Chaos Theory in the Financial World: A New Trend in Central Banks’ Monetary Policies (Part I)

On the surface it seems simple enough. The Federal Open Market Committee (FOMC) of the Federal Reserve adjusts interest rates to manage both inflation and the economy. When inflation rises, the FOMC raises rates, which limits the money supply, raises the cost of credit and slows economic expansion to a manageable level. When inflation falls, the FOMC lowers interest rates, which (in theory, at least) floods the markets with money, lowers the cost of credit and encourages economic expansion beyond its current level. Central banks from Sweden to Australia follow this model, which has been standard practice for the past decade and more.

So if it’s that simple, why can’t central bankers agree amongst themselves? Why was it that, as recently as August, when the Bank of England’s Monetary Policy Committee held its scheduled meeting, seven members voted for no rate change, one voted for a hike and one voted for a cut?

The Taylor Model

The model generally used to determine the Federal funds rate was first proposed by John Taylor in 1992. This model utilizes a mathematical formula to balance inflation against the optimal rate of economic growth for each nation, with the sum of that equation indicating the proper interest rate necessary to achieve that balance. Because the rates of inflation and growth change over time, the interest rate must change in harmony to accomplish its goals.

However, according to a new school of thought, the Taylor model might be causing the very problems it’s attempting to correct.

One variable the Taylor model seems to miss is outside or unexpected shocks to the economy. Granted that any model flies out the window when the entire financial framework is rocking—you just grab whatever’s closest and hang on. But surely we can do better than ignore the pressures leaning on the markets and causing those shocks?

Of Fractals and Finance

Dr. Charles Ivie, a retired NASA analyst with a keen interest in the mathematics of chaos theory, verbally rubbed his chin when asked that question.

“The trajectory of a rocket is determined by Newton’s laws and by celestial mechanics and is completely deterministic,” he wrote in an email exchange. “Market behavior is more like that of an infinitely branching tree. …The actions of the individual players are multidimensionally recursive. By this I mean that individual investors react to a multitude of events and data elements to make their decisions. And these decisions are not always based on objective reality.”

He’s a rocket scientist; he should know.

Perhaps it’s no coincidence that, since the concepts of fractals and chaos theory have gone mainstream, central bankers have started to wonder if the Heisenberg uncertainty principle might not apply to national-level interest rates. If the very act of observing a phenomenon alters it, do we really know enough to jump in?

“In the case of economics,” Dr. Ivie wrote, “investors don’t just observe, they participate so the alteration of the process is compounded. It is this fact that suggests that economic behavior is mathematically chaotic.”

The new school of thought among central bankers, as suggested by an analyst at Danske Bank, could be called the non-activist school. More concerned with structural-level determinants, such as the switch from hydrocarbons to wind or solar energy and the effect that change will have on their nation’s financial foundation, this non-activist school has less time for short-term variables such as the rate of inflation or economic growth. (Of course, it’s also true that much of the financial distress of the Great Depression was caused by the Federal Reserve’s inaction, meaning they’re damned if they do and damned if they don’t.)

According to this school of thought, the current trembling in our global financial system has its roots in loose monetary policy during and after the 2001 recession. It can be argued that lowering interest rates now not only may not help the situation, it also carries the potential to make it much worse. If the global marketplace is not understood well enough to be quantified—if such an action is even possible—then the more the system is tampered with, the more likely it is that an unknown variable will kick in, resulting in unintended and unwanted complications or an even bigger shock to the system. And the biggest variable of all, human nature and the power of emotions, is harder to calculate than the path of the rockets we sent to the moon.

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