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...

The Simple Job of the Swedish State Bank

The Swedish State Bank supposedly controlling inflation by repo rate (with the sign indicating that the repo rate is now approaching 0%)

In the previous post I questioned the stated mission of the Swedish State Bank (Riksbanken) led by Stefan Ingves, to control the rate of inflation through the repo rate, as being unphysical in the sense that the cause-effect is rather the opposite: The State Bank passively sets the repo rate after the inflation, rather than actively controlling the inflation by the repo rate.

So what is then the truth? Well, in equilibrium it is hard to say which is the cause and which is the effect, which is the hen and the egg or the dog and the tail, but in a dynamic situation this comes out through the relation between changes in inflation I and repo rate R. Let us study this relation in the simplest case of a linear relation between I and R of the form

• R = S x I + R0       (here I is the cause and R the effect)
• I = 1/S x R + I0     (here R is the cause and I the effect)

where S is a positive sensitivity coefficient, R0 is the repo rate at zero inflation and I0= - R0/S. 

If S > 1, then we can view I as the control, with perturbations in R requiring a smaller correction from I.

Conversely, if S < 1, then we can view R as the control, with perturbations in I requiring a smaller correction from R.

The steering wheel of a car or rudder of a boat functions as control mechanism, because small changes of the control suffice to counteract perturbations in the direction of travel; if heavy turning back and forth of the steering wheel was needed, controlled driving would be impossible. 

What is then the value of S? Is S < 1 or S > 1, or S = 1?  Let us look at historical data for repo rate and inflation:

We see that after the economical crisis in the early 1990s the inflation has varied between 0% and 2% with a present value of 0%. The repo rate on the other hand has varied between 0.25% and 4.75% with a present value of 1%. These numbers indicate that S ~ 0.5, suggesting that effectively it is the inflation rate which controls the repo rate, that is, Stefan Ingves is the egg or the tail!

When periodically deciding the repo rate at the board meeting of the Swedish State Bank, the boss Stefan Ingves thus asks about the inflation rate and then determines the repo rate to follow the inflation rate. It seems to me that Stefan Ingves has a pretty simple job to do: Just set the repo rate after the inflation rate. I could do that myself at half the salary of Stefan Ingves.

PS At present the inflation is 0% and the repo rate 1%, while the targeted desired inflation is 2%. Is it then possible to increase the inflation from 0% to 2% by lowering the repo rate? No, it does not seem to help much to lower the repo rate below 1%, and thus it appears that the control is lost. Likewise, suppose the inflation is 4% and the repo rate is say 5%. Is it then possible to lower the inflation to 2% by increasing the repo rate to say 7%? Maybe, but a repo rate of 7% and inflation of 2% would probably have severe negative side effects. It thus appears that the inflation can only be controled by the repo rate if the inflation rate is the targeted 2%  and then control would not be needed.

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.

Christmas and New Year Puzzle

The World as Computation presents a Christmas and New Year Puzzle.

Many thanks to the Readers of this blog for this year!

Is the Economical Crisis a Climate Crisis?

Two facts fly in our faces today:

1. EU is in a deep economical crisis.
2. EU has the most ambitious plan for reduction of CO2 emissions.

Is there a connection? Many questions present themselves:

• Has the financial market already adjusted to the new reality of a carbon-free society projected by the Royal Swedish Academy of Sciences to 2050?
• Would the economical crisis evaporate if EU leaders gave up their plans for a Great Transformation?
• Was the climate crisis invented to give clever EU political leaders a mission to lead the World into a new future?
• Is the economicial crisis triggered by the climate crisis now driving the same clever EU politicians out of business ?