A dangerous thing concerning debt is what Irving Fisher (1933) called ”debt deflation.” It is usually described as deflation causing the real value of nominal debt to increase. Loan-to-value and loan-to-income ratios also increase, since the debt is fixed in nominal terms but the nominal value of assets and income fall. This may hurt the economy through bankruptcies, deleveraging, and fire sales.
- But the important thing with the concept of “debt deflation” is not deflation, that is, negative inflation. The important thing is that the price level becomes lower than previously anticipated.
This implies that real debt and loan-to-value and loan-to-income ratios become higher than anticipated and planned for. Everyone has probably not realised that this is something that the Riksbank has caused with its “leaning against the wind” policy, by neglecting the objective of price stability and conducting a monetary policy that has resulted in inflation below target.
The majority of the Riksbank Executive Board maintains in their latest policy decision and in the minutes  that “although a lower repo-rate path could lead to inflation attaining the target slightly sooner, it could also increase indebtedness and thus the risks to economic development in the longer run” (the minutes from the meeting on September 4, 2013, summary).
As I have shown in Svensson (2013) and summarised in a previous Vox column , the majority is wrong when it says that a lower policy rate would increase household indebtedness. It has misunderstood how the policy rate affects real debt and the debt ratio (the debt-to-income ratio).
- A lower policy rate would reduce (not increase) household real debt and the debt ratio. This is because it would increase the price level and nominal disposable income faster than total nominal debt.
This effect is small, however. A 1 percentage point lower policy rate during 1 year leads over the next 4-5 years to about 1% lower real debt and debt ratio than without the rate increase. Thereafter, real debt and the debt ratio slowly rise back to the level they would have had without the rate increase. But a larger effect on household debt and the debt ratio arises because the Riksbank has, over a long period, neglected the objective of price stability.
- The Riksbank has, over a long period, conducted a leaning-against-the-wind policy that has led to average inflation substantially below the inflation target of 2%. This has led in the medium and long run to a substantially lower price level and nominal disposable income than if inflation on average had been kept on target. Then real debt and the debt ratio have become higher.
As we can see in Figure 1, the price level in Sweden has now fallen significantly below the level it would have been at if inflation had been on average 2% since 1997. In this context, the Riksbank stands out among the other central banks that have had inflation targets for the same length of time. The other central banks have kept average inflation on or very close to their targets, as I have shown in another Vox column . For instance, in Figure 1 we see that the Bank of Canada, which also has an inflation target of 2%, has kept average inflation almost exactly at 2% since 1997.
Figure 1. The CPI in Sweden and Canada compared to the CPI for 2% inflation since 1997
Source: Statistics Sweden and Datastream.
That the price level in the medium and long ru