Ida Wolden Bache: Monetary policy in the face of cost shocks
Speech by Ms Ida Wolden Bache, Governor of Norges Bank (Central Bank of Norway),
at the annual conference of LO Stat (Norwegian confederation of public sector trade
unions), Oslo, 23 November 2023.
* * *
Accompanying presentation to the speech
Good morning and thank you very much for inviting me to address this grand assembly
of trade union representatives and officials.
I can see from the conference programme that you have covered a wide range of
important and interesting issues over the past few days. I particularly noted the
programme item on climate change. Heat waves, floods and droughts are rising both in
number and scale, and it is becoming increasingly clear that the transition to a
lowemission world is urgently needed. This is also a topic of concern to us at Norges Bank.
The policy rate is not a suitable instrument for containing climate change. But climate
change and the necessary energy transition are influencing economic developments,
both in Norway and internationally. It is important for us to understand these effects if
we are to be able to make good forecasts and conduct a monetary policy that is
adapted to the economic outlook. And that brings me to the theme of my talk today.
Slide 1: The regulation on monetary policy
The picture shows the five members of Norges Bank's Monetary Policy and Financial
Stability Committee. We set the policy rate jointly following thorough deliberations.
The mandate assigned to us by the Government is formulated in the regulation on
monetary policy. The task of monetary policy is to ensure low and stable inflation. The
operational target is inflation of close to 2 percent over time. We are also mandated to
help keep employment as high as possible and to promote economic stability over time.
The fact that high and stable employment is a public good hardly requires further
justification - especially for an assembly such as this one. High unemployment entails
aggregate output losses and has substantial economic and health consequences for
individuals who cannot find work.
Perhaps not many people have given much thought to the benefits of low and stable
inflation - at least until a couple of years ago. After prices surged, the costs of high
inflation have become noticeable.
When prices rise rapidly and unexpectedly, it becomes difficult to plan - for businesses
and for individuals. High inflation makes it difficult to determine whether the price of a
good or service is reasonable. Uncertainty surrounding price developments may mean
that investments with a longer time horizon must give way to short-term investments.
Pay increases that look generous when agreed may after a few months be eaten up by
high inflation. Rapid and unexpected price increases particularly affect those with low
incomes and the smallest margins.
Slide 2: The policy rate is our instrument
Our monetary policy instrument is the policy rate. When the pandemic broke out in
spring 2020, we lowered the policy rate rapidly, and we kept it at a historically low level
until there were clear signs that economic conditions were normalising. An important
consideration for us was to prevent the pandemic-related rise in unemployment from
becoming entrenched.
In autumn 2021, we started raising the policy rate. At first, we did so gradually, but
when inflation accelerated last spring, it became clear that monetary policy was not
adapted to the situation in the Norwegian economy. Since then, we have raised the
policy rate sharply and rapidly in order to combat high inflation. Unemployment has
remained low - which is very good news. Nevertheless, we expect it to edge up
somewhat ahead.
Since we started raising the policy rate, the average residential mortgage rate has more
than doubled. For those with loans, higher interest expenses come on top of the fact
that prices have risen sharply for food, energy and most other goods and services.
Many are worried about their finances, and for some it is challenging to make ends
meet. We know there is a cost associated with higher interest rates, but the cost of not
tightening policy would have been greater.
The fast pace of tightening has sparked debate.
I welcome this opportunity to explain in greater detail why it has been appropriate to
raise the policy rate as much as we have done. I will also touch upon the importance of
wage determination in our endeavour to bring down inflation while keeping
unemployment at bay.
Slide 3: Inflation is too high
Inflation has receded since last autumn but is still high. Overall consumer price inflation
is now 4 percent. Excluding energy prices, which have fallen, inflation is around 6
percent. Prices for many goods and services have risen at a fast pace.
Higher interest rates contribute to curbing inflation, and if we tighten too little, prices
may continue to rise at a fast pace. This alone entails substantial costs, especially for
those who already have the least. The longer inflation remains high, the more
demanding it may prove to bring it down again.
But we are not solely focused on inflation. Higher interest rates lead to reduced
consumption and lower business investment, which dampens demand for goods and
services. This also curbs the demand for labour, and the number of jobless may then
rise. We do not want to tighten more than is necessary to combat inflation.
Inflation targeting is forward-looking and flexible. We are not seeking to bring down
inflation as fast as possible. That could have caused a sharp rise in unemployment,
which we want to avoid. The trade-offs we make are reflected in our forecasts.
Slide 4: We are not seeking to bring down inflation as fast as possible
Our policy rate forecast shows the policy rate path that we believe will provide the best
trade-off between inflation and employment.
Our projections in September indicated that inflation would recede and move down
towards target in the course of three to four years. The September projections did not
point to a sharp slowdown in the Norwegian economy, but we projected that
unemployment would edge up somewhat.
From a long-term perspective, there is no conflict between the objective of low and
stable inflation and high employment. In the long run, we cannot trade more jobs in
exchange for accepting a faster rise in prices. On the contrary, low and stable inflation
is a precondition for a well-functioning economy and for keeping as many people as
possible employed. How high employment will be over time is determined by factors
such as population composition, wage formation and labour market policy. The more
people who are included in the labour market and can offer their skills, the higher
employment can be over time. This is not something we want to thwart. Increased
inclusion will, in effect, reduce the need to tighten monetary policy when labour demand
is high.
Slide 5: High inflation was triggered by a cost shock originating from abroad
High inflation was triggered by a cost shock originating outside Norway's borders. The
coronavirus pandemic and Russia's invasion of Ukraine led to a surge in energy and
metal prices and freight rates. Norges Bank cannot influence prices abroad. But we can
contain the spillover effects on domestic prices.
Many domestic firms experienced higher costs when prices for metals and other
intermediate goods soared. With high demand for goods and services in the wake of
the pandemic, it became possible to pass on much of the cost increases to selling
prices. When many firms increase prices, it may also be easier for others to take
advantage and follow suit - also for firms that are not facing higher costs. Higher
interest rates contribute to curbing pressures in the economy, making it more difficult for
firms to raise prices.
By tightening policy, we also contribute to a stronger krone than would otherwise have
been the case. A stronger krone reduces prices for imported goods.
The inflationary impulses that triggered the surge in inflation are receding. Energy
prices have fallen. Global inflation is coming down. Global trade in goods is flowing as
normal, and freight rates have returned to pre-pandemic levels. This will gradually curb
inflation in Norway too. Nevertheless, we believe it will take time for inflation to return to
target.
Slide 6: Wage growth has accelerated
One reason for this is that labour costs have shown a marked rise. Wage growth this
year is set to be the highest in 15 years. Still, the pay increases are not large compared
with the rise in living costs many are facing. According to our September projections, it
appears that purchasing power will weaken this year too.
When we make projections for wage growth, we use various sources of information.
Our projections of wage growth are based on the Norwegian model of wage
determination and quantified economic relationships. In addition, our wage projections
are based on the responses we receive when we ask the social partners, among
others, what their wage growth expectations are for this year and next. These
expectations have proved to be fairly closely in line with actual wage growth.
As this assembly is well aware, the Norwegian wage determination process is
characterised by a high degree of coordination. Manufacturing negotiates first and
agrees on wage increases based on firms' ability to pay, which defines the wage norm
that serves as a reference for subsequent settlements.
The historical relationships show that firms' ability to pay is one important factor
explaining wage growth. Price expectations, as estimated by the Norwegian Technical
Calculation Committee for Wage Settlements, are also important. In addition, wage
growth is influenced by labour market tightness. When unemployment is low and
employers face skills shortages, wages tend to rise faster.
Coordinated wage determination, where the parties to wage settlements emphasise
high employment, reduces the risk of a wage-price spiral. As a result, we need to raise
the policy rate to a lesser extent than would otherwise have been necessary in the face
of the cost shock that has hit the Norwegian economy. The Norwegian wage
determination system thus makes it easier for us to succeed in reducing inflation
without many people losing their jobs. But wage determination alone cannot ensure that
inflation is reduced. That is a task for monetary policy.
Slide 7: We have a floating exchange rate
Norges Bank must react when inflation rises. If households and firms become
accustomed to the high level of inflation and it becomes embedded in their price and
wage-setting behaviour, inflation may become entrenched. If foreign exchange market
participants lose confidence that inflation will move down to target, the krone may
depreciate.
Despite the substantial increase in the policy rate in response to high inflation, the
krone has depreciated quite a bit over the past year. Part of the explanation is probably
that interest rates have risen more in many trading partner countries. In recent years,
the pandemic, war and high inflation led to heightened economic and political
uncertainty, and market volatility has increased. These factors have also likely
contributed to the krone depreciation. Even though the krone is influenced by a host of
factors, this does not mean that interest rate setting in Norway is not important. If we
had not raised the policy rate in response to higher inflation, the krone would probably
have been considerably weaker.
Norges Bank does not have a policy target for the krone exchange rate. We are
nevertheless concerned with the exchange rate as it has an influence on inflation. First,
a weaker krone will push up inflation because it increases the prices for imported
goods. In addition, a weaker krone may improve trade-exposed industries' ability to
pay.
With a floating exchange rate, we are not bound to maintain the same interest rate level
as our trading partners. The floating krone exchange rate has acted as a buffer against
downturns in the Norwegian economy. In periods when oil prices have fallen and the
economy turned down, the krone has depreciated and contributed to strengthening
competitiveness. With a fixed exchange rate, more of the adjustment would have had to
come via lower wages and prices. In that case, activity and employment could have
fallen more.
In today's situation, a weaker krone makes managing the monetary policy trade-offs
more demanding. Inflation is already high, and the depreciation of the krone is
contributing to keeping inflation elevated. At the same time, the economy is cooling
down.
Slide 8. Wide differences across industries
When setting the policy rate, we rely on extensive information and analyses prepared
by Norges Bank's staff economists. One important source of information is our regional
network of firms. Every year we talk to 1800 firms in different industries and parts of the
country about their respective situation and prospects. This gives us a good picture of
the state of the Norwegian economy.
After a period of high activity and little spare capacity, the network now reports weak
overall economic growth. At the same time, there are wide differences across
industries. While companies supplying goods and services to the petroleum industry are
enjoying strong growth, the construction industry is experiencing a decline in activity.
Few new homes are being built. In the secondary housing market, many homes have
not been sold, and house prices have fallen.
We cannot use the policy rate to fine-tune developments in individual sectors. At the
same time, we are attentive to industries that stand out. A sharp upswing or decline in
some industries may have substantial spillover effects or more lasting effects that may
change the economic outlook. This may then also have implications for the orientation
of monetary policy.
Slide 9: The policy rate is likely close to the level needed to tackle inflation
Monetary policy is now having a tightening effect on the economy, and we have not yet
seen the full effects of the past rate hikes. The Committee assesses that the policy rate
is likely close to the level needed to tackle inflation. At our monetary policy meeting in
November, we signalled that we will probably raise the policy rate in December, and we
believe there will likely be a need to maintain a tight stance for some time ahead.
There is substantial uncertainty surrounding economic developments. Over the past
couple of years, inflation has repeatedly been underestimated, and we have had to
revise up our policy rate forecasts. It is demanding to make economic forecasts -
particularly now that the economy has been exposed to major shocks, and because we
have little experience of the current high inflation.
I cannot therefore make any promises about the interest rate outlook. What I can
promise is that we will adapt monetary policy to the economic outlook. With effective
interaction between wage determination, fiscal policy and monetary policy, we are well
poised to return inflation to target while avoiding a severe economic downturn.