How monetary policy affects inflation

Monetary policy mainly affects the economy via changes to the Riksbank’s policy rate, the repo rate, which spread to market rates and to the deposit and lending rates of banks and mortgage institutions. The Riksbank can also take other monetary policy measures as a complement to decisions on the repo rate, especially when the repo rate is already very low or even below zero.

The way in which monetary policy affects the real economy – output and employment, for example – and inflation, is referred to as the monetary policy 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. However, experience after the debt crisis of 2011, both in Sweden and internationally, shows that inflation can be below target for a long time despite very low or even negative policy rates.

The effect of the repo rate on market rates

The first that happens when the Riksbank changes the repo rate is that the overnight rate is affected (read more about this under the heading "Steering interest rates"). The overnight rate is the interest rate paid by banks when they borrow from each other from one day to the next. The quantitative effect of a change in the repo rate on other nominal interest rates with longer maturities depends on how expected the change is. If a repo rate rise is expected, market rates can begin to increase even before the repo rate is raised. Then, when the repo rate is actually raised, it will not necessarily have any further effect on market rates if the rise merely confirms the expectations of market participants. The Riksbank aims to make its monetary policy predictable. The Riksbank tries to influence expectations of future monetary policy by regularly publishing forecasts for the repo rate and explaining how monetary policy is affected by economic developments. In this way, it is easier to avoid changes in the repo rate coming as a surprise.

Monetary policy thus has an effect on the interest rates and asset prices paid by households and companies and thereby also on total demand and activity in the economy. The monetary policy transmission mechanism can be described as three main channels, through which market rates influence demand: the interest rate channel, the credit channel and the exchange rate channel. You can read more about these channels under the headings below. The expectations of households and companies about the future and their confidence in the inflation target generally play a major role as regards the impact of monetary policy. As companies, for different reasons, do not adjust their prices immediately when their costs change or demand for their products varies, the inflation expectations of the general public also tend to be sluggish. With sluggish inflation expectations, a repo rate rise will, for example, contribute to higher real interest rates in the economy, i.e. rates adjusted for the expected rate of inflation. This is relevant as households and companies are interested in the real interest they receive on their savings or pay on their loans when they make economic decisions. For a monetary policy with an inflation target, expectations about future inflation are of particularly large significance. You can read more about inflation expectations below.

The interest rate channel

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, i.e. postpone consumption, thus reducing 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, commercial and residential properties, etc. – falls insofar as 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, total demand also drops and there will be less activity in the economy. When activity is low, prices and wages usually rise at a more modest rate. However, it takes time before a decline in activity leads to a fall in inflation. This is partly because wages do not change from month to month but more seldom than that.

The credit channel

The credit channel describes the way in which monetary policy affects demand via banks and other financial institutions. As described above, a higher level of interest rates leads to a fall in the price of various assets. As financial and real assets are used as collateral for loans, banks become more restrictive in their lending when the value of this collateral decreases. This can cause banks to increase their interest rate margins, or reduce their lending by setting tougher conditions on new loans. Higher interest rates that cause asset prices to fall can also make it profitable for banks to reduce their lending to households and companies and buy securities instead. All in all, the credit channel amplifies the effect of the higher repo rate as it makes it more difficult for households and companies to borrow money from banks, which leads to a drop in consumption and investment.

The 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.

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 economic activity, thereby subduing inflationary pressures.
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 their prices and to how wage formation functions, and thereby to inflation. For example, a well-anchored inflation target means that companies will not feel the need to change their pricing as often if inflation deviates from the target, as they rely on the Riksbank taking action to bring inflation to the target. Employees may reason in the same way with regard to their wage demands, leading to more stable wage formation. Both of these circumstances 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, longer-term 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.

Updated 20/01/2018