumption and investment, and thus a weak effect on employment. Also, a 25 basis point cut would probably be countered by a somewhat wider spread on mortgage loans as a result of the Swedish Finan-cial Supervisory Authority’s decision of May 8 on higher capi-tal requirements for the banks. A 50 basis point cut could actually have some effect on infla-tion. Because the cut would be unexpected, the Swedish kro-na would weaken and contribute to higher imported inflation and contribute to stimulating Swedish exports. A 50 basis point cut in interest rates could also contribute to expecta-tions for a stronger economy. If households and companies expect higher growth in the future, this can lead to higher consumption and higher investment in the short term as well.

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jan-12 apr-12 jul-12 okt-12 jan-13 apr-13 jul-13 okt-13 jan-14 apr-14

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Prospera: Inflationsförväntningar bland penningmarkandens aktörer

2 års sikt 5 års sikt

Källa: TNS SIFO Prospera och Riksbanken

Macro focus – Sweden

3 of 5 Strategy and Macro Research – Large Corporates & Institutions

Inflation would then be stimulated both by an exchange rate effect and greater domestic demand. Graph 4: The market’s price setting and the Riksbank’s repo rate track

A 50 basis point cut would strengthen the Riksbank’s credi-bility by demonstrating dedication to the inflation target. This is important for the economic-political debate in Swe-den. It can also contribute to improving the market’s confi-dence in the Riksbank and reduce the difference between the market’s expectations about the repo rate track and the Riks-bank’s forecast. A 50 basis point cut could realistically con-tribute to higher inflation and interest rate increases in the future more in accord with the Riksbank’s repo rate track (see Graph 4). Finally, it could be more effective to make a 50 basis point cut at one go rather than lowering the rate in two 25 basis point steps. If the Riksbank makes a 25 basis point cut and inflation remains weak, expectations of a further cut will increase. Two cuts, each of 25 basis points, risk having less impact than one cut of 50 basis points, not just because the second cut would lag by several months and therefore delay stimula-tion of the economy, but also because expectations will again have time to form, and the effect will then be less. Even if there is a case for 50 basis point cut in July, Swedbank’s forecast is a cut of 25 basis points. It is mainly the risks associated with the high level of household debt that will keep the Riksbank from cutting the repo rate by 50 basis points. Analyst: Anna Breman, anna.breman@swedbank.se, 070 314 95 87

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Outcome

Riksbanken (Feb)

Riksbanken (Apr)

Swedbank (Apr)

Riba (9 maj)

Macro focus – Sweden

4 of 5 Strategy and Macro Research – Large Corporates & Institutions

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