Sweden's Central Bank Poised to Give the Krona a Boost

The rhetoric coming from the Riksbank suggests the odds of interest-rate hikes have increased.

The krona is looking up.

Photograph: Bloomberg

Following the global financial crisis in 2008, central banks increasingly focused on providing so-called forward guidance that would make clear where they expected monetary policy to head. To a large extent, monetary policy works through a concept known as the "expectations channel," which is the ability of central banks to influence the outlook for growth and inflation among investors.

There is no universally accepted quantitative measure of the concept. However, we have developed a measure of whether central bank communication is "hawkish" or "dovish" that we call the Forward Guidance Indicator. The FGI is based on the simple idea that each policy statement issued by a central bank contains words that can be categorized by their relation to either the economy and/or the monetary policy based on a list of about 100 hawkish words such as "expansion" or "recovery" and 100 dovish words such as "slowdown" and "recession." The FGI is calculated so the index will always be between -2 if all words are dovish and 2 if all words are hawkish.

Of course, this is a rather crude way to analyse central bank communications. Merely counting words could quite possibly give faulty signals compared with a more nuanced qualitative analysis of policy statements. However, this straightforward quantitative approach provides a high level of consistency and a purely objective measure of forward guidance over time.

We applied this approach to the Swedish Riksbank, which meets Wednesday, to see what direction the central bank is moving in terms of future interest rate changes. When looking at every monetary policy decision since 1999, we find there has been a very close relation between the FGI for the Riksbank and economic activity measured as a composite index of business and consumer confidence.

In other words, the Riksbank’s rhetoric reflects the state of the Swedish economy and that the relationship between its forward guidance and economic activity has been rather stable over time. One thing that is notable is that the relationship between inflation expectations and the Riksbank's (measured) forward guidance has been weak. Inflation undershot the Riksbank's 2 percent target in the wake of the financial crisis in 2008, but that is no longer the case. In our view, it is more likely that the Riksbank will continue to overshoot its target in the next couple of years based on recent trends in items such as growth in money supply and nominal gross domestic product, as well as currency and interest-rate developments.

The upshot is that the likelihood the Riksbank raises rates in 2018 has increased. Recent history shows a fairly close relationship between the FGI -- lagged six months -- and the subsequent change in rates by the Riksbank, suggesting rate hikes may start in 2018. The central bank's main rate is currently -0.5 percent.

That said, monetary conditions are not only tightened via rate increases alone. A stronger krona could also do the job, and, in fact, there has also been a rather close relationship between the Riksbank's communications and swings in the krona.

The graph above shows the relative forward guidance of the Riksbank and the European Central Bank, and changes in the euro-krona exchange rate. It is clear the krona tends to strengthen when the Riksbank turns more hawkish relative to the ECB. As such, there appears to be upside for the krona in 2018.

To be sure, economies are dynamic and forward guidance isn't set in stone. We have seen quite a bit of softness in the Swedish property market recently, and if that acts as a drag on the broader economy, then the Riksbank's forward guidance could move in a more dovish direction. But until and if that happens, expect higher interest rates in Sweden and a stronger krona.

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