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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. The first thing that happens when the Riksbank changes the repo rate is that the so-called overnight rate is affected. The overnight rate is the rate at which the banks borrow and lend money to one another during the day. The size of the effect that a change in the repo rate has on interest rates with a longer duration depends on how expected the adjustment is. The Riksbank aims to make its monetary policy predictable. The Riksbank tries to affect expectations of future monetary policy by regularly publishing forecasts for the repo rate. In this way it is easier to avoid changes in the repo rate coming as a surprise. 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.
Monetary policy thus has an effect on the interest rates the general public face and thereby also on the total demand and total supply in the economy. The channels that mean that market interest rates affect supply and demand can be divided into the interest rate channel, the credit channel and the exchange rate channel. You can read more about these channels below.
Credit channel
The credit channel describes the way in which monetary policy affects demand via banks and other financial institutions. If the interest rate rises, banks choose to decrease their lending and instead buy bonds. This means that households and companies find it more difficult to borrow money. Companies that are either unable or unwilling to borrow must cut back their activities, postpone investment and so on, and this dampens activity in the economy.
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 crossborder 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 expectations
Inflation expectations are important to the way in which companies set prices and to how wage formation functions and thereby to inflation. If everyone trusts that inflation will remain low and that prices will only rise temporarily, this will lead companies to consider that they do not need to change their prices as often. An employee may reason in the same way with regard to wage demands, which means that the outcome from wage bargaining rounds is at a reasonable level. Both of these events make it easier for the Riksbank to achieve price stability. However, the fact that inflation expectations are firmly anchored at the inflation target is no reason for the Riksbank to leave the repo rate unchanged. Rather, this should be taken as a sign that the public expects the Riksbank to do what is necessary to ensure that inflation is 2 per cent. In other words, inflation expectations can be seen as a measure of the publics confidence in the Riksbank to attain the inflation target. However, if inflation expectations deviate from the target, it may indicate that the public does not believe that the Riksbank will manage to keep inflation around 2 per cent. The Riksbank may then need to adjust the repo rate at a different pace than is reflected in expectations of future monetary policy. In this way, different measures of inflation expectations and market expectations of monetary policy serve as a supplement to the Riksbank's own forecasts for inflation and the interest rate. The Riksbank therefore regularly follows developments in various measures of inflation expectations and publishes them in its Monetary Policy Report.