Øystein Olsen: The conduct of monetary policy
Introductory statement by Mr Øystein Olsen, Governor of Norges Bank (Central Bank of
Norway), at the hearing before the Standing Committee on Finance and Economic Affairs of
the Storting (Norwegian parliament), Oslo, 21 May 2013.
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Please note that the text below may differ from the actual presentation.
I would like to thank the Chairman of the Committee and thank you for this opportunity to
report on the conduct of monetary policy in connection with the Storting's deliberations on the
Government's Financial Markets Report. My statement here today is based on the Bank's
Annual Report, but also on the Executive Board's assessments for the period to the most
recent monetary policy meeting and new information.
When I was here last year, the key policy rate had been reduced by 0.25 percentage point to
1.5 percent in March. The key policy rate has since been kept unchanged. The key policy
rate is low because inflation is low and because external interest rates are at very low levels.
The year 2012 was characterised by weak growth among Norway's trading partners and
turbulence in financial markets. Uncertainty about global economic developments,
particularly in Europe, was high. Key rates in many countries were close to zero, and both
the European Central Bank (ECB) and the Federal Reserve announced that key rates would
be kept low for a long period.
Economic developments in many advanced economies remained weak into 2013. Global
growth is being driven by rapidly growing emerging economies. In the euro area, activity has
slowed in several of the largest economies, and there are prospects that the downturn may
persist for somewhat longer than previously envisaged. Unemployment is high and rising in a
number of countries. In Spain and Greece, unemployment now exceeds 25 percent, and
among young people, more than half are jobless. The economic situation is better in the US,
but growth is moderate. Oil prices have fallen somewhat in the course of spring, but are still
at a high level.
With key rates close to zero, several central banks have adopted unconventional measures
to stimulate growth and support inflation. Measures that change the composition and size of
a central bank's balance sheet differ from the usual monetary policy operations in that
instruments other than the key rate are deployed to influence market rates and economic
activity. The ECB and the central banks in the US, the UK and Japan have implemented
such balance sheet policies to directly influence long-term interest rates and thus funding
costs for enterprises and households. The Japanese central bank also introduced new
measures this spring. The central bank will double the monetary base by the end of 2014,
mainly by buying more Japanese government bonds, in order to boost inflation, reduce real
interest rates and promote economic growth.
The improvement in global financial markets reflected the measures implemented by the
ECB through 2012. Risk premiums in money and bond markets fell in autumn 2012, easing
access to funding for debt-laden European countries. The effect of the improvement in
financial markets has not so far fully fed through to credit conditions for the household and
business sector. In several southern European countries, banks are still facing difficult
funding conditions, keeping bank lending rates high and dampening growth in consumption
and investment. This is affecting small and medium-sized businesses in particular.
Although the improvement in money and bond markets also resulted in an improvement in
funding conditions for Norwegian banks, it had little effect on bank lending rates for
households and enterprises. In the course of spring, banks have raised lending rates for
households and enterprises as a result of expectations of higher capital requirements.
Growth in the Norwegian economy has remained solid for the past 18 months, supported by
higher activity in the petroleum sector and construction industry, favourable terms of trade
and high population growth. At the same time, some segments of the export industry are
feeling the impact of lower demand from Europe and a high domestic cost level.
Unemployment has remained low and there has been a moderate rise in household
consumption.
Household debt is high and is rising faster than incomes. At the same time, households are
saving more. Debt growth is being driven by a sustained rise in house prices. However, debt
and assets are unevenly distributed. This increases household vulnerability.
Inflation is low in Norway and has recently edged downed further. Underlying inflation is
estimated to be in the interval 1-11⁄2 percent. Low external price impulses and an
appreciation of the krone in recent years have held the rise in prices for imported goods at a
low level.
The analyses in the March 2013 Monetary Policy Report indicate that costs in
householdoriented industries have risen at slower pace than in the mainland economy as a whole in
recent years. This is partly due to relatively high productivity growth. At the same time, high
inward labour migration is providing a flexible supply of labour, which is curbing wage growth.
Wage growth in Norway is also being influenced by low wage growth in neighbouring
countries.
Trade-offs in monetary policy
Norges Bank's conduct of monetary policy is oriented towards low and stable inflation. The
operational target of monetary policy is annual consumer price inflation of close to
2.5 percent over time. At the same time, monetary policy shall contribute to stabilising
developments in output and employment.
Since the introduction of the inflation target in 2001, annual consumer price inflation has
averaged 1.8 percent, which is somewhat below, but close to, 2.5 percent. In Norges Bank's
assessment, consumer price developments since 2001 have been well within the flexibility
provided for under the monetary policy mandate.
The monetary policy response pattern can be summarised in three criteria for an appropriate
interest rate path. The first criterion states that the interest rate should be set with a view to
stabilising inflation at target or bringing it back to target after a deviation has occurred. The
specific time horizon for stabilising inflation at target will depend on the disturbances to which
the economy is exposed and their duration.
The second criterion states that the interest rate path should provide a reasonable balance
between the path for inflation and the path for overall capacity utilisation in the economy, i.e.
that the inflation targeting regime is flexible. Flexible inflation targeting builds a bridge
between the long-term objective of monetary policy, which is to provide an anchor for
expectations of low and stable inflation, and the objective of stability in the economy.
The third criterion states that monetary policy should be robust and should seek to mitigate
the risk of a build-up of financial imbalances. The criterion is an expression of the lack of a
complete understanding of how the economy functions or the shocks to which the economy
may be exposed. The consideration of robustness can therefore be interpreted as a form of
insurance against adverse outcomes. Norges Bank does not have independent objectives for
asset price inflation or debt growth. However, by mitigating the risk of financial imbalances,
we may also achieve more stable developments in inflation, output and employment over
time.
In the case of conflicting objectives, the choice of interest rate path will involve a trade-off
between different considerations.
If monetary policy only took into account the low level of inflation, the key policy rate would
be rapidly reduced and kept close to zero for a good while. Inflation might then pick up faster,
partly as a result of a weaker krone. In the light of the trade-off against other considerations,
however, the Bank does not want to accelerate the pace of inflation. The result would be a
pronounced impact on output and employment and increase the risk of a build-up of financial
imbalances. When weight is also given to robustness and to stabilising developments in the
real economy, the interest rate path will be higher.
As a result of ample cross-border labour flows, changes in competitive conditions and new
trade patterns, consumer price inflation has now been below 2.5 percent for a period. Prices
for domestically produced goods have risen considerably more than consumer prices,
reflecting the improvement in Norway's terms of trade. Incomes, output and employment are
growing at a solid pace and capacity utilisation is estimated to be above a normal level.
Household debt and house prices have increased more than incomes. In today's situation, it
is appropriate to use a few years to bring up inflation. The interest rate has therefore not
been reduced further.
A higher key policy rate could have curbed debt growth and demand pressures in the
Norwegian economy. But in view of persistently low external interest rates, such a policy
would likely have resulted in a sharp appreciation of the Norwegian krone, and inflation and
activity in the Norwegian economy would have fallen to too low a level. The weak external
environment is thereby also contributing to keeping Norwegian interest rates low.
With firmly anchored inflation expectations, Norges Bank can today give weight to stabilising
economic developments when setting the interest rate. Inflation targeting has become more
flexible. We have chosen to take a long-term approach to bringing inflation back up. But we
will not lose sight of the inflation target. Should the outlook for inflation or growth weaken
considerably, there will still be room for manoeuvre to counteract such developments through
monetary policy.
Monetary policy in the light of new banking sector regulation
The financial crisis taught us some important lessons. First, the crisis illustrated that low and
stable inflation is not sufficient to ensure financial stability. Second, the crisis clearly revealed
shortcomings in the regulatory framework for banks. As a result, banking and financial
regulation is now undergoing change worldwide. Regulation and supervision are the
authorities' most important instruments to prevent financial instability.
In March, the Government presented a legislative proposal on new capital adequacy
requirements for banks. The proposal is in line with the EU's new regulatory framework. A
key element in the new framework is capital buffers that banks will be required to hold in
addition to the minimum requirement. This will increase banks' loss-absorbing capacity. A
countercyclical capital buffer will come on top as a capital requirement that can be increased
in good times and removed in bad times. The countercyclical buffer is to consist of Common
Equity Tier 1 capital and will normally be set between 0 and 2.5 percent of a bank's
riskweighted assets.
The countercyclical buffer is intended to counteract the procyclical effects of substantial
changes in credit and asset prices. The buffer will help contain the risk of deleveraging in bad
times. But an increase in the buffer can also dampen rapid credit growth in good times. The
effect will depend on banks' reaction when the buffer is increased.
Norges Bank will have primary responsibility for elaborating the basis for decisions on the
countercyclical capital buffer. In drawing up the basis, the Bank will collaborate and
exchange relevant information with Finanstilsynet (Financial Supervisory Authority of
Norway). The buffer will be set by the Ministry of Finance.
Once the regulation is in place, most likely in late summer, Norges Bank will issue concrete
advice to the Ministry of Finance on the level of the buffer. Thereafter, the Bank will issue
advice on the buffer four times a year. The criteria on which the Bank's advice is based were
presented in the March Monetary Policy Report.
Norges Bank will present analyses and issue advice on the size of the countercyclical capital
buffer in conjunction with the decision basis for monetary policy. The aim is to ensure that the
analytical basis is consistent with the formulation of monetary policy.
The objectives of the countercyclical capital buffer and the key policy rate are different. The
objective of the buffer is to strengthen banks' resilience to losses in an economic downturn,
while the objective of monetary policy is low and stable inflation over time. The inflation target
is weighed against the aim of smoothing fluctuations in output and employment.
The new instrument will be taken into account in monetary policy. Both the key policy rate
and the buffer work through banks' responses. The buffer will be set on the basis of an
assessment of the risk that financial imbalances may trigger or amplify an economic
downturn. Capital adequacy requirements, and their effect on bank lending rates, will be one
of many factors underlying the monetary policy analysis and interest rate setting.
The countercyclical capital buffer will strengthen the resilience of the banking sector during
an upturn. It may also, to some extent, counteract the build-up of financial imbalances. But
the effect on bank behaviour is uncertain. Thus, Norges Bank cannot disregard financial
imbalances when setting the key policy rate. The criteria for the conduct of monetary policy
remain firm also after the introduction of a countercyclical capital buffer.
When assessing the various considerations, monetary policy must pursue its primary
objective - low and stable inflation. We cannot overburden monetary policy. Other economic
objectives must be pursued using policy tools such as financial regulation, the tax system
and fiscal policy.
Thank you for your attention.