Sweden took the bold step of cutting interest rates, which surprised some analysts and marked a new phase in global monetary policy that could accelerate economic expansion or return countries including the United States to a more cautious approach.
Riksbank Moved in Thursday morning He cut the base interest rate from 4% to 3.75%, following other small European countries, including Switzerland and Hungary, in declaring that the worst was over in the battle with inflation.
Sweden's preferred inflation measure fell to 2.2%, which is close to the Riksbank's target of 2%. On the surface, it is a fair reward for disciplined monetary policy that has seen interest rates rise sharply from 2022 onwards to overcome the problem.
But with the Swedish economy stagnating, it may just be a sign of desperation.
“When inflation is close to target while economic activity is weak, monetary policy can be eased,” the Riksbank wrote.
“If inflation expectations remain valid, two additional rate cuts are expected during the second half of the year, in line with March expectations.”
Sweden's economy Shrink by 0.2% in the fourth quarter of 2023 compared to the same period in 2022. This was the third consecutive quarter in which Swedish GDP contracted.
With the Fed expected to cut interest rates for the first time in its expansion cycle in September or November, this marks the first time this century that Sweden has moved ahead of the United States in terms of changing interest rates, and other smaller countries may follow. Follow suit.
But there were good reasons for the Riksbank to follow in the Fed's lead for so long, and its leap of faith may cause it to get into more problems than it solves.
Currency problems
In a note published last week, Morgan Stanley did not sugarcoat the myriad risks Sweden will face if it goes ahead with a rate cut in May.
While inflation has fallen, Morgan Stanley analyst Gabriela Silova noted that several pressures including higher oil prices and higher services inflation have complicated the overall picture in Sweden.
There is also the issue of its currency, which controls a small portion of the US dollar's power.
The value of the Swedish currency, the krona, is expected to decline after the interest rate cut by the Riksbank. Interest rate cuts typically weaken currency values by increasing the supply of money available relative to other currencies. This is especially true for smaller currencies such as the krona.
In fact, the krona fell by 0.5% against the dollar on Wednesday morning after the Riksbank's announcement.
“In a small open economy like Sweden’s, it is important to place significant weight on foreign exchange considerations, interest rate expectations abroad and geopolitical developments,” Gabriela Silova wrote.
Meanwhile, the Fed is taking a more cautious approach to cutting interest rates, keen to avoid a return to an inflationary cycle that has taken months to tame.
But they may have to act under the threat of a “hard landing” if the recession is caused by a longer period of high interest rates.
Meanwhile, the European Central Bank (ECB) is expected to follow the Riksbank next week by cutting interest rates of its own. It will soon become clear whether Europe is a useful guinea pig for the United States on interest rate cuts, or a canary in the coal mine for renewed economic contraction.
