Deflation fears: Is Sweden the next Japan?

It's not just political chaos that's creating uncertainty in Sweden, with deflation and stagnation posing a real threat to the triple-A rated economy, according to economic research consultancy Capital Economics.

Sweden called its first snap election in more than half a century on Thursday after the far-right, anti-immigration Sweden Democrats party voted against the ruling coalition government's first budget.


Stockholm, Sweden
Melanie Stetson Freeman | The Christian Science Monitor | Getty Images
Stockholm, Sweden

The current center-left government led by Prime Minister Stefan Löfven was formed just three months ago, out of a partnership between the Social Democrats and Green party. But the Sweden Democrats, with 13 percent of the vote, effectively have the power of veto.

While political turmoil is highly unusual in Sweden - and is likely to create uncertainty in the country - Capital Economics said it did not pose a significant risk to the economy. Rather, falling prices were the main danger facing Sweden.

"In fact, the persistent threat of deflation is likely to pose a much greater threat to the Swedish economy," Hinds said in a note Wednesday. Consumer prices in the country rose a mere 0.1 percent in October down from 0.2 percent in September.

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"Prices have been falling in annual terms for most of 2014 and there is a real risk that Sweden slips into a spiral of deflation and stagnation like Japan," Hinds added. "The central bank has already slashed its policy rate to zero to boost inflation, but it may well need to take more drastic action."

Japan experienced what has become known as a "lost decade" to deflation in the 1990s. Falling prices mean consumers hold off purchasing goods in the belief that they will get even cheaper, which in turn damages the economy as demand drops, producers suffer and unemployment ensues.

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Japan's government introduced a series of reforms in an attempt to boost the economy, which is something that Sweden may have to do – despite it having avoided the financial crisis so far and being one of the few European nations that can boast a robust economy.

The country's economy grew by 2.1 percent year-on-year in the third quarter of 2014, the country's statistics agency reported last week. Furthermore, government debt is low by international standards at about 40 percent of gross domestic product (GDP) in 2014. Unemployment too is also low at around 7.9 percent, as of October.

Despite being outside of the 18-country euro zone, Sweden's low inflation data may signal that it is not immune to the disinflation plaguing the region. The rate of inflation in the euro zone slowed again in November to 0.3 percent.

Sweden's price growth of just 0.1 percent is well below the central bank's target of 2 percent and this has put pressure on the Riksbank to stimulate more spending, which could be problematic for a country with high levels of borrowing and household debt.

- By CNBC's Holly Ellyatt, follow her on Twitter @HollyEllyatt. Follow us on Twitter: @CNBCWorld.