Today marks a crucial day in Riksbank history as the central bank, which only moved out of negative interest rate territory in December 2019, embarked on its first interest rate hike since the pandemic.
While timing the first rate hike in this environment has been a challenge for all central banks in the DM space, it has been all the more difficult for the Riksbank given their recent failed experiment of negative rates; the last thing the central bank wants to do is hike rates too early and risk having to enter negative territory again. However, with inflation having soared over the last months and several Riksbank policy makers including Governor Ingves having voiced concerns around the inflation outlook and accommodative policy, expectations for today’s meeting were elevated. Still, the consensus saw a scenario of more aggressive forward guidance as more plausible than an actual rate hike today, making the move a substantial hawkish surprise which led to a broad SEK rally.
Swedish krona sees a strong rally as the Riksbank comes out with an unexpected rate hike
Alongside the 25bp rate hike, the Board has also stated that the repo rate will be raised a further two to three times this year, and will be slightly below 2% at the end of the forecast period in Q2 2025. Additionally, the Riksbank has decided to halve the pace of asset purchases during the second half of the year to gradually let holdings decline.
With the current policy tools in place, the Executive Board expects inflation to fall back next year and be close to 2% from 2024. This would mark a substantial decline in inflation from the current projections of 5.5% this year. Interestingly, the Board does add in the monetary policy report that they remain ready to raise the repo rate faster if needed, to ensure inflation returns to target. On the contrary, an adjustment in rates when inflation falls below target is not discussed. This highlights that the Riksbank is going all-in on fighting inflation in the wake of the pandemic and the war in Ukraine, and that this endeavour will be prioritised. The focus on inflation is also justified by the fact that GDP increased rapidly last year, despite the many disruptions in supply. Growth did slow at the start of 2022, partly due to the war in Ukraine, but the rise in inflation is more worrisome. CPIF, which is the Riksbank’s preferred CPI index as it excludes changes to mortgage rates and uses fixed rates instead, printed at 6% YoY in April.
The Board expects it to drive back to an average of 5.5% in 2022 – far above target and above February’s 2.9% projection. In 2023, CPIF is expected to average out at 3.3% before moving to 2% in 2024.
As March and April’s high inflation prints in Sweden were accompanied by a new form of hawkish communications by policy makers, market participants were already expecting a faster pace of monetary policy tightening. This was evidenced by the rise in the 5-year bond yields in Sweden, which are now almost 1ppt higher than at the monetary policy meeting in February. Swedish bond yields were on the rise prior to today’s announcement as market expectations for forward guidance were high already, but the Riksbank still managed to deliver a hawkish surprise. This drove yields up across the whole curve, with the 2Y now nearing the 1% mark.
Swedish bond yields rise as Riksbank exceeds expectations
While this week’s policy decision is offering support to the krona as it narrows yield differentials between Sweden and other DM nations, it also adds a risk to the outlook.
If growth conditions worsen due to the war, lockdowns in China or other supply chain disruptions, then this could put pressure on the Riksbank over the more medium-term (1-3 years) to ease policy again when the inflation target has been met. Although it is unlikely that a deterioration in the medium-term growth outlook will be isolated to just Sweden in this scenario, the earlier action by the Riksbank and slow projected hiking cycle suggests that there will be less room to ease policy in the event of an economic slowdown relative to peers, which adds downside risks to a more bullish SEK outlook.
Ima Sammani, FX Market Analyst