Having twice cut rates into negative territory, Sweden's central bank is locked in a high-stakes currency war with the European Central Bank that could stave off deflation but risks creating another property bubble.
The Riksbank is worried that a strengthening crown, fueled in part by ECB bond-buying, will reverse a recent upturn in consumer prices and raise the specter of deflationary damage to Sweden's fast-growing AAA economy.
The moves by Riksbank Governor Stefan Ingves represent a dramatic rethink by a bank that was accused of "sado monetarism" for keeping policy tight after the financial crisis for fear of stoking household debt that is among the highest in Europe at 170 percent of disposable income.
The Riksbank cut its key interest rate by 0.15 percentage points last week, to -0.25 percent, and said it would buy a further 30 billion Swedish crowns ($3.5 billion) of government bonds.
The danger, however, is that the ultra-loose monetary policy could encourage households to take on more debt.
"Our fundamental view is that they have been forced to take this aggressive action because of past mistakes," said James McCann, European economist at Standard Life Investments.
"The risk for them is if they go big on asset purchases it could feed through into bigger credit creation in the housing sector and they would be stoking financial stability risk."
Memories of Sweden's crippling property crash of the early 1990s remain vivid. Though set against a different backdrop — high inflation was then endemic in Sweden — a real estate lending boom crippled several banks as loans went bad, necessitating a costly state rescue.
The rest of the decade was spent slowly restocking public finances amid soaring unemployment that even now has yet to return to pre-crisis levels.
Making the Riksbank sweat now is a fall in long-term inflation expectations before wage negotiations for about a third of the country's population are finalized early next year. The deflationary scenario could become self-fulfilling if unions and bosses agree meager salary increases.
Former finance minister Anders Borg said the Riksbank's slow reaction on low inflation meant it could ill afford a strong crown. Combined with low interest rates, fast economic growth threatens to create asset bubbles, especially in property.
"We must see some of the history coming here. Sweden has now had falling inflation for the past four years ... so it is quite clear we overestimated the inflationary pressures," Borg said, serving to explain why Sweden is taking a looser line than Britain, another European economy with good growth but deflation risks.
QUESTION OF TRUST
Par Magnusson, chief analyst at Nordics RBS, said: "Now inflation expectations are falling, so they are forced to go all in. How do you solve that? By giving a promise to the export industry that you will be weakening the crown ... The message is aimed at the employers: trust us and raise the wages and we will promise to weaken the crown."
The Riksbank's strategy may be working. The crown on Friday traded at around 9.32 to the euro, compared with 9.17 before the central bank's action..
But other small countries, such as Switzerland, have had trouble winning a currency war against the euro, with the ECB pledging to buy 60 billion euros ($64.9 billion) of bonds each month.
"It will be an extremely difficult task," said Robert Bergqvist, chief economist at SEB. "It's a very uneven battle between the ECB and the Riksbank."
If rate cuts fail, Sweden has other tools at its disposal, including currency intervention or increased bond buying. Many traders expect more action if the crown strengthens again.
"I think they can win the war if they increase the size of the asset purchases," said Petr Krpata, currency strategist at ING in London.
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