Believe it or not – there is a country in the world where I now believe that monetary policy is becoming (moderately) too easy. Yes, that is correct – I will not always say that monetary policy is too tight. The country I talk about is Sweden. More on that below.
Assessing monetary conditions
I strongly believe that the assessment of the monetary stance of a country should not be based on for example looking at the level of nominal interest rates, but rather on whether or not the country is on track to hitting the central bank’s nominal target in lets say 12-18 months.
A way of assessing that is of course to look at market inflation expectations (if the central bank targets inflation as in the case of Sweden’s Riksbank). If inflation expectations are below (above) the target (for example 2%) then monetary conditions are too tight (easy).
An alternative to this approach is to look at other monetary indicators – for example money supply growth, nominal GDP growth, interest rates and the exchange rate. And this is exactly what we are doing in our (Markets & Money Advisory’s) upcoming publication on Global Monetary Conditions.
Hence for all of the nearly 30 country we analyse in the publication we look at the four monetary indicators mentioned above and compare the development in these indicators with what we believe would be consistent with the given central bank’s inflation target.
This means for example in the case of money supply growth we determine what money supply growth rate is consistent with the Riksbank’s inflation target of 2% given the trend in real GDP growth and and then trend in money-velocity. If the actual money supply growth rate is faster than our “policy consistent” growth rate then monetary conditions are too easy.
We have then calibrated the four indicators individually so a “zero” score is the policy consistent monetary stance and we think of the range between -0.5 and +0.5 as a “neutral stance”.
Four Swedish indicators
Below you see the development in the four monetary indicators for Sweden:
What we are seeing is that both money supply growth and nominal GDP growth have been faster than the policy consistent growth rate since 2014-15 and the key policy rate has been below the policy consistent level since mid-2014.
In terms of the exchange rate it has been the last of the four indicators to turn in a more “accommodative” direction, but recently the exchange rate development has also helped ease monetary conditions in Sweden.
Based on these four indicators we create a composite indicator for Swedish Monetary Conditions.
As mentioned above the indicator is calibrated so that zero is monetary conditions, which is consistent with the Riksbank’s 2% inflation target. If the indicator is above (below) then the Riksbank is more likely to overshoot its inflation target in the medium-term.
We see that Swedish monetary conditions essentially have been too tight since mid-2009, but we also see that since late-2013 monetary conditions have become less tight and in the past two years or so we have been in the “neutral” range (above -0.5) and we are now approaching +0.5 meaning we are moving out of the “neutral” range and into the “too easy”-range.
Riksbanken needs to tighten monetary conditions
Riksbanken without a doubt has been one of the best performing central banks in the world in the post-2009 period and particularly the performance over the last couple of years has been very positive in the sense that inflation expectations seem to have become somewhat unanchored in recent years in the US and the euro zone, while the Riksbank has been able to ensure nominal stability and ensure that inflation expectations have been close to 2%.
However, we now – based on our monetary indicator analysis of Sweden – believe that the Riksbank is beginning to overdo it on the “easy side”. It is certainly not dramatic and there are absolutely no reason for the Riksbank to slam the brakes on and if the Riksbank is credible it is likely that the markets will do most of the job tightening Swedish monetary conditions – most likely through a stronger Swedish krona, but if that does not happen the Riksbank likely will have to more forcefully start to express concerns that monetary conditions are becoming too accommodative.
Finally, compared to this analysis the Riksbank’s monetary policy announcement last week seems to have been overly dovish. That said given the track-record of the Riskbank I don’t believe that it is about to make a major policy mistake, but I would certainly expect it to scale back on the dovish signal going forward.
Want to know more?
If you want to more on our Global Monetary Conditions publication (we still need a sexy title) and discussion the indicators or have suggestions please contact me (LC@mamoadvisory.com) or my colleague Laurids Rising (LR@mamoadvisory.com).
The publication will be a monthly and will likely be priced around EUR 2000 for 12 months.