How changes in the repo rate affect inflation
The way in which changes in the repo rate affect inflation and the rest of the economy is known as the transmission mechanism. The transmission mechanism is actually not one but several different mechanisms that interact. Some of these have a more or less direct impact on inflation while others take longer to have an effect. It is generally held that a change in the repo rate has its greatest impact on inflation after one to two years.
Banks’ lending rates and interest rates on securities are affected therefore by both the actual and expected repo rate. If a raise in the repo rate is fully expected, market rates can begin to rise before the repo rate itself is raised. Then, when the repo rate is actually raised, it will not necessarily have any further effect on market rates if it merely confirms market expectations.
Schematic diagram of the monetary policy transmission mechanism
Interest rate channel
Lower aggregate demand results in lower resource utilisation. When resource utilisation is low, prices and wages usually rise at a more modest rate. However, it takes time before a decline in resource utilisation leads to a fall in inflation. This is partly because wages do not change from month to month but more seldom than that.
Exchange rate channel
The exchange rate channel describes how monetary policy affects the value of the currency. Normally, an
increase in the repo rate leads to a strengthening of the krona. In the short term, this is because higher interest rates make Swedish assets more attractive than investments denominated in other currencies. The result is a capital inflow and increased demand for kronor, which strengthens the exchange rate.
Monetary policy also plays an important part for the exchange rate in the long term. By definition, the exchange rate is the price of a country’s currency expressed in terms of another country’s currency, which means that it is affected by differences in inflation between countries. Tighter monetary policy means lower inflation, which in the long run can be expected to be reflected in a stronger exchange rate.
A stronger exchange rate – an appreciation – has an impact on the economy in two main ways. First, foreign goods become cheaper compared with domestically produced goods. This leads to a rise in imports and a decline in exports. Lower demand for domestic goods contributes to a reduction in resource utilisation and dampens inflationary pressure.
Second, the exchange rate affects inflation through changes in the krona prices of goods for cross-border trade. Firms that import goods to Sweden pay a lower price in kronor for their imports. In this way, a stronger krona tends to lower the inflation rate, since imported goods and import-competing goods become cheaper. This reinforces the dampening effect on inflation of falling demand.
Inflation expectationsSource: www.riksbank.se