Krona's slide sparks exchange rate debate

The Swedish krona has lost 43 percent of its value against the US dollar over the past six months which at lunchtime on Monday was trading at 8.52 kronor. On July 15th 2008, a US dollar cost only 5.96 kronor.

The krona has also lost around 15 percent of its value against the euro over the same period. A euro cost around 11 kronor at lunchtime on Tuesday.

As financial turbulence shows signs of easing and market rates tumble, inflation forecasts continue to point downwards, however.

Swedish bank SEB has released a forecast predicting that the Riksbank repo rate will be cut to zero by the end of the year.

In a speech to the Centre for Business and Police Studies (SNS) in Stockholm, the deputy governor of the Swedish Riksbank, Lars E. O. Svensson, confirmed the prospect of zero interest rates and presented the options available if this would not be sufficient to boost "price levels".

In his speech, entitled "Monetary policy with a zero interest rate", Svensson describes "the exchange rate as a policy instrument - 'The Foolproof Way' to escape a liquidity trap".

Svensson's proposal for "a small open country to escape from a liquidity trap" raises the prospect of a reintroduction of exchange rate controls.

In a first step a "price level target" would be introduced.

"In the event that unwelcome low inflation or deflation has already arisen, the price level target can be set correspondingly higher than the current price level," Svensson explains.

An "exchange rate target" would then be introduced consistent with the "price level target".

Svensson illustrates that if prices should rise by 10 percent then the currency would be allowed to devalue by the equivalent amount.

Monetary policy would then return to normal "when the price level target has been achieved". In other words the currency would then be allowed to float freely and monetary policy would return to monitoring inflation.

Svensson recognizes that this policy instrument would work easily if the krona were strong. Acquiring a large foreign currency reserve as the currency appreciates would boost inflation and inflationary expectations, the stated goal in this case.

However if the krona were in a weak position then, Svensson observes, it would depreciate when allowed to float freely, as was the case during the fixed rate exchange regime in the early 1990s.

Johan Javeus a currency analyst at SEB, argues that financial turbulence and fear of recession typically leads to a retreat to major world currencies such as the US dollar, Japanese yen and Swiss franc.

Javeus, talking to news website E24, argues that perceived passivity by the European Central Bank (ECB) and a weakening European economy, will only increase the flow of capital.

In his speech, Lars E O Svensson, recognizes that his proposed methods would constitute "very drastic action" but that "it shows the central bank really means business".