Buried under the heap of news on the ever vacillating US Federal Reserve, Europe's mounting woes and Japan's new testosterone fuelled monetary policy was the somewhat innocuous news of Sweden's decision to cut its key policy rate to zero amid rapidly escalating deflation. Sweden handled the financial crisis rather well and while its economy, like the rest of the world, took a hit in 2009, it seemed to have bounced back by to its pre-crisis trend growth path by 2010. Yet, Sweden's monetary policy moves from 2010 have become the quintessential cautionary tale for policymakers. What did it do wrong then? In 2010, it started to raise its repo rate on the ground that inflation pressures were likely to build up (Sweden's Riksbank is a strict inflation targeter). And between June and July 2011 it hiked rates by a good one and three quarters of a percentage point despite dire warnings about the dangers of premature tightening, including from its own deputy governor Lars Svensson, a noted expert on deflationary traps. The central bank resolutely defended its stance initially, citing the risk of inflation pressures, the need to prevent a housing bubble from building up and then the risks to financial stability. But then things started going horribly wrong as growth fell behind forecasts and more importantly, prices started softening. Sweden is a massive exporter (exports are about 50 per cent of its gross domestic product) and the global recovery that it had betted on from 2012 (influenced considerably by the International Monetary Fund's assessment that its central bank explicitly follows) didn't quite materialise. In September, its consumer price index inflation rate was -0.4 per cent, making it the sixteenth month of sustained deflation. Sweden's monetary stance - its decision to jump the gun on rate hikes and then its slow reversal has predictably come in for severe criticism. Paul Krugman has called the Riksbank officials "sadomonetarists". However, we tend to have a little more empathy for Sweden's monetary bosses. For one thing, Sweden's evidently premature decision to hike rates represents a classic problem that all central banks, including the Reserve Bank of India, face in fighting either deflation or inflation - whether to try and stay ahead of the proverbial curve (that financial markets often demand of them) based on a view on an uncertain future or to hold back and risk the possibility of triggering upward or downward price spirals that become hard to control.
There is no doubt that Sweden's central bank erred very badly in its reading of how things would pan out, but it was certainly not the first central bank to try to be forward-looking and make the wrong judgement call. The lesson from Sweden's botch-up for all central banks perhaps would be to avoid taking too long a view on the future, especially after traumatic and volatile episodes like the financial crisis. In this, the US Fed's decision not to commit to a rate hike despite its fair share of critics seems to be prudent. The one thing that Sweden could have clearly done better was to slash rates more drastically when deflationary trends became visible. This could have compromised its short-term credibility but it would almost certainly have been better off in the long term. However, one could again argue that Sweden was not that unique in its reluctance to do something drastic. Inflation targeting central banks tend to be squeamish about cutting rates even when recession or deflation stare them in the face. Whatever be the reason, central banks have to shed this streak of "sadomonetarism" in them. Holding on to dogmas might be the staple of politics - however, it makes for poor economics. Finally, Sweden's tribulations are yet another reminder that deflation is the global economy's biggest foe despite the modest signals of recovery in the UK and US. That should make a strong case for low interest rates across the developed world for a while to come.
Abheek Barua is with ICRIER. Bidisha Ganguly is Principal Economist, CII