Svein Gjedrem: Monetary policy in Norway
Lecture by Svein Gjedrem, Governor of Norges Bank (Central Bank of Norway), at the Norwegian
School of Economics and Business Administration, Bergen, 17 October 2002.
The text below may differ slightly from the actual presentation. The references for the speech can be found on the
Norges Bank's website.
* * *
A year and a half ago, the Government and the Storting adopted new guidelines for economic policy in
Norway. The guidelines outline a medium-term strategy for the use of petroleum revenues over the
government budget. Government petroleum revenues are transferred to the Government Petroleum
Fund. The guidelines provide for the use of the expected real return on the Fund, i.e. 4 per cent of the
Fund's market value each year. As the Fund's market value grows, so does its return. A gradual
increase in the use of petroleum revenues ensures greater stability than a rapid withdrawal.
The Government laid down a new operational mandate for monetary policy at the same time. Norges
Bank shall set the key interest rate with a view to maintaining low and stable inflation. The inflation
target is set at 21⁄2 per cent.
The responsibility for implementing monetary policy is delegated to Norges Bank pursuant to the
Norges Bank Act and appurtenant regulation. Norges Bank sets the interest rate on the basis of our
understanding of the regulation. Our interpretation places emphasis on the Government's rationale
behind the regulation, on the objective as formulated in the first paragraph and on our knowledge
about the relationships between the interest rate, the krone exchange rate, output, employment and
inflation.
The first sentence in the monetary policy mandate refers to the value of the krone. Stability in the
internal value of the krone implies that inflation must be low and stable.
The regulation also states that monetary policy shall be aimed at stability in the external value of the
krone. The krone exchange rate fluctuates from day to day, from week to week, and from month to
month. We have free international trade and free capital movements. We do not have the instruments
for fine-tuning the exchange rate. But when monetary policy is oriented towards low and stable
inflation, this will contribute to a stable krone exchange rate over time.
The first paragraph of the mandate sets forth its intentions. The last paragraph specifies what Norges
Bank is required to do. The inflation target is set at 21⁄2 per cent. If we take steps to counteract an
appreciation of the krone when there are pressures in the economy, we reduce the possibility of
keeping inflation at bay and increase the risk of fluctuations in the economy. Maintaining stability in the
internal value of the krone must thus take precedence.
There are high costs associated with high inflation. It increases uncertainty about future income and
expenses among households and enterprises. This will result in unsound investments and wider
fluctuations in the economy. It is also important to avoid deflation, a fall in prices, because this often
accompanies and can amplify a downturn.
Low and stable inflation provides households and enterprises with a clear indication of changes in
relative prices. This makes it easier to make the right decisions and contributes to price stability in
financial and property markets. This is the best contribution monetary policy can make to economic
growth and stability.
A number of studies have looked at the effects of high inflation on the real economy, see for example
references in Qvigstad and Røisland (2000).
We have had four periods of very high inflation over the past 100 years: during the two world wars; the
Korean War and a 15-year period from the first half of the 1970s to the second half of the 1980s. In
Norway, very high inflation is a wartime phenomenon and a 1970s and 1980s phenomenon.
Substantial real economic losses and financial instability have followed in its wake. Inflation was a
costly affair.
The fourth period of high inflation was unlike the three previous periods. In the 1970s and 1980s,
inflation accelerated gradually. It was not as high as during the two world wars, but it took a long time
for the level to fall.
The fixed exchange rate system of the post-war period, the Bretton Woods system, broke down in
1971. The Yom Kippur War followed two years later, with the OPEC countries' oil embargo and the
first oil crisis. The sharp increase in oil prices led to a recession in Western economies. At the same
time, inflation took root in many countries.
In Norway, the welfare state was rapidly developed and transfers to the business sector increased
considerably, partly because we were expecting substantial oil revenues in the future. Economic policy
sought to build a bridge over what was expected to be a temporary downturn in the global economy.
This resulted in a contest for economic resources between the business sector and the public sector
and between the internationally exposed and the sheltered sectors.
In the 1970s and 1980s, there were wide fluctuations in the Norwegian economy, with high and
variable inflation. This also resulted in wide swings in output and employment.
The absence of a nominal anchor was one of the main reasons behind the pronounced swings. With a
policy of low interest rates and devaluations, inflation took root. Nominal interest rates were kept at a
low level even though inflation and the value of tax-deductible interest rose. Frequent devaluations
from 1976 were not able to prevent a decline in manufacturing. On the contrary, they proved to be
selfreinforcing. The wide fluctuations culminated in a credit boom in the mid-1980s, followed by a deep
recession and high unemployment towards the end of the 1980s.
History shows that low unemployment cannot be achieved through high inflation. A monetary policy
that fuels inflation does not promote economic growth. On the contrary, it paves the way for recession
and unemployment. Furthermore, without a nominal anchor, employment and output will not move on
a stable path. The economy must have a nominal anchor. This is the task of monetary policy. The
Norwegian economy was without a nominal anchor under the policy of low interest rates and
devaluations in the 1970s and 1980s.
The fixed exchange rate regime, which was introduced in 1986, reinstated monetary policy as an
instrument of economic policy in Norway and laid the foundation for more stable economic
developments. With the free flow of capital, deep capital markets and the phasing in of petroleum
revenues into the Norwegian economy, inflation targeting is the appropriate regime for setting interest
rates.
The most important monetary policy instrument today is the interest rate on banks' deposits with
Norges Bank. The banks can also borrow from Norges Bank. Since the banks combined have net
deposits in Norges Bank, the interest rate on banks' deposits with Norges Bank is the banks' marginal
deposit rate. The rate forms a floor of the corridor for short-term money market rates and influences
bank rates. The interest rate on banks' deposits with Norges Bank is thus Norges Bank's key rate.
Norges Bank's system for managing interest rates is described in Kran and Øvre (2001).
Let us make a stylised review of what happens if the central bank raises the key interest rate. Higher
interest rates make it more attractive to take krone positions and borrow in foreign currency. As a
result, higher interest rates normally lead to an appreciation of the krone. This reduces prices for
imported goods. We call this the exchange rate channel.
Interest rates also influence inflation indirectly via domestic demand. When interest rates rise, it is
more profitable to save and more costly to borrow. This has a dampening impact on consumption and
investment. Lower demand in turn curbs the rise in prices and wages. In addition, a strong krone
reduces activity, profitability and the capacity to pay in the internationally exposed sector. This is what
we call the demand channel.
In addition, changes in inflation expectations influence price and wage inflation. Inflation expectations
are, for example, important for wage negotiations. Enterprises do not want to change prices too often.
Hence, they take inflation expectations into account when they set prices. Interest rate changes may
influence expectations and thereby inflation itself. This is the expectations channel. Monetary policy
channels are further described in Svensson (2002).
It is important to be aware of the relationships between employment, output and inflation. If there is a
shortage of labour and other economic resources, a tight monetary policy stance will reduce inflation
by affecting aggregate demand. Conversely, when unemployment is high, low interest rates stimulate
demand, which will contribute to stable wages and prices. A monetary policy stance that is aimed at
stabilising inflation will thus also contribute to stabilising aggregate output and employment.
The impact of monetary policy occurs with considerable and variable lags. Our analyses indicate that a
substantial share of the effects of an interest rate change will occur within two years. Two years is thus
a reasonable time horizon for achieving the inflation target.
It is nevertheless conceivable that in a situation with a high rate of inflation and weak economic
developments, Norges Bank may decide to apply a somewhat longer time horizon than two years to
reach the target of 21⁄2 per cent. Nor do we need to be in any hurry to raise the level of inflation in a
situation where inflation is very low, while economic activity is high. By influencing inflation over time,
monetary policy will not in itself cause unnecessary disturbances to the economy.
A precondition for applying a longer time horizon is that financial market participants have strong
confidence in low and stable inflation over time, and that wage formation has a nominal anchor.
Frequent and marked interest rate changes can keep inflation under tight control, but will lead to wide
variations in output and employment. This can be called a strict inflation target. Theoretically, we could
also have chosen to stabilise output without taking into account variability in inflation. This can be
called a strict output target. In Norway, as in a many other countries, we have chosen an intermediate
solution. Interest rates are changed more gradually with less impact on output than under a strict
inflation target, and inflation is allowed to deviate from the target over a somewhat longer period. This
is called flexible inflation targeting. (See for example Svensson (2000).)
Flexible inflation targeting both provides the economy with a nominal anchor and contributes to
smoothing fluctuations in output and employment.
In the countries that normally figure in our comparisons, the responsibility for monetary policy has now
been delegated to a central bank. The first and most widely known examples of independent central
banks are the Bundesbank and the Federal Reserve. The delegation of monetary policy decisions to
an independent central bank also finds support in economic theory. It contributes to securing
credibility, confidence and consistency because an independent central bank must adhere to its
mandate. This increases the scope for monetary policy to contribute to stability. For a discussion of
central bank independence, see Hylland (2000).
The benefits of autonomy are related to the way in which it induces economic agents to look ahead
when making decisions. They take into account economic policy as they expect it will be tomorrow and
the day after. It is thus important that the authorities do not sow doubt, but on the contrary act in a
predictable manner within a long-term framework. The authorities must be credible and inspire
confidence. There must be consistency between the stated objectives of economic policy and what is
actually done to achieve them. This is the most important reason why the implementation of monetary
policy has been delegated to central banks. In Norway, the responsibility for interest rate decisions
was delegated to Norges Bank in 1986.
The differential between Norwegian and German implied forward rates 10 years ahead provides an
indication of how successful we have been in creating confidence that we will attain the inflation target.
Implied forward rates are calculated using the yield curve and can be interpreted as the expected
three-month rate ten years ahead.
The forward rate differential can be interpreted as the expected inflation differential in the long term
plus a risk premium. In the euro area, the objective is to keep inflation below 2 per cent. If we assume
that this gives an average inflation rate of 11⁄2 per cent, the inflation differential against Norway will be
about 1 percentage point. This means that an investor that is seeking the same real return must have
a one percentage point higher interest rate in Norway than in Germany. After the introduction of the
inflation target, the differential between German and Norwegian forward rates remained at about
1 percentage point for a long period. The differential has recently narrowed to about 0.8 percentage
point. This indicates that there is confidence that we will attain the inflation target.
Monetary policy shall contribute to smoothing fluctuations in the economy that are due to changes in
demand. At the same time, the fiscal guidelines state that "(in fiscal policy) considerable emphasis
must continue to be placed on stabilising fluctuations in the economy with a view to ensuring
appropriate capacity utilisation and low unemployment". We see here that there is an overlap between
the tasks that monetary policy and fiscal policy are intended to perform. This naturally raises the issue
of whether there is still a need to coordinate fiscal and monetary policy decisions.
A precondition for effective interaction is that decision-making bodies recognise how their decisions
will affect decisions of the other body. In the absence of such recognition, a decision will not produce
the intended result. The economy may move in a highly unfavourable direction, with high interest
rates, sluggish economic growth and a deterioration in the state's financial position. A situation may,
for example, arise in which Norges Bank tightens monetary policy to achieve the inflation target, while
at the same time the central government authorities increase the use of petroleum revenues (more
than implied in the fiscal policy guideline) in order to increase employment and reduce
unemployment.1
However, even without continuous coordination, a fairly good result may nevertheless be achieved if
fiscal policy acts as "leader" and monetary policy as "follower", to use expressions from game theory.2
The authorities conduct fiscal policy knowing how monetary policy will react. Today's flexible inflation
targeting regime establishes a firm framework for monetary policy and provides clear guidelines on
how monetary policy is to respond in different situations. The fiscal policy authorities can thus
internalise the monetary policy response pattern. This is only natural, since the mandate for monetary
policy was laid down by the Government and the Storting.
In other words, the proper framework is in place for delegating interest rate decisions, but the central
bank's response pattern must be known, so that the fiscal authorities can take this into account. Game
situations that may arise with an independent central bank with an inflation target are further discussed
in Leitemo (2000) and in Steigum (2000).
Norges Bank analyses the inflation outlook three times a year in its Inflation Report. The Executive
Board discusses the economic outlook at a separate meeting three weeks before the Inflation Report
is presented. The following day, the Executive Board summarises its discussions and assesses the
consequences for monetary policy for the next four months. This assessment constitutes an important
internal reference when the Executive Board later makes a decision regarding the interest rate. It will
also provide the basis for our external communication through speeches and the media.
The key rate is assessed by the Executive Board every sixth week. Monetary policy decisions are
announced in a press release followed by a press conference.
As an example, allow me to present the background for the monetary policy decision in June, when
the key rate was raised from 6.5 per cent to 7 per cent.
Developments in international financial markets were uncertain at that time, as they are today. We
assumed that activity among our trading partners would show only a gradual recovery. Oil prices were
high, also measured in NOK.
Private consumption had shown a substantial rise as a result of strong income growth. Households
expected strong income growth and borrowed heavily. Housing investment was high and financial
investment was low. House prices were rising. Public expenditure was growing as a percentage of
GDP. It was also expected that the level of petroleum investment would be high. Against this
background, pressures on real economic resources were deemed to be strong.
Wage growth was markedly higher than projected earlier. The outcome of the various settlements
pointed to wage growth of 51⁄2-6 per cent this year. The wage settlement awarded high pay increases
with effect from next year for some groups even though they will also be negotiating pay increases in
2003.
Developments in the krone exchange rate had the opposite effect. The krone had appreciated.
Expectations of higher interest rates as a result of developments in wage settlements probably
contributed to this.
Against this backdrop, consumer price inflation, with an unchanged key rate of 6.5 per cent and an
unchanged krone exchange rate from the average exchange rate for the second quarter, was
projected at 23⁄4 per cent from the summer of 2004.
Projections showed that price inflation could be lower than 21⁄2 per cent in the short run. If we had tried
to reach the inflation target in the short term, i.e. strict inflation targeting, we would have lowered the
key rate. We know that would probably imply a weaker krone and higher inflation. A more pronounced
increase in interest rates than the increase we actually implemented would then probably have been
necessary in a year's time. This would have led to unnecessary fluctuations in output and
employment.
Nor did concerns about stabilising output and employment warrant an easing of monetary policy. Had
we placed greater emphasis on these variables, i.e. a strict output target, monetary policy should have
been tighter and the interest rate higher to prevent a borrowing and spending spree, resulting in wider
variations in the inflation.
On the basis of an overall assessment, the key rate was raised by 0.5 percentage point to 7 per cent
at the monetary policy meeting that same day.
At the same time, Norges Bank presented inflation projections based on an exchange rate equal to the
average for June and an interest rate of 7 per cent. Since early this summer, the krone has remained
in this range. Consumer price inflation was slightly higher than projected in June and July, but returned
to the level forecast in our path in August and September. The next Inflation Report will be presented
in connection with the Executive Board's monetary policy meeting on 30 October.
Thank you for your attention.