Monday, July 06, 2009

Sweden's New Inflationist Strategy

In this post at the Naked Capitalism blog, the new inflationist strategy of the Swedish Riksbank is discussed. The facts appears to be mostly correct, though it is misleading to claim that Sweden has price deflation. While the official CPI is in negative territory that is only because it counts interest rate cuts as price cuts (Meaning that in the short term, interest rate changes will have the opposite effect of the intended). Looking at the EU-harmonized price index which lacks that distortion instead, the HICP, Sweden has an inflation rate of 1.7%, significantly above the euro area average.

Anyway, what the Riksbank decided was to reduce its main interest rate from 0.5% to 0.25% and start with quantitative easing. There's nothing unusual or new about that these days, as near zero interest rates and quantitative easing are the rule rather than the exception for central banks in advanced economies. What was unusual was that this decision meant that the interest rate on bank deposits in the central banks was cut to -0.25%. That's right, a negative interest rate. The reason why they now have a negative deposit rate can be found in the reason why it is considered nearly impossible to bring market interest rates below zero: namely that people would then start to withdraw their money. By having a negative deposit rate, the Riksbank hopes to discourage banks from keeping the money they receive from quantitative easing as reserves. Instead, they want the banks to create more credit, something which in turn will increase money supply, something which in turn will increase inflation.

The most radical inflationist in the board, Lars E.O. Svensson, has advocated currency market intervention to bring down the exchange rate of the SEK, which in turn is meant to increase import prices and inflationary expectations. The rest of the Riksbank board decided against it, probably because other countries could interpret this as a way to subsidize exports and discourage imports, rather than as a way to increase inflation. The strategy they are now pursuing will also lower the exchange rate of the SEK, but probably not by as much and not in such a conspicuous way.

One interesting question that the Riksbank's negative deposit rate this raises is why the Fed insists on paying a positive interest rate on bank reserves. If you want to achieve inflation, which the Fed wants, then that is counterproductive as it encourages banks to keep the money at the Fed instead of lending them out to the public. As I've pointed out repeatedly, the monetary base has no direct effect on the real economy. It only has an indirect effect to the extent it helps increase the money supply. But as long as the banks keep the money they receive from the Fed's asset purchases at the Fed, money supply is not affected.

I am not sure why the Fed insists on having a positive deposit rate, since it counteracts the inflationist effects of their other schemes, but one possible reason is that it wants to subsidize the banks and boost their profits. By paying interest on their deposits, the Fed is essentially giving away money to the banks. Another possible reason is that they think that large reserves are essential to restore confidence in the banking system.


Blogger Reginald said...

As to the Fed paying interest on reserves, Gary North has directly addressed that issue and comments by Bernanke support his conclusions. The Fed is paying interest to hinder the amount of money creation via bank lending, and only wants growth in the money base affecting prices.

In gist, the Fed is reversing the usual roles of bank lending being the predominate form of money creation. The Fed has direct control over money base creation. It's an attempt to avoid the inflation part in stagflation. If they really believed in Keynes they'd charge the banks a fee for holding excess reserves, and spur massive bank lending as in Chinese state-controlled banks.

11:44 AM  
Blogger Tempus fugit said...

"By paying interest on their deposits, the Fed is essentially giving away money to the banks."

Bingo, that's what's been going on for the last 9 months. All private losses have been socialized. Rather than another 700 billion TARP from congress (which would create a greater deficit) it's easier to give corporate welfare through the fed. Add on TALF and the PPP and the whole system is a joke. How do you justify people getting payed at the bank for their "work".Bonus? for what? Sucking the governments teats?

5:55 PM  
Anonymous Anonymous said...

I was not aware of this fact, yet I follow the economy rather closely. Has this been tried before? Will a negative interest rate on deposits cause an "explosion in lending", that is, are we likely to surpass other countries in the race towards massive price inflation? Scary stuff, no doubt.

12:10 AM  

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