Where There’s Smoke, There’s Fire : An Analysis of the Riksbank’s Interest Setting Policy

Abstract: We analyse the Swedish central bank, the Riksbank’s, interest setting policy in a Taylor rule framework. In particular, we examine whether or not the Riksbank has reacted to fluctuations in asset prices during the period 1995:Q1 to 2016:Q2. This is done by estimating a forward-looking Taylor rule with interest rate smoothing, augmented with stock prices, house prices and the real exchange rate, using IV GMM. In general, we find that the Riksbank’s interest setting policy is well described by a forward-looking Taylor rule with interest rate smoothing and that the use of factors as instruments, derived from a PCA, serves to alleviate the weak-identification problem that tend to plague GMM. Moreover, apart from finding evidence that the Riksbank exhibit a substantial degree of policy rate inertia and has acted so as to stabilize inflation and the real economy, we also find evidence that the Riksbank has been reacting to fluctuations in stock prices, house prices, and the real exchange rate.