Sweden: Hot or Not?

Thomas Gade and Elga Bartsch | London

The land of positive surprises
The economy of Sweden has expanded at impressive rates during recent years. Going forward, we expect a gradual slowdown in GDP growth from 4.5% this year to 3.3% in 2007, and slowing further to trend growth of 2.6% in 2008. On our forecasts, the Swedish economy continues to outpace that of the euro area. The risks to growth are on the upside, we believe. Inflation on the favourite Riksbank’s measure, UND1X, will likely remain subdued throughout the forecasting period and head above the official 2% inflation target towards the end of the forecast period only. On our baseline scenario, a combination of continued withdrawal of monetary stimulus by the Riksbank, gradual strengthening of the Krona, as well as a cyclical slowdown in productivity growth will weigh down on growth. Meanwhile, the lowering of income taxes as announced in next year’s public budget proposal will likely sustain private consumption growth going forward. In our baseline case we continue to expect a gradual normalization in house price appreciation. However, the increasingly stretched housing market remains a significant risk factor. The second key risk will once again be developments in productivity growth. We expect a gradual slowdown in productivity growth, but we wouldn’t rule out further upside surprises.

Withdrawal of stimulus, but a change in pace
With nominal GDP growth likely at around 5.7% this year, the current monetary policy rate of 3.0% remains quite expansionary and well below neutral, we estimate. The period of very accommodative monetary policy has been one of the main drivers of demand, we believe. Throughout 2007 we expect the Riksbank to continue withdrawing monetary stimulus at a gradual pace. Depending on the future developments in consumer price inflation and house price inflation, we expect the Riksbank to continue towards a neutral rate, which we estimate to be around 4.5%. From the end of 2007 and onwards, we expect the Riksbank to continue removing monetary stimulus, but at a lower pace.

Inflation on both the CPI and less so the UND1X measure will be constrained through 2007 by a series of politically induced one-off effects. These one-off effects will unwind in 2008 and inflation should rise. UND1X inflation continues to be the favourite Riksbank measure. This could possibly create slight pitfalls in monetary policy going forward, since UND1X and the formal CPI target measure will continue to diverge. The latter, which is important for inflation-linked bonds, does not strip out interest payments on mortgages, while the UND1X measure does, so the two will likely continue to diverge as the monetary policy tightening continues. The key risk factors next year for the Riksbank will be the outcome of the large rounds of wage negotiations, productivity growth, and developments in house prices and household debt. Wage demands and the possible outcome (although still high) already seem to settle slightly below our expectations of 4% on average, so the key risk factor for inflation will once again be productivity growth, we believe.

The all-important productivity growth

The recent period of high GDP growth and subdued inflation in Sweden has been largely driven by a high rate of productivity growth. Should higher productivity growth remain sustained, Sweden could be in for several years of above-trend growth. Meanwhile, wage growth has been high in an international context in recent years and looks likely to remain on the high side for the next three years. This is indicated by initial wage demands set out before the large 2007 wage negotiations. A subdued rate of growth in unit labour costs (ULC) and inflation will be contingent on a continued high rate of productivity growth. Should productivity growth slow as we are expecting, then growth in unit labour costs will be on the rise (See Sweden Economics: The 2007 Wage Negotiations - Expectations and Implications, Nov. 21, 2006).

More specifically, we expect cyclical productivity growth to slow going forward as hiring and employment pick up. Structurally, productivity growth is benefiting from a growing ICT sector and capital deepening associated with the use of ICT equipment in other sectors from an early stage. The Swedish economy has enjoyed both a higher capital-to-worker ratio as well as a relatively higher degree of ICT penetration. In this way the Swedish economy resembles the US economy. Efficiency gains from capital deepening may raise the productivity level permanently, but boost productivity growth only temporarily. Thus productivity growth will likely abate as the efficiency gain from the use of new technology starts to level off. However, structural productivity growth need not necessarily slow going forward provided there is ongoing innovation in ICT equipment. Nevertheless, other regions, particularly the euro area, in which capital deepening started at a later stage, may start to catch up and experience higher productivity growth and lower ULC growth going forward. Thus there is a risk that the competitive position of the Swedish economy could slip going forward.

Potentially a poisonous cocktail for exports

The key factor needed for controlling growth in unit labour costs (ULC) is a sustained high rate of productivity growth. In particular, as the preliminary wage demands suggest, the 2007 wage negotiations will likely result in wage growth somewhere around the expected 4% on average over the three years traditionally governed by the wage contracts. Should wage growth rise by half a point on average from the previous years’ level and productivity growth slow to around 2%, unit labour costs could rise by 2.5% in the years ahead. Add to that a potential strengthening of the trade-weighted exchange rate (TWER) of 4% in 2006 and about 1% in 2008, as projected by our currency economists, and this combination has the potential of significantly hampering export growth and manufacturing and service sector revenue and profits in the years ahead.

Bottom line - Hot or Not?
The answer is: it depends. It depends on productivity growth. The Swedish economy is likely to slow, while staying above trend and above Europe. Domestic demand growth will be sustained by private consumption growth as disposable income will see a significant rise due to lower income taxes and higher employment. Investment spending growth will likely continue due to high capacity utilization, but the investment spending momentum may slow as the Riksbank continues to withdraw monetary stimulus, we think. Indeed, demand-driven growth appears likely to stay hot. Inflation will gradually creep higher as we expect cyclical productivity growth to slow. However, we cannot rule out further positive surprises in productivity growth. Should that be the case, Sweden may once again be in for high growth and low inflation.