Sweden: the mistake Yellen wants to avoid

This month, after one year of too-slow price gains and another two years of falling prices, Sweden's central bank was forced to slash interest rates into negative territory. Photo / Thinkstock

Women-friendly work laws. An inclusive social safety net. Beautiful bike lanes. While there's a lot to love about what Sweden's policymakers have done, here's one blunder the United States will want to avoid: Underestimating the dangers of too-low inflation.

This month, after one year of too-slow price gains and another two years of falling prices, Sweden's central bank was forced to take unprecedented action. The bank slashed interest rates into negative territory in addition to announcing its intention of buying government bonds.

Critics said the drastic move came too late and could have been avoided altogether had the bank just acted sooner. In the four years leading up to the historic stimulus, the central bank's board had bitter debates over the need to cut interest rates, leading to the resignation of Deputy Governor Lars E.O. Svensson.

Critics such as Svensson say the Riksbank started raising interest rates too soon, then cut rates too slowly even though the economy rapidly plunged into deflation.

The Riksbank was once seen as the world's state-of-the-art inflation-targeting central bank. Now, with deflation on its doorstep, its credibility has been damaged.

The Fed's policy rate is still at zero, where it has been since December 2008. US policymakers want to raise interest rates this year. The haunting fact behind that intent: They have missed their 2 per cent inflation target for 32 months, and aren't likely to get back there anytime soon. Fed officials continue to say that as the unemployment rate falls inflation should move back to the target.

In Sweden, central bank Governor Stefan Ingves was also firm in his belief that prices would soon rise and that more aggressive stimulus would further fan an emerging housing bubble.

In Sweden, price gains slowed from 3 per cent to 1 per cent over the course of a single year, only to decelerate further and actually start declining by late 2012.

Minutes of the Fed meeting in January showed an intense debate about the course of inflation in the US and the risks of raising interest rates too early. That may be a sign that Fed officials have learned the Riksbank's lesson.

"An earlier tightening would increase the likelihood that the committee might be forced by adverse economic outcomes to return the federal funds rate to its effective lower bound," the Fed minutes said.

To be sure, there are some important differences between the US and Sweden. One is that the US, at least as of now, is still seeing price gains. And in the US, what's driving plans to tighten is more a strengthening labour market and not so much concerns about fueling asset bubbles - even though some policy makers have been quite vocal about their concerns about excessive risk-taking in some sectors.

Right now, inflation rates in other Western democracies are low or negative too. In Germany, inflation is negative 0.5 per cent; in the United Kingdom it is 0.3 per cent; and in Canada it is 1.5 per cent. No central banker today will raise interest rates without looking carefully at Sweden's example.

- Bloomberg