Negative Interest Rate: Interesting Experiment!

Switching the interest rate from positive to negative makes a stable system unstable and vice versa.

The Swedish State Bank decided yesterday to set the so-called repo interest rate to - 0.1%, thus a negative interest rate between the State Bank and commercial banks. Nobody knows how a monetary system with negative interest rate really works, and so it is an interesting experiment. It is also being tried in e.g. Switzerland, the land of banks, and by ECB.

A negative interest rate is like a negative friction or dissipation mechanism in a physical system, which is an unknown phenomenon: frictional and dissipative losses are positive or zero, but never negative!

So what does then negative dissipation mean in a mechanical system? Well, it changes the direction of time and thus switches the cause-effect relation. This means that a stable system becomes unstable and that conversely an unstable system may become stable.

Suppose now that our capitalistic system in its standard form with positive interest rate is unstable, which we all fear and which according to experience may well be an actual possibility. By switching the interest rate to be negative, we could then hope to stabilize this potentially unstable system and the negative aspects of the capitalistic system could be eliminated, right?

This must be the idea of Stefan Ingves as the boss of the State Bank, when he decides to set a negative interest rate. Ingves is a smart guy but the question is if the switch also turns stable systems into unstable systems, and if so what negative effects that could have on our economical system.

This connects to an earlier post on the relation between interest rate and inflation, where it seems that in the standard system, it is the inflation that sets the interest rate (to be essentially equal), and not the other way around, as is the mantra of Stefan Ingves. But with a switch to negative interest rate, the cause-effect relation would switch and thus Ingves dream of controling inflation by interest rate would come true. The only drawback would possibly be negative inflation...

Another Blow by Swedish State Bank to Inflate the Bubble

                 Chairman Stefan Ingves proclaiming the inflation to be 2%, however without effect.

The Swedish State Bank to day announced as expected that the repo rate will be lowered by 0.25% to 0.75% in order to force the inflation to increase from depressing 0% to the optimal level of 2% set by the Swedish Government.

But nobody believes, not even the Bank Chairman Stefan Ingves, that the inflation will react at all from the resolute step taken by the bank. This gives new support to my earlier analysis that it is the inflation that determines the repo rate, and not the other way around.

The only effect of the lowered repo rate is a new push up on real estate and stock prices, which with close to zero interest rate can reach any heights. Since the lowering of the interest rate is 25% (0.25% out of 1%) it is to be expected that real estate and stock bubble will inflate by 25%.

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.