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After zero rates, Sweden ponders next steps to avoid deflation

Pedestrians walk past the Swedish Riksbank headquarters in Stockholm September 30, 2008. REUTERS/Bob Strong

By Simon Johnson

STOCKHOLM (Reuters) - What should a central bank do next when it already has zero interest rates and arguably still faces the threat of Japanese-style deflation? If it's the Swedish Riksbank, it should keep cutting, and do so soon, says Lars Svensson.

Svensson no longer has a say; he quit as a deputy Riksbank governor last year after failing to persuade fellow board members to cut rates aggressively. Last month, they heeded his advice, lowering the repo rate to 0 percent and pushing back the official forecast for when the Riksbank will start tightening monetary policy again to mid-2016.

After years of tense, polarized meetings that eventually led to Svensson's resignation, a united Riksbank now sees zero rates as enough to push inflation up toward its 2 percent target.

Svensson disagrees, saying Sweden should go into negative rates - effectively charging banks to deposit funds at the central bank - to avoid the deflation which has trapped Japan in low economic growth punctuated by periodic recessions for more than a decade.

"From this point it is unlikely that the current policy at zero is enough," he told Reuters. "They should lower to -0.25 or even -0.50. The next meeting would be the natural time."

The Riksbank's next policy meeting is on Dec. 15, with its decision announced the following morning.

Rate-setters have not ruled out negative rates, but Riksbank Governor Stefan Ingves has rejected the comparison with Japan, pointing to expected Swedish growth this year of around 1.9 percent, with the economy moving up a gear again in 2015.

Nevertheless, Swedish consumer prices have been flat or falling for most of the last two years on an annual basis. Underlying inflation, the Riksbank's preferred measure which excludes interest rate effects, was 0.6 percent in October.

Some fear the bank may have again underestimated how weak price pressures are, especially with economic problems in the euro zone and China, and it needs to do more..

"For Sweden, it all hinges on international demand picking up," said Roger Josefsson, chief economist at Danske Markets. "We are afraid to admit it, but I think there are a lot of similarities between Sweden and Japan."

Should inflation fail to rise, the Riksbank's first line of defense will be to push back its mid-2016 forecast for when rates will start going up.

The bank could also repeat measures it took in 2008-9 during the global crisis, when it pumped liquidity into the financial system, offering long loans and loans in currencies other than the Swedish crown. It also accepted a wider range of collateral for this funding.

Another tool could be adopting the kind of quantitative easing (QE) used by the United States, Japan and Britain - and now being contemplated by the European Central Bank. That could involve printing money to buy up government or mortgage bonds.

But with Swedish economic growth and access to credit not a problem, such measures may fail to move inflation much.

"Swedish banks are well capitalized and our judgment is that companies and households are getting the loans they require, so we don't see a need there," Riksbank First Deputy Governor Kerstin af Jochnick said in a recent speech.

She added that the Riksbank would not achieve much if it bought government debt; yields on 10-year Swedish bonds are already at historic lows at around 1 percent..


Another option would be a currency floor, like that adopted by the Swiss National Bank, to stop the crown appreciating.

"If the Riksbank is serious about inflation they have to do something about the currency," said Danske's Josefsson. "QE in Sweden is very difficult because we have very shallow markets."

The crown has already eased around 4.5 percent against the euro this year. A further drop would help Swedish exporters, a backbone of the economy but who are struggling with stagnant demand in the euro zone.

It would also avoid stoking already worryingly high levels of household debt - the risk of other measures such as QE.

But with the relatively strong economy, a large current account surplus and a currency that may be undervalued in a longer term perspective, action on the crown could upset European neighbors. They could accuse Sweden of engineering a devaluation to gain an unfair advantage in export markets.

Ingves said recently that intervention to weaken the crown was "not an option currently".

Much blame for the low inflation has been laid at the central bank which raised rates in 2010 and 2011 to 2 percent, and kept policy relatively tight even as the global recovery stuttered, fearing easy money could stoke a housing bubble.

Nobel Prize-winning economist Paul Krugman said in the New York Times that the Riksbank had been "awesomely wrongheaded".

New European Commission President Jean-Claude Juncker wants to kick start EU investment but in Sweden the government has said higher spending will have to be offset by higher taxes.

That leaves the Riksbank to fight the Swedish deflation threat alone, and for the moment it is relying on zero rates. "Rate cuts take time before they reach the economy," af Jochnick said. "We should feel the effects of the rate cuts and our judgment is that this will be enough to push up inflation."

(Editing by Alistair Scrutton and David Stamp)