Inflation is the highest in 30 years

Economists from different schools describe inflation and its causes differently. But for the sake of simplicity, it can be said that inflation is the same as the rate of increase of the general price level over a year.

It is measured in Sweden, and many other countries, according to the consumer price index (CPI), which is a “basket” of the goods and services that a typical household consumes.

The classic inflation is the one that emerges during a strong and long boom, like Sweden in the late 1980s. Households have a lot of money and they consume a lot of goods and services. Demand in the economy is growing faster than producers have time. Prices are rising rapidly and central banks are responding by raising interest rates to make it more expensive to borrow for both consumption and investment. The economy is cooling down.

Another is the one that has emerged during the pandemic and now during the war in Ukraine. There are disruptions in the supply. Companies do not receive important inputs on time due to shutdowns in China, for example. Or the price of wheat rises as Russia blocks Ukrainian shipping ports. Ukraine is otherwise one of the world’s largest exporters of wheat.

Prices are rising and since these goods are important inputs, the price increases are passed on and hit large parts of the economy. Even if the central banks, including the Riksbank, cannot do much about supply disruptions, they must still raise interest rates to curb the rate of price increases.

We will take a closer look at a number of occasions when inflation has been high in Sweden – and what the authorities have done about it.

World War I

The warring countries needed the products that Swedish industry produced. Profits rose and it was easy for companies and speculators to borrow.

The economy overheated – at the same time as the blockades during the war led to a shortage of goods, which ignited the inflation fire.

The Riksbank’s management has long hesitated about which way to go to combat inflation. Finally, in the autumn of 1917, the bank raised the discount rate, the policy rate at the time, to 7 percent – a level that was considered very high.

Despite this, the real interest rate, interest rates after deducting inflation, was negative. In other words, it was still profitable to borrow and then buy and sell later at a profit.

With peace, the economies of the warring nations began, but supply could not keep pace with demand. Companies built up stocks in anticipation of even higher prices in the future.

In 1920, the bubble burst. Companies were forced to quickly reduce their stocks. Commodity prices fell first, followed by a general decline in prices. Sweden experienced deflation, the opposite of inflation.

The crisis was relatively short, lasting until 1923, but it was deep and unemployment was actually higher than during the depression of the 1930s.

WWII

Inflation picked up speed at the beginning of the war, reaching 13.5 per cent in 1940 and 1941.

This time, fiscal policy, which is controlled by the government and the Riksdag, was mainly responsible for combating war inflation.

Early on, a rent regulation was introduced that would prevent speculation in rent increases when housing construction fell. This was followed by a general halt to price and wage increases.

It worked. Inflation soon fell back and in 1944-45 there was even deflation.

Many economists and politicians also believed that with peace there would be a recession, a deep recession, just like after the First World War.

That did not happen. The lessons of the First World War led the victorious powers, especially the United States, to support the build-up of even former enemies’ economists through Marshall Aid. International institutions such as the International Monetary Fund and the Bretton Woods system, which fixed the exchange rates of the currencies of the countries involved, contributed to stability and laid the foundations for reconstruction.

Stagflation…

The war in Vietnam became an increasing economic burden for the United States during the 1960s. Inflation picked up speed. At the same time, the United States was the anchor in the Bretton Woods system, which of course meant a fixed exchange rate for the countries involved.

When inflationary pressures in the United States increased due to the war, the system could no longer withstand and it collapsed.

In the autumn of 1973, the October War broke out when Egypt and Syria attacked Israel. OPEC, the Organization of the Petroleum Exporting Countries, imposed an oil embargo. It was the first oil crisis and the oil price rose at rocket speed.

This cracked the boom and the 1970s came to be dominated by “stagflation”, both high inflation and stagnant economies with modest growth.

Companies were eliminated when they could not compete internationally, at the same time as their costs increased.

Sweden still had a fixed exchange rate, ie the value of the krona would be fixed measured against a number of other currencies. The idea was that the Riksbank must defend the exchange rate by raising the interest rate.

In fact, there was a series of devaluations, deliberate write-downs of the value of the krona, which culminated in the great devaluation in 1982.

… and overheating.

The devaluation in 1982 gave the export companies the boost they needed and in November 1985 the Riksbank, with the good memory of the government, abolished the existing loan ceiling. Now it was free for the banks to lend money to borrowers indefinitely.

Together with the generous deductions for loan interest rates at the time, this laid the foundation for an overheating of the economy. Prices and wages chased each other in an upward spiral.

The crisis of the 1990s

The government had difficulty dealing with 1980s inflation. Towards the end of the decade, the Riksdag took a decision on a new tax system, which would lead to higher uniform VAT and a limitation of the right to deduct loans, at the same time as the tax on labor was reduced.

This happened at the same time as the Kuwait War, Iraq’s invasion of its neighbor. The price of oil rushed and the world went into a recession.

In Sweden, the crisis became particularly deep. Highly leveraged companies were eliminated, unemployment rose to levels not seen for several decades and in 1992 the Riksbank was forced to release the fixed exchange rate.

The crisis led to new rules for monetary policy – an inflation target of 2 percent – and for fiscal policy – tighter budget rules. From the end of the 1990s onwards, inflation was kept in check.

And now?

Inflation, the old ghost, has returned – and rightly so. Households, employees and companies must expect that Sweden is facing a painful process in which the Riksbank will raise interest rates step by step.

But will there be a rapid return to low inflation after the increases – or will it be like the 1970s when wages and prices chased each other?

Nobody knows.