Svein Gjedrem: Norwegian monetary policy
Speech by Mr Svein Gjedrem, Governor of the Norges Bank, held in Copenhagen on
17 November 2000.
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Introduction
I am happy to have this opportunity to speak to you here in Copenhagen about trends in the Norwegian
economy and about Norwegian monetary policy.
Norway's choice of monetary policy regime is closely linked to the structure of the Norwegian
economy. Norway is a welfare society with a large public sector, a high level of transfers to
households and enterprises and high direct and indirect taxes. Our economy is also characterised by
the great significance of petroleum activities. We have a growing aquaculture industry, and our
manufacturing is also partly resource-based. The engineering industry - which is substantial - is partly
based on petroleum activities. The exposed sector of the mainland economy has been fragile and
vulnerable. A key concern in economic policy since the 1970s has been to avoid undermining the
exposed sector too much, in view of our desire to avoid becoming too dependent on petroleum
revenues. In this address I will discuss the relationship between the special structure of the Norwegian
economy and Norwegian monetary policy. I will attempt to shed some light on certain differences
between the Norwegian and Danish economies, and how these differences have influenced the
formulation of monetary policy.
Background
Oil production started in the early 1970s and has gradually increased. Forecasts show that production
will peak in 2002, and thereafter decrease gradually. Gas production is expected to continue to
increase in the years ahead, and will account for a growing proportion of total petroleum production.
The long-term forecasts for oil and gas extraction are highly uncertain, and future price movements for
oil, market opportunities for gas and production and extraction costs in the petroleum sector are
shrouded in uncertainty.
The revenues from the petroleum sector are of great significance to the Norwegian economy as a
whole, and to the public sector in particular. In the 1990s, the export value of oil accounted for
roughly one third of total exports excluding ships and oil rigs.
Government revenues from petroleum activities are currently extremely high, due to high oil prices
coupled with high production volumes. Current projections indicate that petroleum revenues will peak
in 2002, and thereafter decline in pace with the production volume and lower oil prices.
Government revenues from petroleum activities have contributed to substantial government budget
surpluses in recent years. As can be seen from the chart, considerable surpluses are also expected in
the next few years. The amount of petroleum revenues used to finance public expenditure varies from
one year to the next. A large portion of the revenues is saved, and is invested in foreign equities and
bonds through the Government Petroleum Fund.
Long-term fiscal policy challenges - the role of the Government Petroleum Fund
Nevertheless, the Norwegian economy is facing considerable challenges as a result of an ageing
population and a marked rise in pension expenses and in the cost of nursing and care services.
The number of old-age and disability pensioners is estimated to rise by 50% by 2030, and central
government expenditure on old-age and disability pensions is expected to increase from approximately
7% of GDP in 2000 to 15% in 30 years' time.
In order to meet these long-term fiscal policy challenges, it is appropriate for resources to be put aside
in times of high petroleum revenues. The larger the Petroleum Fund, the less dependent we will be on
petroleum revenues in the future.
The Norwegian Ministry of Finance assesses the long-term outlook for public expenditure using
generational accounts.1 Such accounts can be used to assess whether the tax burden will need to be
increased in the future to meet the government's long-term social security obligations and to maintain
public services and amenities.
The calculations presented by the Ministry of Finance2 indicate that the generational accounts are
more or less balanced. The ministry emphasises the uncertainty shrouding this type of long-term
assessment of fiscal policy.
Fluctuations in the oil price and petroleum earnings also create challenges for economy policy in the
short and medium term.
Let us suppose that the oil price temporarily increased by USD 1 per barrel. This is a small change,
well within normal variations from one year to the next. Government revenues - and thus the budget
surplus - would increase by almost 1% of Norway's annual GDP. If the increase in petroleum
revenues is used in Norway, it corresponds to almost half of the annual growth in the non-oil economy
in a normal year. If the private sector of the economy is also expanding, and the economy is already
close to capacity, this policy would swiftly lead to strong pressures on the resources in the economy.
This would result in a rise in wages and prices, and would also lead to unstable conditions in the
foreign exchange market.
The Government Petroleum Fund shall serve as a buffer against short-term fluctuations in oil
revenues. As large portions of the revenues from oil activities accrue to the state, fluctuations in oil
prices and oil revenues will primarily result in changes in allocations to the Petroleum Fund. Since all
of the capital in the Petroleum Fund is invested abroad, such changes will in principle not influence
the level of activity in the economy. This makes the Norwegian economy more robust to fluctuations
in oil prices and thus less dependent on oil, even in the short run.
Some of the petroleum revenues are therefore used to finance central government budget expenditure.
The portion used by oil companies in Norway, partly to finance investment, also has an effect on the
mainland economy.
We can say that oil revenues enter the Norwegian economy through an external and an internal
circular flow. The distinction between the external and internal circular flow is important for exchange
rate stability. This means, among other things, that short-term changes in oil prices shall not influence
the orientation of economic policy. If the distinction between the two circular flows were to break
down, and the use of oil revenues were to fluctuate more in step with oil prices, we would have an
unstable economy, and hence an unstable exchange rate.
The Government Petroleum Fund thus has two objectives. It serves as a buffer for the mainland
economy against fluctuations in oil revenues, and it manages a considerable portion of the
government's financial wealth.
In addition to capital outflow from the Petroleum Fund, in recent years there have also been
considerable capital outflows from various non-oil sectors. As in other Nordic countries, large asset
managers such as life insurance companies and securities funds accumulated substantial holdings of
foreign equities and bonds in the latter half of the 1990s. These portfolio investments abroad reflect a
desire to diversify risk. The substantial net outflow of long-term capital from the private sector may
partly reflect a thin Norwegian capital market. The Norwegian bond market is not very developed and
the total value of equities in the Norwegian market in relation to GDP is very low.
Norwegian monetary policy
In the long term, a country's exchange rate tends to move in line with developments in domestic price
and cost inflation compared with other countries. If the level of prices in one country rises at a faster
pace, that country's currency will tend to depreciate to the same extent over time. Empirical evidence
for these effects has been found for a number of countries, although the effects are relatively weak in
the short term. However, substantial medium-term convergence in purchasing power parity has also
been found between Norway and its trading partners.3 This means that higher inflation in Norway than
in our trading partners has been followed by depreciation of the nominal exchange rate. This is
reflected in the fact that the real krone exchange rate has been relatively stable over time.
Movements in the krone exchange rate against the German mark over the past 30 years may serve to
illustrate this. In the 1970s and 1980s interest rates were kept low, and they were politically
determined. Price and cost inflation was generally higher than that of Norway's trading partners.
Frequent devaluations were used to redress the negative effects of high price and wage inflation on
competitiveness. The average rate of increase in prices between 1973 and 1987 was almost 10%
twice as high as the level in Germany. The value of the Norwegian krone against the Deutsche mark
was nearly halved between 1973 and 1987. We paid about 2 kroner for 1 mark in 1973 and close to
4 kroner in 1987. Since 1987, the krone exchange rate against the Deutsche mark has remained more
or less unchanged. During this period, price inflation in Norway has been no higher than that in
Germany.
We cannot be sure how fast the inflation differential between Norway and other countries will
translate into changes in nominal exchange rates in the future. Nevertheless, we must expect that any
differences in the rate of inflation may be a key cause of changes in the nominal krone exchange rate
over time.
The Norwegian monetary authorities abandoned the devaluation approach in 1986. From 1986 to 1992
Norway had a fixed exchange rate with a defined central rate and fluctuation margins. This system was
abandoned in 1992 following extensive speculation against the krone in connection with the
turbulence in European exchange markets. After the krone was allowed to float on 10 December 1992,
the guidelines for monetary policy were also revised. Monetary policy was still oriented towards the
objective of krone exchange rate stability, but no specific central rate with fluctuation margins was
stipulated.
The krone depreciated slightly in 1992, but thereafter it remained relatively stable. Looking back at
developments in the Norwegian foreign exchange market in the 1990s, no significant change really
appears to have occurred in 1992.
However, there was a marked shift in January 1997. From that time, daily and monthly variations in
the krone exchange rate show that the krone is floating. Our analyses suggest that oil price fluctuations
are just one of several contributory factors behind the variation in the krone exchange rate in recent
years.4 In the short term the krone exchange rate is also affected by uncertainty in the global economy
and turbulence in international financial markets.
The Exchange Rate Regulation - which is the mandate assigned to Norges Bank by the political
authorities - states that monetary policy shall be aimed at maintaining a stable krone exchange rate
against European currencies. Since 1 January 1999, Norges Bank has defined European currencies as
the euro.
The Exchange Rate Regulation takes into account that the krone exchange rate may remain outside its
normal range. In the event of significant changes in the exchange rate, Norges Bank shall orient
instruments with a view to returning the exchange rate over time to its initial range. The concept
"significant changes" is not quantified. The term must be given an economic content. Norges Bank
considers an exchange rate change to be significant if it influences expectations concerning price and
cost inflation to the extent that the change in the exchange rate may become self-reinforcing.
In its conduct of monetary policy, Norges Bank places emphasis on satisfying the fundamental
preconditions for exchange rate stability against the euro: instruments must be oriented with a view to
reducing price and cost inflation to the level aimed at by the European Central Bank (ECB). At the
same time, monetary policy must not in itself contribute to deflationary recessions, as this could
undermine confidence in the krone.
According to the Maastricht Treaty, the main objective of the ECB is the maintenance of price
stability. The ECB has defined price stability as inflation of less than 2%.
Inflation in Norway cannot remain higher than inflation in the euro area year after year without this
having consequences for the exchange rate of the Norwegian krone against the euro. If price and cost
inflation remains higher than the rate of increase aimed at by the ECB over a long period, our
experience indicates that the krone will depreciate against the euro sooner or later. Norges Bank must
therefore counter such a development.
There are institutional differences between the Norwegian monetary policy regime and monetary
policy in countries with an inflation target.
Norges Bank will inform the government authorities (via the Ministry of Finance) if measures other
than those available to the central bank are required in the event that the krone exchange rate cannot be
returned to its initial range without creating inflation or a deflationary recession. For instance, in the
UK the Bank of England reports to the Treasury if inflation deviates by more than 1 percentage point
from the inflation target of 21⁄2%. Other inflation targeting countries have chosen various other
reporting arrangements.
The Norwegian system allows economic policy as a whole to focus more strongly on movements in
exchange rates. The reason for this is the considerable emphasis placed on the consideration of healthy
growth in the exposed sector. This in turn reflects the risk of the Norwegian economy becoming too
dependent on oil. In the medium term, growth in the exposed sector is affected to a large degree by the
proportion of petroleum revenues included in the Norwegian economy via the government budget.
With large and to some extent varying budget revenues, the basis for determining central government
expenditure and taxes from one year to the next may easily be impaired. If budget expenditure is
allowed to fluctuate in step with oil prices, the result may be abrupt shifts and instability in the
Norwegian economy. Changes in oil prices may then quickly influence wage and price expectations,
the exchange rate and long-term rates. In that case it will be very demanding to achieve nominal
stability. Short-term interest rates will have to be adjusted frequently and sharply and will generally
reflect a high risk premium for the Norwegian krone. It is therefore important that the annual budgets
are anchored in a long-term strategy that takes into account that oil revenues can fluctuate from one
year to the next. It is an advantage if fiscal policy can also be used to counter fluctuations in demand
and production. In this way fiscal policy can contribute to ensuring stable operating parameters for the
exposed sector. When fiscal policy is given responsibility for stabilisation policy, the government and
the Storting have a firmer basis for their annual budget decisions. The political authorities also place
emphasis on the fact that by using the fiscal budget to stabilise economic growth, they are able to
dampen fluctuations in short-term interest rates. This is important because, for instance, dwellings are
to a large extent financed through short-rate loans, and many Norwegians have owner-occupied
dwellings.
It is the political authorities, ie the government and the Storting, which formulate the guidelines for
monetary policy in Norway. The Norges Bank Act also states that the King makes decisions regarding
the exchange rate arrangement for the krone. The Exchange Rate Regulation is based on this
provision. The actual conduct of monetary policy is the responsibility of Norges Bank. The Bank has
explained its interpretation of the Exchange Rate Regulation, and the Bank's Executive Board makes
decisions concerning the use of monetary policy instruments.
Executive and advisory authority is invested in Norges Bank's Executive Board, which consist of the
Central Bank Governor, the Deputy Central Bank Governor, and five external members appointed by
the government. As in Australia, it is thus a body consisting partly of external members which makes
decisions on interest rates. As in Australia and Canada, by law the political authorities have the right
to issue instructions to the central bank in matters of special importance. However, this right has never
been exercised.
The Norges Bank Act requires Norges Bank to inform the ministry when, in the opinion of the Bank,
there is a need for measures to be taken by others than the Bank in the field of monetary, credit or
foreign exchange policy.
For example, in a scenario with a sharp and prolonged fall in oil prices, the krone exchange rate may
remain outside the initial range for an extended period. If Norges Bank responds by raising interest
rates in order to force the krone back to its initial range, monetary policy could trigger a recession of a
type that will undermine confidence in the krone. Similarly, after an appreciation a situation may arise
in which interest rates must be set at such a low level to return the krone exchange rate to the initial
range that this results in higher inflation. The basis for exchange rate stability is weakened in both
cases. Hence, Norges Bank cannot with open eyes orient policy instruments in such a way that they
fuel inflation or lead to a deflationary recession.
If a situation arises where Norges Bank is not able to return the krone to its initial range without such
consequences, as already mentioned, the Bank will inform the government authorities that measures
other than those available to the Bank are required. This may involve recommendations concerning
fiscal measures that make it possible to return the krone exchange rate to its initial range and to
stabilise it. In the event of pronounced and prolonged shifts in the economy, fiscal policy and wage
determination must contribute to restoring balance in the economy. However, if fundamental and
permanent changes have taken place in the framework conditions for the Norwegian economy, it may
also be appropriate to consider a revision of the guidelines for monetary policy.
Monetary policy instruments
In theory, Norges Bank conducts its monetary policy through two main instruments: the interest rate
and exchange market interventions. However, in Norges Bank's experience, extensive and sustained
interventions to influence exchange rates have yielded poor results. Interventions can often lead to
game situations in which market operators regard the central bank's attempts to influence the
exchange rate as an interesting opportunity to make a profit. Events in autumn 1992, at the start of
1997 and in autumn 1998 show that exchange market interventions cannot stem the pressure on the
krone. This is why Norges Bank's primary instrument of monetary policy is the interest rate.
The interest rate is a powerful instrument for influencing cyclical trends, and thus inflation, in
Norway. Long-term fixed-rate financing is far less common in Norway than in Denmark, for instance
for financing dwellings. As a result, interest rate changes have a greater impact in the relatively short
term. However, the strong impact of the interest rate also places constraints on its use to underpin the
exchange rate.
The situation in Denmark, with its well-developed bond market, is somewhat different, since here the
short-term interest rate has rather less pronounced effects on the real economy and prices, and can
therefore be used to a greater extent to underpin the exchange rate. Consequently, a monetary policy
strategy in which interventions are used to influence the exchange rate will have greater credibility,
and the risk of ending up in game situations with the market is smaller than in Norway.
Norges Bank does not intend to act in a way that will prompt game situations. The bank may
nevertheless use interventions to a limited degree if the exchange rate moves significantly out of line
with what we consider to be reasonable on the basis of fundamentals or in the event of exceptional
short-term volatility in thin markets. In such circumstances, there is less risk of ending up in a game
situation against exchange market operators.
We have also experienced game situations in which one or more major operators were behind the
krone exchange rate fluctuations at the same time as they took speculative positions in the bond
market in the expectation that Norges Bank would raise its key interest rate to defend the krone. If we
focus too narrowly on the exchange rate when setting the interest rate, we are liable to end up in a
game situation. Speculators have little to gain from such game situations if Norges Bank adopts a
gradualist approach and avoids abrupt changes in interest rates.
In practice, the interest rate is therefore the only monetary policy instrument available in Norwegian
monetary policy. The interest rate can influence the exchange rate directly through the differential
between domestic and foreign interest rates, and indirectly through inflation expectations.
Higher interest rates normally make it more attractive to hold NOK-denominated assets. An increase
in the interest rate will result in an appreciation of the krone, and a lower interest rate will weaken the
krone. However, this relationship presupposes that the market is confident that monetary policy
provides the economy with a nominal anchor. In some situations, interest rate changes may have the
opposite effect. A higher interest rate can weaken the krone if it contributes to a deflationary recession,
and a lower interest rate can strengthen the krone if it contributes to preventing a deflationary
recession. The interest rate only has a predictable effect on the krone exchange rate when it affects
price inflation in the right direction.
The interest rate functions in different ways in our two economies. There are also other dissimilarities
between the functioning of our respective economies and between our institutional frameworks which
may shed some light on the differences between our monetary policy regimes:
• Denmark has a long history of a fixed exchange rate which inspires credibility;
• Denmark's membership of ERM II provides exchange rate policy with an institutional
anchor;
• Denmark has more stable terms of trade than Norway.
Moreover, there is strong and well-deserved confidence in the ability of fiscal policy to stabilise
economic growth in Denmark.
The most substantial changes in the Norwegian terms of trade are due to fluctuating oil prices.
Variations in Denmark's terms of trade are negligible.
In this sense the Norwegian economy has more in common with countries like New Zealand and
Australia, which are also large exporters of commodities. A substantial change in the terms of trade
translates into considerable changes in these countries' earnings and balance of payments. Over the
years this has resulted in sizeable exchange rate fluctuations.
The exchange rate is a buffer against changes in the terms of trade. While a country like Denmark has
maintained a stable exchange rate, commodity-producing countries typically experience fluctuations in
the exchange rate in tandem with changes in the terms of trade.
In New Zealand, Australia and many other countries monetary policy is oriented directly towards price
stability, and these countries permit short-term fluctuations in the exchange rate. This means that
monetary policy bears the primary responsibility for price stability, whereas fiscal policy is to a greater
extent oriented towards long-term stability in government finances.
In Norway, the Government Petroleum Fund acts as a buffer against fluctuations in petroleum
revenues. This makes the Norwegian economy more robust and in the short term less dependent on oil,
at least as long as the government budget is running a substantial surplus. The Government Petroleum
Fund is Norway's most important shock absorber against shifts in the terms of trade. This explains
why we have had far greater exchange rate stability than New Zealand or Australia.
For the past 15 years, cyclical trends in Norway have been desynchronised in relation to other
European countries. Because of the stagnation in the 1990s, inflation has been particularly low in
Europe in recent years. Norway, on the other hand, experienced a long period of economic expansion
in the 1990s. Since 1997, price inflation in Norway has been higher than in the euro area countries.
This is reflected in the higher level of interest rates in Norway compared with the euro area. Even if
instruments are oriented with a view to stability in the krone exchange rate against the euro, cyclical
differences will result in inflation differentials between Norway and euro area countries.
This year we have seen a tendency for the krone exchange rate against the euro to be strong at times.
This is due in part to the weakness of the euro, not least against the US dollar and the Japanese yen.
On the other hand, the effective krone exchange rate - the krone exchange rate measured against an
average of our trading partners' currencies - has not been particularly strong. If Norges Bank were to
respond to this situation by using the interest rate to attempt to fine-tune the krone exchange rate
against the euro in the short term, this would lead to higher price and cost inflation. This would lay the
foundation for subsequent instability in the krone exchange rate.
The orientation of monetary policy in the past year (and in the future)
Projections of future inflation and macroeconomic developments play an important part in the
orientation of monetary policy. Norges Bank's projections are published in quarterly Inflation Reports,
which provide an overview of recent price trends and factors influencing price and cost inflation.
These Inflation Reports contain a review of the outlook for the Norwegian economy, and the Bank's
projections of inflation with a two-year horizon. Norges Bank's assessments are summarised in a
leader in each report.
If the Bank's inflation projections, for a given interest rate scenario, do not approach the level of
inflation aimed at by the euro area countries at a two to three-year horizon, this will constitute grounds
for adjusting interest rates. This system has similarities with what Lars Svensson terms "inflation
forecast targeting".
In recent years we have attached importance to contributing to a transparent monetary policy. This is
in keeping with trends in many other countries. Transparency promotes predictability in the behaviour
of the central bank and helps diminish uncertainty for all participants in the economy. It is our hope
that in this way the Norwegian economy will be less exposed to doubt and speculation concerning the
setting of interest rates, with attendant greater stability in the formation of expectations and smoother
movements in long-term interest rates. We aim to create a pattern of continuity and consistency in the
implementation of monetary policy.
Developments in financial indicators do not indicate that there is great uncertainty in the markets
regarding developments in the internal and external value of the Norwegian krone. For instance,
developments in bond yields show that the risk premium has been relatively stable in recent years. The
pricing of the Norwegian krone in the options market indicates that substantial uncertainty with regard
to movements in the value of the krone against the euro is not factored into the price of options.
Norges Bank's Executive Board engages in a broad discussion of monetary policy every six weeks.
Any decisions concerning interest rate changes or other important changes in the use of monetary
policy instruments are normally taken at these meetings. Monetary policy decisions made by the
Executive Board (be they decisions to change key rates or to leave them unchanged) are announced in
press releases at 2 pm on the day of the meeting. Monetary policy decisions usually include a
statement of bias, ie the probability that the next change in interest rates will be an increase or a
reduction. At the same time as the press release, a press conference is held at which a more detailed
account of the background for the decision is given.
15 BIS Review 105/2000
On 20 September this year, Norges Bank decided to increase its key interest rate, the deposit rate, by
0.25 percentage point to 7%. This has brought the overall increase in interest rates this year to
1.5 percentage points. This has happened in a climate of interest rate rises in other countries and a
relatively weak effective krone exchange rate. Moreover, the past year has seen increased risk that
price and cost inflation may remain considerably higher in Norway than in other European countries.
Norges Bank had no choice but to counter this, in order to satisfy the fundamental preconditions for
exchange rate stability. This is why the Bank has raised its key rates.
I would like to conclude by once again thanking you for inviting me to give this account of the basis
for Norwegian monetary policy.
References:
Akram, Q F (2000): "PPP despite real shocks: An empirical analysis of the Norwegian real exchange
rate". Working paper 2000/7, Norges Bank, Oslo.
Auerbach, Alan J, Jagadesh Gokhale, Laurence J Kotlikoff and Erling Steigum Jr: "Generational
Accounting in Norway: Is Norway Overconsuming Its Petroleum Wealth?" Report No 75, Foundation
for Research in Economics and Business Administration, Bergen 1993.
Bernhardsen, Tom and Øistein Røisland (2000): "Factors affecting the krone exchange rate",
Economic Bulletin No 4 2000 (to be published).-{}-
Report to the Storting No 1 (2000-2001), National Budget for 2001.