Is Sweden headed the Japan way?

Things are getting more and more complex. Countries which had recovered post-crisis are slipping. Sweden is the latest entrant to the list. The last reading was at -0.6% fueling debates over deflation in Sweden.

  • Krugman always on red alert to these developments started the debate – one and two .
  • Lars Svensson, former Riksbank MPC member and deflation expert added fuel to the fire. He blames the Riksbank rightaway:

What has caused the deflation?

The deflation has been caused by the Riksbank’s tight monetary policy since the summer of 2010. The majority of the executive board chose in the summer of 2010 to start increasing the policy rate, which was then at 0.25 percent. The policy rate was increased at at steady and fast rate to 2 percent in the summer of 2011. The increases started, in spite of the forecast in the summer of 2010 for inflation the next few years lying below the inflation target and the forecast for unemployment lying far above a long-run sustainable rate. (See figure 2 in this post.) The policy-rate increase caused the real policy rate (measured as the repo rate less HICP inflation, in order to be comparable across countries) to increase from minus 2.5 percent to plus 1 percent. This is a very large increase of 3.5 percentage points and was a very dramatic tightening of monetary policy. (See figure 3 in this post.)

With such a strong tightening of monetary policy, it would be very strange if inflation would not fall far below the target, and even become negative, as it indeed has done. It would also be strange if unemployment would not increase and stay high above a long-run sustainable rate, as it also indeed has done. Without the tightening that started in the summer of 2010, inflation would most likely now have much closer to the target and unemployment might have been about 1.2 percentage points lower. (See this post.)

By the way he has always been dissenting against Riksbank policies both as MPC member and an econ..

I mean what is going on? This was one of the fears when central banks adopted inflation targeting -that they will ignore deflation kinds of situation. To this most argued hey the target is x% + a range. Anything over and below the range would not be tolerated. No one really imagined that below the range (or belt) kind of situation will come as that time most struggled only with high inflation.

And now collectively most are failing in addressing the deflation conditions in their economies. Over the years these central banks have become highly cosy clubs just copying each other.  As their powers grew they became more and more ignorant of the reality. The models they adopted ignored most things that matter and as a result have been clueless towards addressing these issues. As most central banks copied each other, what we have is a classic case of groupthink trap and failure..

Krugman in a classic paper talked about this paradox – how do central banks which have build their image as responsible inflation fighters, now become irresponsible inflation generators? And Japanese have always said the best way to get out of deflation is to not get into it at the first place!

What a turn around of events in the last 5-6 years.

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