Dear Riksbank,

I am concerned about your view on monetary policy and inflation and so should many others.

You predicate that raising interest rate has some meaningful effect on the inflation rate. I understand that you are stuck in your Neo-classical framework where inflation is essentially a demand side issue whereas stagnation is on the supply side.

Unfortunately, in the real world it is the other way around, inflation is (always) caused by disruptions in the supply chain and it is the aggregate demand the main driver to economic stagnation.

When inflation returned to the economic scene after a 3-decade absence, you fought it the only way you know how—by raising interest rates on government bonds. Your mainstream economic models, which ignore banks, debt and money predicted that raising interest rates would lower the public’s expectations of inflation, and this would cause actual inflation to fall. Problem solved.

Careful when you say, “far too high”, 10% inflation on annual basis is higher than normal but not far too high. There is basically no empirical evidence of significant negative effects from inflation with rates below 40% per year.

But since you are so eager to see an increase in unemployment, go and check the social costs of having a large share of the population involuntarily jobless especially in a social environment in dismay like the Swedish one.

Spoiler alert.

Tightening monetary policy won’t produce the effect on inflation you seek to achieve since money is endogenous, the quantity of reserves is determined by the private sector, not by the Central Bank.

The only thing a Central Bank can do is to set the interest rate target and always accommodate for the demand of reserves of private banks, whatever this is.

The current inflation is once again generated by several disruptions in the supply chain. The damages that Covid-19 brought to production of consumption goods are still there and companies still must recover for previous profits loss.

Not to mention the Nato-Russia that dropped another heavy weight on the supply chain, especially for food, energy, and food production goods.

Companies cannot afford to lose profitability for a long time so they will keep their price markups high, hence prices will stay higher for longer than expected.

Monetary policy can do very little to slow down aggregate demand and force companies to decrease prices since spending for food and energy is not sensitive to the interest rate. What is very sensitive to the interest rate is the cost of doing business, so the more rates go up the more companies will be forced to increase prices to remain profitable.

By the way, we still need to see some piece of empirical evidence showing a negative correlation between interest rates and inflation, maybe you can publish something so we can all learn something new.

The thing that is most worrying and that you seem to ignore is the effect of higher interest rates on treasury bonds. We have already seen how devastating was the monetary-consensus policies implemented by Volcker in the 80s for the banking system (especially thrift).

Again, it seems to me that you are basing your decisions on Neo-classical macroeconomics models (i.e. mainstream) which by definition, ignore the existence of banks, debt and money.

Meanwhile, in the real world, rising interest rates on government bonds can cause banks to go insolvent. Silicon Valley Bank is a recent example, but the underlying problem is shared by all financial institutions, because government bonds are a major component of their assets. When interest rates rise, bond values fall, and this can drive financial institutions into insolvency, where their Liabilities exceed their Assets (again see what happened in USA in the 80s).

Not to mention that treasury bonds are often posted as collateral in case of overnight loan at the Central Bank during the crucial process of inter-bank settlement. So, the domestic payment system is also at stake here, which correct functioning is “only” the main goal of any Central Bank.

Now, it is true that banks hedge their interest rate risks and they don’t instantly “mark to market”. But the underlying systemic factors remain. Its arguable too that, though an individual bank can hedge its risk, the banking system, as a whole, can’t; and while the whole system can delay a day of reckoning with falling asset values, it can’t avoid that day while interest rates remain well above those paid by the bonds they own.

What can you do then?

Keep the interest rates low so that the stability private non-financial sector and the solvency of the financial sector is guaranteed.

Then talk to your boss, the Government, and remind him that monetary policy is not the best choice to fight inflation. Fiscal policy, through targeted deficit spending, is the key to restore the supply chain and build-back better so we are all geared when the next disruption looms.