OpinionSep 25 2014

Fiscal revamp

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Sweden’s recent general election unfolded as expected: the political environment will take a step to the left as a group led by the Social Demo­crats. But the outcome is still not clear cut. But neither of the main party blocks secured enough votes for a majority.

A minority government is not a new pheno-menon for Sweden, and while a party only needs a simple majority to govern, this rarely happens in practice. The Social Democrats held power for most of the last century, until losing out to a centre-right group of parties in 2006.

The country faces a period of uncertainty until a new government is formed, either through a formal coalition or through the Social Democrats taking a minority governing position. But the greater uncertainty may lie with the central bank and its long-term objectives.

However, two things seem clear. Firstly, we are likely to see a greater focus on lowering the unemployment rate at the expense of -fiscal consolidation. Swedish law imposes a 1 per cent surplus budget target over the business cycle. However, the focus on growth and lowering unemployment from the current 7.4 per cent may see this target reduced to zero.

Secondly, the sustained period of very low inflation in Sweden has created intense debate about the appropriate mandate for the Riksbank. Critics of the Bank point out that it has failed to achieve the mandated 2 per cent target for the past two years, with inflation hovering around zero and frequently dipping into negative territory.

This has led to a call for a change in the mandate to a dual-price stability and full employment approach similar to that of the US Federal Reserve.

The undershoot on inflation is probably down to the forecasting ability of the central bank. Central banks across the world are not renowned for their forecasting ability.

Here in the UK, the Bank of England’s attempts to forecast inflation have been -woeful, with the inflation rate running above the 2 per cent target for nearly three-quarters of the last decade.

The Riksbank may have also been keen to keep rates higher than warranted by the inflation outlook, given concerns over the level of indebtedness of households, -currently at 170 per cent of household income, and rampant house price inflation.

However, the Riksbank has defused much of this pressure by surprising markets in July with a 50 basis point rate cut, bringing the official policy rate down to 0.25 per cent. The rate cut may seem to fly in the face of the Riksbank’s concerns over financial stability.

By cutting rates, the Riksbank is relying on other organisations, such as the Financial Supervisory Authority, to fine-tune macro-prudential policy in order to bring about financial stability.

The IMF has criticised the country’s hand-ling of the housing market, saying that the current 85 per cent cap on mortgage-to-loan ratios is too low, but there is little political incentive for this to be changed. Indeed, the Social Democrats have even mooted the possibility of raising the loan-to-value ratio for first-time homebuyers.

The Riksbank may be given a reprieve by the government itself if it decides to loosen the stance on fiscal policy and shift away from that 1 per cent budget surplus target. Less fiscal consolidation should translate into higher rates of economic growth and greater inflationary pressures. But with such low levels of inflation, the chance of further downside surprise should not be ruled out, as the Riksbank may be forced into more accommodative monetary policy.

Markets re-priced after the surprise rate cut and the Swedish krona has fallen by 10 per cent versus the US dollar since the start of the year, which releases more of those disinflationary pressures.

Given the sizeable shift to date in monetary policy expectations, it is now difficult to see a change in government having a large and sustained impact on markets.

However, without an outright majority, the Social Democrats may find it difficult to pass a new Budget later this year.

Meanwhile, the political will of the smaller left-leaning parties, Green and Left, could mean the change to the Riksbank’s mandate is back on the table, with an explicit unemployment objective as part of the -package.

Kerry Craig is global market strategist of JP Morgan Asset Management