When Does an Interest Rate Path 'Look Good'? Criteria for an Appropriate Future Interest Rate Path – A Practician’s Approach

When professor Lars E. O. Svensson (Princeton University) visited Norges Bank’s conference on monetary policy in 2004, he suggested we should “find an instrument-rate path such that projections of inflation and output gap ‘look good’. ” We took on the challenge of how to translate the theoretical framework into some concrete criteria when evaluating interest rate paths in practice. The criteria should be viewed as necessary conditions for regarding the interest rate path as one that provides a reasonable balance between developments in inflation and the real economy. <br><br>In other words, this paper discusses the grounds for the criteria we use when evaluating whether an interest rate path “looks good”. <br><br>We have drawn up six criteria for an appropriate interest rate path. The criteria are also presented in a box in Norges Banks Inflation Report 1/2005. Even though it has proved difficult to satisfy all the criteria at the same time, I think they can function as a normative guideline for an interest rate path that provides a reasonable balance between the objective of stabilising inflation and the objective of stabilising output. <br><br>This memo explains the grounds for the criteria. Although the criteria have already been presented in the March 2005 Inflation Report, they can to some extent be considered as work in progress. The criteria will probably evolve over time, as new insights and new considerations emerge about how monetary policy should be conducted. <br><br>Norges Bank operates a flexible inflation targeting regime, so that weight is given to both variability in inflation and variability in output and employment in interest rate setting. Flexible inflation targeting builds a bridge between the longterm objective of monetary policy, which is to keep inflation on target to provide an anchor for inflation expectations, and the more short-term objective of stability in the real economy. As monetary policy influences the economy with a lag, interest rate setting must be forward-looking. <br><br>According to modern macroeconomic theory, developments in output, employment, income and inflation are affected by current interest rates and expectations about future interest rates. To the extent that the central bank can influence these expectations, they play a key role in monetary policy. Expectations regarding the future path of the interest rate must be based on the assumption that monetary policy keeps inflation close to the target over time and contributes to stabilising developments in output and employment. Often several interest rate paths may produce these results, and it may be difficult to assess precisely which future interest rate path yields the preferred balance between the different considerations. Economic theory provides some guidelines, but they are not easy to apply in practice. <br><br>The following criteria may be useful in assessing whether a future interest rate path appears reasonable compared with the monetary policy objective:<br><br>Criteria for a “good” interest rate path:<br><br>1. If monetary policy is to anchor inflation expectations around the target, the interest rate must be set so that inflation moves towards the target. Inflation should be stabilised near the target within a reasonable time horizon, normally 1-3 years. For the same reason, inflation should also be moving towards the target well before the end of the three-year period. <br><br>2. Assuming that inflation expectations are anchored around the target, the inflation gap and the output gap should be in reasonable proportion to each other until they close. The inflation gap and the output gap should normally not be positive or negative at the same time further ahead. If both gaps are positive, for example, a path with a higher interest rate would be preferable, as it would bring inflation closer to the target and contribute to more stable output developments. <br><br>3. Interest rate developments, particularly in the next few months, should result in acceptable developments in inflation and output also under alternative, albeit not unrealistic, assumptions concerning the economic situation and the functioning of the economy. <br><br>4. The interest rate should normally be changed gradually so that we can assess the effects of interest rate changes and other new information about economic developments. <br><br>5. Interest rate setting must also be assessed in the light of developments in property prices and credit. Wide fluctuations in these variables may constitute a source of instability in demand and output in the somewhat longer run. <br><br>6. It may also be useful to cross-check by assessing interest rate setting in the light of some simple monetary policy rules. If the interest rate deviates systematically and substantially from simple rules, it should be possible to explain the reasons for this.