An embarrassing U-turn by Sweden's central bank translates into good news for North American investors.
That's because the Nordic nation's change of heart this week sends a clear message to Janet Yellen and other policy makers at the U.S. Federal Reserve that an early tightening of monetary policy carries a significant risk of backfiring.
The U.S. central bank will keep that in mind as it contemplates when to start raising interest rates. Surveys of economists show that most expect the Fed to start boosting the cost of money in the second quarter of next year. Any such move by the Fed could be echoed by the Bank of Canada.
But, as Sweden's example demonstrates, there's a growing case for holding off on action until a recovery is in full swing – which may not be until 2016. If so, low interest rates are likely to continue to support stock prices for at least another year. Low rates make stocks more attractive by, among other things, reducing the appeal of bonds.
Sweden hiked its benchmark interest rate to 2 per cent in 2011 to discourage a run-up in household debt and prevent the inflationary surge that some of the country's central bankers feared. The Riksbank's stubborn insistence on fighting the phantom menace of rising prices prompted Lars Svensson, an internationally recognized macroeconomist, to resign from the central bank's board last year in protest.
As inflation remained missing in action and the economy struggled to make headway, it became clear that the early rate rise was a mistake and the Riksbank had to retrace its steps. On Tuesday the central bank swallowed its pride and took the final step of cutting the rate to zero.
Like several other central banks, the Riksbank fell into the trap of assuming that higher inflation was just around the corner. Instead, persistently low inflation and even deflation have emerged as the real threats. Both amplify the real burden of debt and make wage adjustment more difficult in countries struggling with current account deficits.
To be sure, the United States and Canada are not Sweden and don't face the same drag from a troubled euro zone economy. But central bankers in both countries have to weigh the risks of raising rates too early against the danger of leaving them low too long.
The balance of those perils looks increasingly lop-sided. If a central bank raises rates too early, it may help to crash a fragile recovery – which is exactly what appears to have happened in Sweden.
On the other hand, if it leaves rates low for too long, inflation could bubble well past the 2 per cent target that central bankers prefer. That, however, seems like a mild risk after years in which inflation has consistently fallen short of expectations.
In Canada, inflation is running at 2 per cent, while consumer prices in the United States are rising at only a 1.7 per cent annual rate. In both countries, falling oil prices are tugging inflation lower and slowing growth in Europe and China are taking a toll on exporters.
All of that should add up to a powerful case for acting slowly – very slowly – when it comes to tightening monetary policy. On Wednesday, the Fed said it would keep short-term interest rates near zero for a "considerable time." Don't be surprised if the considerable time is longer than most economists expect.