Figure 1: Growth Momentum Ever Clearer
Source: Statistics Sweden, NIER
Even Larger Positive Output Gap Envisaged…
This increasingly unrealistic policy outlook of the Riksbank sits ever more uncomfortably with the upbeat real economy backdrop and outlook and continues to persuade us to point to official rates instead starting to rise in 2023, with a risk of such a move being even earlier. The Riksbank has started to accept this emerging reality somewhat. In what to us was an unexpected admission given the Riksbank’s traditional caution, the July Board assessment was decidedly more upbeat regarding economic activity, albeit not quite as optimistic as our own, which echoes business survey findings (Figure 1) and upside surprises in real activity data. Indeed, our forecasts imply that pre-pandemic levels of GDP will be returned to this quarter and that growth this year will be nearer 5%, i.e. half a percentage point higher than the Riksbank envisages, supported in the near term by a further relaxation of COVID restrictions. Crucially this means that the positive output gap (a consideration central to Riksbank thinking) may be even larger than the 1% of GDP in 2022 and 1.5% in 2023 outcomes the Riksbank acknowledged last time around.
Against this outlook, the Riksbank had no option but to point to high(er) inflation and possibly an even clearer overshoot of its target into 2024 than it envisaged in July (Figure 2), notwithstanding the overshoot that has emerged of late. The question is whether the Riksbank changes its tone further. Back in July, while still suggesting that rates could be cut and also hinting that QE could be extended beyond the current end-year timetable, it pointed to the possibility of having to tighten policy, saying a ‘less expansionary monetary policy may be justified if inflation were to risk overshooting the target significantly and persistently’.
…Making Inflation Overshoot More Likely?
What constitutes a significant and persistent overshoot is unclear, as Figure 2 also shows that CPIF inflation (the favored measure) is seen increasingly above target for the last six months of existing projections. That the Riksbank is still making a central case that it thinks policy will be on hold with the current zero repo rate persisting out to 2024 may be more a technical issue, in that the relevant horizon for framing policy is two years as opposed to the three years the Riksbank actually projects. But as Figure 2 implies, the new policy horizon is now likely to encompass a clearer and more sustained inflation overshoot. This thereby increases the case that maybe even sometime in the next year, the Riksbank will need to grasp the nettle and acknowledge that rate hikes will be needed sooner than by 2024.
Figure 2: CPIF Inflation Overshooting Now, Reinforcing above-target Medium-term Outlook
Source: Riksbank, past three vintages of CPIF projections
The Skewed Reaction Function
However, the Riksbank reaction function does not work this way: Back in April’s more upbeat risks scenario assessment in which inflation rises faster, the Riksbank argued that monetary policy need not react as surely as under the scenario of a clearer inflation undershoot. All of this underscores a deep-rooted unwillingness to consider formal hiking, presumably linked to the Board’s longstanding aversion to krona appreciation. But if the economy does continue to recover, the question is whether markets will press the Riksbank into changing tack or whether the Riksbank will act first in an attempt to stay ahead of a curve that may already be drifting away. Indeed, we think it cannot be long before the Riksbank will have to point to rates moving higher, something we think is already likely by 2023.