Sweden has taken the bold step of cutting interest rates, surprising some analysts and marking a new phase in global monetary policy that could accelerate economic growth or return countries like the United States to a more cautious approach.
The Reichsbank Moved Thursday morning to cut its key interest rate from 4% to 3.75%, following other small European countries including Switzerland and Hungary that said the worst was over in the fight against inflation.
Sweden’s preferred inflation measure fell to 2.2%, close to the Riksbank’s target of 2%. On the face of it, it is a fair reward for a disciplined monetary policy that allowed interest rates to rise sharply from 2022 to forestall the problem.
However, with Sweden’s economy in recession, this could just be a sign of desperation.
“If inflation approaches the target while economic activity is weak, monetary policy can be eased,” the Riksbank wrote.
“If the inflation outlook continues, the key interest rate is expected to be cut two more times in the second half of the year, in line with the March forecast.”
Sweden’s economy shrank by 0.2% in the fourth quarter of 2023 compared to the same period in 2022. It was the third consecutive quarter in which Sweden’s GDP had contracted.
With the Fed expected to cut interest rates for the first time in its expansion cycle in September or November, this is the first time this century that Sweden has made a rate change before the US, and other small countries could follow.
But there were good reasons for the Riksbank to follow the Fed’s lead for so long, and its leap of faith could cause it to create more problems than it solves.
Currency problems
In a note published last week, Morgan Stanley didn’t sugarcoat the myriad risks Sweden would face if it cuts interest rates in May.
While inflation fell, Morgan Stanley analyst Gabriela Silova pointed out that various pressures, including rising oil prices and higher services inflation, complicated the macroeconomic picture in Sweden.
There is also the problem of its currency, which represents only a small fraction of the power of the US dollar.
Sweden’s currency, the krona, is expected to fall in value following the Riksbank’s interest rate cut. Interest rate cuts typically weaken currency value by increasing the supply of available money relative to other currencies. This is particularly true for smaller currencies such as the krona.
In fact, the krone fell 0.5% against the dollar on Wednesday morning following the Riksbank announcement.
“Given a small open economy like Sweden’s, it is important to give significant weight to foreign exchange [foreign exchange] Considerations, interest rate expectations abroad and geopolitical developments,” wrote Gabriela Silova.
Meanwhile, the Fed is taking a more cautious approach to cutting interest rates, lest it be thrown back into an inflation cycle that has taken months to overcome.
But it may be forced to move under threat of a “hard landing” when a recession results from a prolonged period of elevated interest rates.
Meanwhile, the European Central Bank (ECB) is expected to follow the Riksbank with its own rate cut next week. It will soon be clear whether Europe has been a useful guinea pig for the US in cutting interest rates or a canary in the coal mine for another economic downturn.