What to do About Inflation?

by German Bender, Håkan A. Bengtsson, Daniel Lind, Elinor Odeberg  |  23rd Dezember, 2022

Inflation in Sweden over time

In recent decades, Sweden has had a low and stable inflation rate. Inflation was rampant from 1970 to 1995, however. This period was moreover marked by spasms of crisis and plummeting real wages. The economic crisis at the beginning of the 1990s ushered in a new era of lower inflation rates. At that time, new fiscal guidelines were also elaborated and monetary policy was separated from fiscal policy. The Swedish central bank was given greater latitude and an inflation target of two per cent was instituted.

Over the past 25 years, however, Sweden has usually failed to meet the inflation target of two per cent. Between 2011 and 2021, inflation hovered at around 1.1 per cent, settling at between 1.2 and 1.5 per cent between 1996 and 2011. Many economists have contended that Sweden's economy, growth and employment levels would perform better if inflation were higher, and in recent years there have been more vocal calls to elevate the inflation target.

In addition, criticism is to be heard that fiscal policy has not used the period of low interest rates to invest in housing and infrastructure. If fiscal policy had been more expansionary, it is argued, monetary policy might in turn have been less expansionary, as government investment would likely have driven demand and thus inflation. From a distribution-of-wealth perspective, it would have been more favourable to achieve inflation of two per cent through government investment instead of encouraging very high levels of private indebtedness on the part of Swedish households through negative interest rates, while generally favouring income from capital over income from labour.

The period of low inflation that set in during the mid-1990s was unique in terms of economic development in Sweden: real annual wage hikes for all employees subject to collective agreements – even in the wake of the financial crisis and during the pandemic. Wage increments remained low, but as inflation rates ebbed even more, workers' wallets started to grow a bit every year. Real wage increases surpassed what labour and management had expected when they signed the contract, as everyone had been projecting a two per cent inflation target. Just like in other countries, the modest inflation rate meant that real estate and investments could be financed at bargain rates through loans, which in turn triggered a sharp rise in asset values, further aggravating an already skewed distribution of wealth.

Like most countries at present, in 2022, Sweden finds itself confronted with a completely new economic situation. In September, the inflation rate peaked at 9.7 per cent, then however dropping to 9.3 per cent in October. Further price increases are anticipated. The Swedish National Institute of Economic Research expects inflation to settle at 7.9 per cent this year, while the central bank's November forecast is 8.3 per cent. This has prompted it to rapidly increase interest rates to historically high levels. Most experts believe that inflation will drop in 2023, but uncertainty about the direction inflation will take remains high.  

On the road to recession

Due to inflation and interest rate hikes, forecasts for the Swedish economy darkened over the autumn. The stock market is expected to tumble further in the winter, and property prices are expected to drop, while energy costs are expected to surge and become more volatile. Forecasts indicate that Sweden is headed for recession, with unemployment expected to mount next year, even though the employment rate has been on a positive trajectory so far in 2022. The Ministry of Finance is projecting Sweden's gross national product to drop by 0.4 per cent next year, and risks have taken on clear contours in the face of such headwinds.

This situation is owed to a number of factors. As a small, export-dependent country, Sweden is at the whims of global events. It will be recalled that the inflation rate had already begun to inch up before the war in Ukraine, especially in the U.S. During the pandemic, demand for goods picked up, but opportunities to buy services unsurprisingly faced constraints. At the outset of the pandemic, inflation dropped off to 0.5 per cent, only to then swell later due to logistical bottlenecks afflicting several commodity chains. At the same time, substantial economic aid packages were crafted to stimulate demand, while pent-up consumer demand began to release as the pandemic subsided. This elevated demand was further augmented in Sweden by the central bank's previous low interest rate policy, which resulted in high levels of private debt being carried by Swedish households.

But with the outbreak of war on 24 February 2022, inflation began to skyrocket, largely due to supply-side shortages during the pandemic and scant raw materials due to the war in Ukraine, especially energy. This cannot be solved using the blunt tool of interest rates. Although Sweden abstains from gas imports from Russia, Swedish electricity prices react to disruptions in the European energy market – not least the German one. In a country characterised by large geographical distances, high oil prices are also able to sway public opinion. Criticism has been directed for example at the blending of more biofuel in Sweden compared to other countries, making diesel more expensive.

High levels of private debt in tandem with a high percentage of flexible interest rate mortgages make Swedish households more exposed to interest rate ups and downs than households in other countries. This poses a major challenge for Sweden. The flagging exchange rate of the Swedish krona is another factor triggering a new spate of interest rate hikes in the current situation. The Swedish central bank cannot set its prime interest rates too far below that of other central banks, even if the situation in the housing market is crying out for it. Any other interest policy would weaken the Swedish currency, thereby making imports more expensive and even further fuelling inflation.

The impact of inflation on economic development

The direct, immediate effects of inflation are that strata of the population with little or minimal financial wiggle room may no longer be able to pay their everyday living expenses. Low-income earners are particularly hard hit, as their cost of living is rising, with food, energy and transport, on which much of their income is spent, becoming dearer. Other strata of the population generally have greater financial breathing space and are able to prioritise spending. But unlike businesses, which can pass on increased costs to their customers in the form of higher prices, households have to shoulder their own costs. The hardest hit are groups of workers with the lowest wages, part-time workers and those working for companies without a collective agreement. This also goes for the unemployed, those on sick leave or people relying on social support. Priority must therefore be assigned to measures that bolster and safeguard the buying power of these groups. Social security systems must be expanded to ensure an adequate standard of living, especially if unemployment is expected to rise.

One of the major strengths of the Swedish social security system is that many transfer benefits are pegged to the rate of inflation. In economics parlance, this is referred to as "indexation". This term denotes, e.g. guaranteed pension, student and parental benefits, but also certain taxes. Not all systems are pegged and hence adjusted for inflation, however. Public sector financial resources, for example, are not hitched to general price and wage increases. But herein lies an important contrast to some other countries that are now introducing so-called inflation packages to support households. These packages often provide direct financial aid, while Swedish households are automatically bolstered by means of indexing.

It is also evident that households facing mortgages with no fixed interest or only very short-term fixed interest rates are affected when the central bank boosts the prime interest rate. Almost every other housing mortgage has no fixed interest rate, i.e. is only tied to a three-month commitment period. Fixed-interest loans are usually set for two or three years. At the same time, interest rates on fixed-interest loans are now on the rise, which gradually translates into mounting housing costs for everyone: Tenants, holders of housing rights and homeowners. Demand has already cooled for the construction industry and planned projects are not being carried out, as inflation and interest rate hikes begin to chew away profitability. This dramatically spikes the risk of stagnating housing construction and sagging house prices on a commensurate scale as the central bank ratchets up the prime interest rate. In October 2022, house prices fell by ten per cent year on year.

A recession shakes the whole economy, stressing individuals, workers, businesses and the public sector as tax revenues plunge and costs soar, with things becoming particularly tricky if inflation becomes entrenched at a high level. But there is, as always, a wealth-distribution aspect, since crises affect different social groups differently. Policy decisions taken in the course of the coming recession must therefore include equity in the equation.

The biggest risk looming for the Swedish economy is that the real estate market may collapse in the face of high private debt and falling property prices. Another menace on the horizon is turbulence in the commercial real estate sector, which has been reeling from climbing interest rates, thereby jeopardising financial stability. Forty percent of bank loans go to commercial real estate companies. This would require the state – ultimately taxpayers – to provide loan guarantees to avoid a financial crisis. At the same time, the Swedish economy has a vigorous public sector and is thus able to cope with a downward-spiralling economic situation, while Swedish banks have considerable room for manoeuvre in their lending policy.

New challenges for Swedish wage formation

So far, inflation has not been fuelled by a price-wage spiral, which warrants emphasis here. In the spring of 2023, stakeholders in the Swedish labour market are scheduled to enter into the next round of wage negotiations, with a considerable share of collective agreements coming up for bargaining. The wage demands that are being forwarded, even if they are completely met, will result in further significant wage reductions next year in real terms. Thus, it would appear, inflation is shattering a long-standing trend of rising real wages. Negotiations will be taking place under completely new conditions: high rather than low inflation in a decidedly uncertain economic situation. This is a new sort of challenge for Swedish wage formation as a whole, and for the cohesion of trade unions in particular.

At the same time, historical experience tells us that wage compensation for high inflation has led to weakened purchasing power because of further rising prices. Trade unions do not want to return to a wage-price spiral like the one that pushed down real wages in the 1970s and 1980s. Since the mid-1990s, the Swedish wage formation model has been based on a so-called industrial contract, which means that "contract agreements" within the industrial sector set the pace for wage increases for the whole labour market. The industry wage norm is accepted by all labour market stakeholders in the guise of coordinated wage negotiations at local and sectoral levels. This model has proven to be stable and has curbed inflation. The advantage offered by coordinated and centralised wage formation is that the norm-setting role of industry is broadly accepted by labour market actors.

The question is how to manoeuvre when facing high inflation over a longer period of time. Wage negotiations will thus prove to be extremely arduous going forward. It is likely that shorter-term contracts will be concluded (for one year) because of difficulties in forecasting future developments. The question remains, however, how great the unions' wage demands will be and how willing employers will be to compromise in order to avoid serious conflicts in the Swedish labour market.

It can be assumed that the discussion surrounding the wage margin on the trade union side will shift from the state of the economy to the level of profits. Climbing prices combined with low wage increases inevitably translates into higher profits if companies' costs do not rise at the same rate. A sense of responsibility on the part of workers and trade union organisations requires a sense of responsibility among employers. The agenda cannot be to seize the opportunity to rake in excessive profits (see below) or dish out outrageous salaries and bonuses to executives.

Higher inflation can lead to an increasing share of profits  

The focus must be set on price increases that are not on par with the rise in costs for companies, especially when real wages are stagnating or falling. Unfortunately, it is difficult to imagine this in a situation in which the annual inflation rate is eight per cent. From a present-day perspective, it does not appear likely that wages will advance by ten per cent. This creates a risk of growing strains and pressures.

So it is important to look at the profit share. If it ascends while real wages drop, the prevailing consensus in the labour market will break down. In their latest report on the economic outlook, economists of the Swedish Trade Union Confederation (LO) forecast that the share accounted for by profits, which was 38.1 per cent of value-added in 2021, will climb to 40.9 per cent in 2023. The Swedish National Institute of Economic Research's wage formation report shows that profitability in the economy was generally good even before inflation picked up, while the profit share was above the historical mean.

It is also worthwhile examining the trend in profitability over time, as is underscored by Daniel Lind, research director of the industrial unions group in the Productivity Commission at the think tank Arena Idé. Figures suggest that companies' profitability has not been gobbled up by inflation on any significant scale so far, neither in trade nor in the economy as a whole. An analysis of the record profits reaped by business and industry in 2022 on the contrary shows that many companies have boosted their sales prices disproportionately to the cost of upstream goods required.

Scrutiny needs to be shifted to price hikes that do not keep pace with surging costs incurred by companies – especially when real wages are stagnant or falling. As the LO economists put it in their economic outlook: "It will be particularly interesting to monitor the profit share in comparison to the operating costs fuelling inflation in coming years." The Swedish central bank has also raised this issue, and the Swedish National Institute of Economic Research was commissioned by the previous government to keep an eye on companies' pricing and profit margins.

"Creeping inflation" and mounting profits

It appears warranted to draw attention in this context to terms like “stealth inflation” or “sneakflation”, i.e. a price increase by companies that is not communicated to the customer. The term "shrinkflation" is related to this. This occurs when companies hoist prices by charging the same amount for smaller packages as they did for the original larger package.  

In the service sector, there is a similar mechanism at work in which the price is left unchanged while the service component is downsized, such as when customers have to pay a surcharge for luggage or seat reservations because the service is no longer included in the ticket price. Sometimes the reason for raised prices is greater expenses which the company tries to compensate for.

But sometimes it is about expanding profit margins, i.e. prices outpacing cost rises. In the context of the Swedish debate, German Bender at Arena Idé draws attention to this phenomenon in an essay published in the Internet journal “Dagens Arena”, in which he coins the term "creeping inflation". There is also a tendency to substitute inputs of a product so that goods are cheaper, but of poorer quality. This is the case, for example, with clothing and food. This tendency also highlights the difficulty of measuring inflation, as the consumer price index does not take into account the quality of goods measured.

Measures taken and planned to curb inflation

Government and policy-makers have moved to respond to rising fuel and electricity prices. Sweden's "krona for krona" financing doctrine, according to which public spending was not allowed to go up, was already abandoned during the pandemic, when the government decided to institute extensive aid packages. Against the backdrop of a surge in inflation, further measures have now been taken to put in place supports and subsidies. Social security issues are back on the agenda. In last spring's public budget, the lowest pensions were raised, while unemployment benefits, which were temporarily raised during the pandemic, now apply indefinitely; the same goes for housing benefits for needy families with children.

In the spring of 2022, all parties advocated compensation for skyrocketing petrol and diesel prices. The government at the time proposed tax cuts on fuel. But in parliament, a coalition made up of the three conservative parties plus leftists and the Sweden Democrats on the radical right voted for even greater tax cuts. In addition, the government decided on a price compensation scheme to benefit households because of higher electricity prices, which was later expanded. An assessment of this tax cut by the Swedish National Institute of Economic Research indicated that 25 to 40 per cent of the relief went directly to the fuel companies instead of bringing about a price reduction at the pump.

In the winter of 2022/23, the current government, like the previous one, has pledged a cost shield against higher electricity prices, with the bill for the scheme running at a total of 60 billion kroners. This compensation is to be partly financed by higher levies on the windfalls realised by Swedish energy companies through the high electricity prices. The levies are seen as a form of reimbursement to households. This relief is only to be provided in the spring 2023 as a retroactive payment, however. There is an obvious danger that it will not reach the households hardest hit in terms of their actual ability to pay bills and that it will instead fan the flames of inflation.

All in all, Sweden is autonomous when it comes to electricity and has an extremely low level of gas consumption. It is much more often the case that Sweden exports electricity to the European electricity market than vice versa. But at the same time, rising electricity and energy prices and a tightening of supply also affect the Swedish electricity market. The country has four price zones for electricity. Shortfalls in transmission capacity result in significantly higher electricity prices in the south than in the north. Hence, the issue of electrical power prices is high up on the agenda.

Political parties on the right are now calling for an expansion of nuclear energy, which would have no impact in the short term. The left of the political spectrum is calling for Sweden to detach itself from the European electricity market and apply "Swedish prices". All the parties seem to agree, however, that households and businesses should be recompensed in some way for rising electricity prices in the coming winter. Proposals from the right have for the most part revolved around tax relief in the form of reduced value added tax (VAT) or a reduction in consumer taxes on petrol and diesel, while social democrats have tended to propose direct financial support, i.e. for motorists or households facing surging electricity prices. The autumn budget contains a tax cut for petrol and diesel, which is expected to lead to a total price reduction of 14 öre per litre, which is unlikely to have much of an effect on inflation. On the other hand, it is going to be an expensive bill the state is footing, to a tune of 6.8 billion kroners according to the 2023 budget. There has also been a discussion about lobbying the EU to impose a price cap on Russian gas, on which all parties agree.

In the Swedish debate there is a general concurrence that fiscal policy must not counteract monetary policy. Furthermore, it should be kept in mind that the group of the population receiving the focus during the election debate on inflation consists of car drivers, small business owners and homeowners. The more acute the situation becomes for low-income groups and the more dismal the economic outlook, the more fiscal policy will be forced to set priorities, so it is possible that the debate may lead to a better distribution of wealth.

Desirable policy measures

Policy recommendations before a recession usually centre on cutting the prime interest rate and using fiscal policy to boost demand in the economy. This time, however, central banks in Europe, the US and Sweden are doing just the opposite: raising the prime rate, thereby heightening the risk of a deepening recession, while fiscal policy on the whole remains tight. At the same time, it is not certain how efficacious the interest rate weapon is against the factors that push inflation. The stubbornness of inflation and the point at which central banks ease the pressure with interest rates are therefore the crucial questions for economic development – in Sweden and elsewhere.

It is imperative that politicians in the current crisis not take decisions that power the inflation rate or frustrate other key policy objectives. During the recent parliamentary election campaign in Sweden, a number of parties got carried away with promises of measures that would have ultimately stimulated inflation. The parties that have now hold the reins of power are being accused of deception because they cannot deliver the promised reductions in petrol and electricity prices. They have also pledged to abolish the obligation to repay loans, but this promise does not appear to be feasible. Given the high level of debt already carried by Swedes, it would also be imprudent. The Swedish central bank has noted that this measure would lead to even higher interest rates.

It has already been decided to step up spending on defence. This will require enormous sums (even if Sweden had not applied for NATO membership), while at the same time there is a great need for investment in the energy transition. This critical situation requires that some compensation be provided for electricity prices. But the measures should also target a reduction of electricity consumption, if only out of solidarity with other countries in Europe as well as to foster and advance the longer-term energy transition. Bringing down electricity consumption also offers the greatest impact on electricity prices in the short term. Household electricity consumption has decreased year on year. Now, after the elections, the dire situation and possibility of having to ration electricity may well move into the political spotlight.

The issue of boosting energy efficiency may also play a key role. Long-term investments moreover also ease bottlenecks in supply as well as commodity chains and, ultimately, inflation itself. Such investments lay the foundations for a more robust economy. All in all, the current situation shows how vulnerable Europe is due to the fact that we import a large part of our energy from non-democratic states. Although Sweden is well advanced in terms of electrification and energy efficiency, the rest of Europe is an integral part of the pricing equation.

Inflation is mainly caused by factors that Sweden cannot steer. Hence, there are few measures that can be taken to curb it. Wielding the sword of interest rates, the central bank can take certain steps, but there is an obvious danger that monetary policy will be overly aggressive and thus ravage the economy, while supply disruptions – and thus the problem of rising prices – remain unaddressed. Domestic measures that have already been discussed include, for example, tighter controls on creeping inflation to also force employers to assume their fair share of social responsibility. Here, politicians and public debate can set the agenda on a grander scale. It is also crucial that the social partners in the labour market – not only the trade unions, but also employers – act to ensure that real wages are not weakened too much.

There is a need for a distribution policy key for the measures to be implemented both in the current crisis and for the years to come. Schemes for welfare state benefits, unemployment benefits, sickness benefits and social assistance definitely need to be strengthened. Social protection afforded to people living on the minimum economic margins must not be sacrificed. This goes for older people with low pensions, low earners, part-time workers and people working under precarious and atypical forms of employment.

Political decisions that further fuel inflation should be avoided in the first place or scaled back. Malinvestments must be avoided, with the crosshairs instead being placed on long-term needs: funds for municipalities and regions, the energy transition, transport infrastructure, schools and higher education. The mantra that fiscal policy should not run counter to monetary policy should not lead to a strangulation of needed investments or to random, untargeted short-term tax cuts, while low-income households are increasingly straining to cope with everyday economic life.

Municipalities and regions working in the social, education and health sectors are being hit in the same way as households by higher costs for heating, transport and food. It is thus the task of the state to ensure that the level of prosperity is maintained by providing compensation for costs that are now being incurred by the municipal sector. At present, state subsidies are not adequate to meet needs in the municipal sector, with the social, education and health sectors facing cutbacks in spending. Policies must ensure that vulnerable groups survive the winter despite rising price levels. Conditions for this are good in Sweden, as there is a sturdy public sector.  

Above all, political decisions that accelerate climate change must be shunned. It is distressing to witness the governing parties, after emerging from the pressure of an election campaign, deciding to ease requirements regarding the blending of bio-fuel with diesel in order to reduce the price. This means Sweden will fail to reach its climate targets. Instead, the fight against climate change should be prioritised; otherwise the future costs of extreme weather or passing the tipping points that are to be expected will be astronomical. Policy-making needs to adopt a long-term perspective, which must not be lost sight of in the tangible, specific work devoted to mitigating the consequences of inflation and crisis in the here and now.