fredag 19 april 2013

Can Swedish State Bank Really Control Inflation through Repo Rate?

The wise boss of the Swedish State Bank Stefan Ingves believing he is controling inflation by repo rate.

The stated mission of the Swedish State Bank (Riksbanken) is to control the rate of inflation through the repo rate (the lending rate is the rate of interest banks pay when they borrow overnight funds from the Riksbank and is normally 0.75 percentage points higher than the repo rate). The present repo rate is 1% while the inflation is 0%.

The basic idea is that (somehow) the inflation is controlled by the repo rate, that is that the State Bank controls the inflation by turning the repo rate up or down according to the wise decision of the Board of the Bank: If the inflation is too high the repo rate will be increased to bring the inflation down, and if the inflation is too low the repo rate will be decreased to increase the inflation. The repo rate is the cause and the inflation rate is the effect.

But is the description correct? Or is it the other way around: Is the inflation the cause and the repo rate the effect? Of course this is not the view of an activistic State Bank working under the illusion that it controls the economy, but what is the true cause-effect connection between inflation and interest rate?

The idea that the repo rate controls the inflation, is contradictory in the sense that if the inflation is high, increasing the interest rate will increase the cost of money and thus add to inflation. And if the inflation is low, decreasing the interest rate, will decrease the cost of money and thus subtract from inflation.

On the other hand, if you believe that inflation controls interest rate, then increased inflation will demand higher interest rates and vice versa. Inflation and interest rate will thus increase or decrease together, with the inflation being the cause and the interest rate the effect.

In this understanding the State Bank has only a passive role to play by letting the repo rate (controlled by the State Bank) follow the inflation (outside the control of the State Bank).

PS There is a similar tail-wagging-the-dog mix-up of cause-effect in global climate with CO2 alarmists claiming that the trace gas CO2 controls global temperature, while the true physics is that temperature controls CO2, as evidenced in ice cores showing that temperature change precedes CO2 change by about 1000 years.

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