How changes in the repo rate affect inflation

The way in which changes in the repo rate affect inflation and the rest of the economy is known as the transmission mechanism. The transmission mechanism is actually not one but several different mechanisms that interact. Some of these have a more or less direct impact on inflation while others take longer to have an effect. It is generally held that a change in the repo rate has its greatest impact on inflation after one to two years.


The first thing that happens when the Riksbank changes the repo rate is that the so-called overnight rate is affected. The overnight rate is the rate at which the banks borrow and lend money to one another during the day. The size of the effect that a change in the repo rate has on interest rates with a longer duration depends on how expected the adjustment is. The Riksbank aims to make its monetary policy predictable. The Riksbank tries to affect expectations of future monetary policy by regularly publishing forecasts for the repo rate. In this way it is easier to avoid changes in the repo rate coming as a surprise.


Banks’ lending rates and interest rates on securities are affected therefore by both the actual and expected repo rate. If a raise in the repo rate is fully expected, market rates can begin to rise before the repo rate itself is raised. Then, when the repo rate is actually raised, it will not necessarily have any further effect on market rates if it merely confirms market expectations.

 

Schematic diagram of the monetary policy transmission mechanism

 

Picture of the transmission mechanism

 

Monetary policy thus has an effect on the interest rates the general public face and thereby also on the total demand and total supply in the economy. The channels that mean that market interest rates affect supply and demand can be divided into the interest rate channel, the credit channel and the exchange rate channel. You can read more about these channels below.

 

Credit channel

The credit channel describes the way in which monetary policy affects demand via banks and other financial institutions. If the interest rate rises, banks choose to decrease their lending and instead buy bonds. This means that households and companies find it more difficult to borrow money. Companies that are either unable or unwilling to borrow must cut back their activities, postpone investment and so on, and this dampens activity in the economy.  

 

Interest rate channel

The interest rate channel affects the demand for goods and services. Higher interest rates normally lead to a reduction in household consumption. This happens for several reasons. Higher interest rates make it more attractive to save, in other words to postpone consumption, thus lowering present consumption. Consumption also falls because existing loans now cost more in terms of interest payments. Finally, higher interest rates mean that the price of both financial and real assets - shares, bonds, property, etc. - falls in that the present value of future returns drops when interest rates rise. When faced with dwindling wealth, households become less willing to consume.


A rise in interest rates also makes it more expensive for firms to finance investment. As a result, higher interest rates normally curtail investment. If consumption and investment fall, so does aggregate demand. 


Lower aggregate demand results in lower resource utilisation. When resource utilisation is low, prices and wages usually rise at a more modest rate. However, it takes time before a decline in resource utilisation leads to a fall in inflation. This is partly because wages do not change from month to month but more seldom than that.

 

Exchange rate channel

The exchange rate channel describes how monetary policy affects the value of the currency. Normally, an increase in the repo rate leads to a strengthening of the krona. In the short term, this is because higher interest rates make Swedish assets more attractive than investments denominated in other currencies. The result is a capital inflow and increased demand for kronor, which strengthens the exchange rate.


Monetary policy also plays an important part for the exchange rate in the long term. By definition, the exchange rate is the price of a country’s currency expressed in terms of another country’s currency, which means that it is affected by differences in inflation between countries. Tighter monetary policy means lower inflation, which in the long run can be expected to be reflected in a stronger exchange rate.

 

A stronger exchange rate – an appreciation – has an impact on the economy in two main ways. First, foreign goods become cheaper compared with domestically produced goods. This leads to a rise in imports and a decline in exports. Lower demand for domestic goods contributes to a reduction in resource utilisation and dampens inflationary pressure.


Second, the exchange rate affects inflation through changes in the krona prices of goods for cross-border trade. Firms that import goods to Sweden pay a lower price in kronor for their imports. In this way, a stronger krona tends to lower the inflation rate, since imported goods and import-competing goods become cheaper. This reinforces the dampening effect on inflation of falling demand. 

 

Inflation expectations

Inflation expectations are important to the way in which companies set prices and to how wage formation functions and thereby to inflation. If everyone trusts that inflation will remain low and that prices will only rise temporarily, this will lead companies to consider that they do not need to change their prices as often. An employee may reason in the same way with regard to wage demands, which means that the outcome from wage bargaining rounds is at a reasonable level. Both of these events make it easier for the Riksbank to achieve price stability.


However, the fact that inflation expectations are firmly anchored at the inflation target is no reason for the Riksbank to leave the repo rate unchanged. Rather, this should be taken as a sign that the public expects the Riksbank to do what is necessary to ensure that inflation is 2 per cent. In other words, inflation expectations can be seen as a measure of the public’s confidence in the Riksbank to attain the inflation target.


However, if inflation expectations deviate from the target, it may indicate that the public does not believe that the Riksbank will manage to keep inflation around 2 per cent. The Riksbank may then need to adjust the repo rate at a different pace than is reflected in expectations of future monetary policy. In this way, different measures of inflation expectations and market expectations of monetary policy serve as a supplement to the Riksbank's own forecasts for inflation and the interest rate. The Riksbank therefore regularly follows developments in various measures of inflation expectations and publishes them in its Monetary Policy Report.


The articles below contain a more in-depth study of households’ inflation expectations.

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