Svein Gjedrem: Inflation targeting - some theory with main focus on practice
Speech by Mr Svein Gjedrem, Governor of Norges Bank (Central Bank of Norway), given at the
Centre for Monetary Economics/Norwegian School of Management, Oslo, 8 June 2004.
The speech does not contain assessments of the economic situation or of current interest rate setting.
* * *
Norway has had an inflation target for monetary policy since March 2001. In my speech today, I will
attempt to explain why and how an inflation targeting regime was introduced.
In a number of countries, including Norway, short-term interest rates are now the lowest for
generations. Let us look back to the views on monetary policy in Norway the last time interest rates
were very low, in the postwar period up to the mid-1950s. As part of the measures taken in February
1955, Norges Bank increased the discount rate, which had remained unchanged since the war, from
2.5 per cent to 3.5 per cent. In his annual address, central bank governor Erik Brofoss discussed this
change:1
"In the longer run, the aim must be to bring interest rates down again. The outlook for achieving this is
promising. Saving is high and can be supplemented by foreign capital. This provides the basis for a
low interest rate if moderation is shown in relation to an expansionary urge."
In retrospect, we can safely say that the expansionary urge proved to be too strong. It took 50 years
before the interest rate returned to this level, which we now regard as abnormally low.
However, prevailing views on monetary policy at that time is probably of more interest. Brofoss said
the following:
"Increasing the discount rate will probably be widely regarded as the most important monetary policy
measure. The interest rate is, however, a controversial instrument, both in Norway and in other
countries. Nonetheless, an increasing number of countries use it. Whether the purported good results
can be ascribed solely to interest rate policy is another question. The effects in Norway may differ
somewhat from the effects in other countries. Countries with major currencies can influence short-term
capital movements via the interest rate. This is only possible to a limited extent in Norway. A
substantial share of business investment is self-financed and is not affected by the interest rate. The
same applies to shipowners that finance new ships built in other countries with their foreign exchange
earnings. As a cost factor, the interest rate will probably curb debt-financed investment. The question
is whether this will eliminate the lowest priority investments. In the long run, we are dependent on
long-term investment. Interest rate changes may therefore have adverse effects in Norway that do not
occur in other countries."
This stands in contrast to the current view, as expressed by Norges Bank's delegating authority, the
Ministry of Finance:2
"The new guidelines for economic policy also imply that monetary policy has been given a clear role in
stabilising economic developments. This means that the scope for manoeuvre in monetary policy
should be used if the outlook for the economy changes."
In the 1950s and 1960s, a strong belief evolved that the economy could be controlled and steered in
the desired direction. This optimistic view gradually lost favour in the face of developments. The way in
which economic policy is oriented today reflects the experience gained and the lessons learned in the
1970s and 1980s.3 Economic policy at that time was marked by coordination, control and regulation.
Important elements were:
•
fiscal policy oriented towards full employment
•
credit regulation within limits specified in a separate credit budget
•
channelling of loans through the state banks
•
regulation of capital movements
• low nominal interest rates stipulated by the government authorities
• a fixed, though adjustable, krone exchange rate
•
use of price regulation
•
an active business policy through state ownership and state grants and subsidies
The use of price regulation was particular to Norway. The following description is by Petter Jakob
Bjerve:4
"A characteristic of postwar Norwegian economic policy, compared with policies in other countries in
the west, is that prices have largely been directly set by the authorities, while wages and other income
have been determined by the market and by market organisations. With the high level of employment
that the government sought to achieve in the 1970s, inflation was probably lower with price regulation
than it would have been without it. Nonetheless, there was repeated evidence that freezing prices
without freezing wages could not prevent a fairly sharp rise in prices. In 1978-1979, we witnessed a
demonstration of the extent to which the rise in prices can be slowed, at least temporarily, when a
price freeze is combined with a wage freeze. But even this combination, which can only be temporary,
cannot in the long run prevent a sharp rise in prices if the gap between demand and supply is too wide
- as demonstrated by the rise in prices after 1980."
In Norway, the efforts to develop an economy under strong centralised coordination and control
culminated in the 1973 proposal to establish an incomes policy council.5 According to the proposal, the
social partners would undertake a commitment through the council to keep negotiated wage increases
within specific limits. It was also stipulated that demand management policy should be included as part
of incomes policy.
The proposal to establish an incomes policy council did not receive support. There was ultimately too
much control and coordination. Now, only 30 years later, virtually nothing of this system remains. The
structure was not solid enough. We know from experience that fiscal policy alone cannot ensure a high
level of employment. The structure of the labour market and wage formation are probably of greater
importance. The direct regulation of credit, interest rates and capital movements collapsed and was
phased out in the 1980s. The krone is floating. Price regulation no longer plays a role as a
macroeconomic instrument. The scope of business policy has become more general. State ownership
in the Norwegian business sector remains extensive, but ownership management has been
reorganised following the negative experience of companies in Kongsberg, Mo i Rana and
Syd-Varanger.
The economic policy of the 1970s and 1980s contributed to wide fluctuations in the Norwegian
economy. Economic developments were marked by high and variable inflation. Inflation rose gradually
and it took a long time before it fell. The absence of a nominal anchor was one of the main reasons
behind the pronounced swings in the Norwegian economy. 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 expenses rose. Frequent devaluations from 1976 were unable
in the long term to prevent a decline in the manufacturing sector. On the contrary, they proved to be
self-reinforcing. The wide fluctuations culminated in a credit boom in the mid-1980s. A pronounced
downturn and high unemployment followed at the end of the 1980s.
I would like to highlight three factors that have taken on particular importance for economic policy in
general, and monetary policy in particular.
- First, economic agents look to the future when they make decisions about consumption and
investments, wages and prices, and take account of not only current economic policy, but also their
expecations of future economic policy. This is particularly evident in foreign exchange and financial
markets, where exchange rates and interest rates are influenced when participants shift large amounts
partly on the basis of their expectations concerning economic policy and economic developments.
Financial market expectations concerning economic policy are entirely different today from what they
were 20-30 years ago. Behaviour can change from being very rational to herd behaviour. The issues
that receive attention, and that govern movements in exchange rates and interest rates, change. 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 the central bank in Norway, as has been the case in other comparable countries. In
Norway, the responsibility for interest rate decisions was delegated to Norges Bank through the 1985
Norges Bank Act and through the application of the Act in 1986.
Developments in economic theory have also had considerable influence in this context. Seminal
studies on economic policy guidelines were conducted by Finn Kydland and Edward Prescott at the
end of the 1970s.6 These studies are based on the assumption that economic agents do not make
systematic errors in their assessments of what the authorities are planning for the future. The insights
gained from these studies provide arguments in favour of ensuring the independence of the central
bank vis-à-vis the political authorities, and of defining binding monetary policy objectives. Former
governor of Norges Bank Hermod Skånland was particularly interested in this issue. Skånland stated
the following as early as 1979:7
"What the central bank can do, on the other hand, is to use its professional judgment to conduct a
policy for demand management, which is in line with the more long-term objectives and guiding
principles that have been drawn up by the political authorities. This presupposes, however, that the
central bank also has the possibility of objecting to requests from the same authorities when their
efforts to solve more short-term problems bring them into conflict with more long-term objectives."
- The other lesson drawn from the experience of the 1970s and 1980s was that it was not
possible to reduce unemployment in the medium and long term by merely accepting somwhat higher
inflation. Faced with the question of whether an increase in inflation from say 10 to 12 per cent was
acceptable if stimulating the economy could at the same time reduce unemployment from say 2 to 11⁄2
per cent, the decision-making authorities would most likely have been inclined to answer yes. But
experience showed that this was not an available option. An attempt to increase output beyond the
level that is consistent with stable inflation will over time lead to steadily rising inflation. Economic
agents will eventually incorporate higher inflation into their inflation expectations. In the long run, the
result will only be higher inflation, not higher employment. Output and employment will return to their
potential level.
- The third factor is the special challenges to stabilisation policy posed by petroleum revenues.
Norway's export revenues and government revenues can be expected to be very high as long as
production remains high and as long as the global market allows producing countries to extract
substantial economic rent. At the same time, we know from experience that revenues may vary
sharply from year to year. As a result of the high level of earnings and fluctuations in these revenues,
the most important contribution fiscal policy can make to stabilising the Norwegian economy is to
provide a sound, long-term strategy for the use of petroleum revenues. Attempts to use the central
government budget to fine-tune economic activity may have a destabilising effect if these attempts are
perceived as a breach in the long-term strategy for the phasing in of petroleum revenues. It is
necessary to show that fiscal policy is applied symmetrically in periods of economic expansion and
contraction.
From the mid-1980s, during and after the credit bubble, it was recognised that a substantial revision of
economic policy would be necessary and that the problems created by inflation had to be taken
seriously. The exchange rate was chosen as the nominal anchor. Deteriorating competitiveness due to
high wage growth would no longer be remedied by means of devaluations. Substantial emphasis was
placed on the importance of wage formation for developments in employment. Only when wage
growth dropped below the level of our trading partners did unemployment begin to fall and the
manufacturing sector began to pick up. Thus, the fixed exchange rate policy was not introduced in
order to strengthen the internationally exposed business sector in the short term. On the contrary, it
was a breach in the approach whereby monetary policy and "exchange rate policy" had been oriented
towards safeguarding these sectors. A fixed exchange rate was an intermediate target for achieving
low and stable inflation.
The alternative of inflation targeting was not developed in 1986, and adhering to the fixed exchange
rate regime was probably the best available option. The report from the publicly appointed Steigum
Commission, submitted in 1988, contains a very thorough discussion of the need for a credible
longterm policy, but also of the challenges involved in providing the economy with a nominal anchor after
such a long period of high inflation:8
"Such a consistent exchange rate policy can yield better results in the long run than a strategy that is
based on frequent devaluations or downward adjustments of the krone. This applies even if a
devaluation, in isolation, has a favourable short-term impact on the real economy. The disadvantage is
that devaluations tend to fuel expectations of further devaluations, which makes it difficult to break with
this form of policy. As a result, inflation will be higher than in other countries while neither employment
nor economic growth will be systematically higher. On the contrary, higher inflation will most likely
have considerable negative effects on the real economy, partly because this will amplify the adverse
effects of the tax regime.
However, there may be considerable real economic costs associated with the transition to a consistent
fixed exchange rate regime. It may take time for devaluation expectations to fade and for wage, price
and interest rate developments to adapt fully to the exchange rate regime. The less credible a fixed
exchange rate policy is at the outset, the longer it takes for devaluation expectations to fade, and the
greater the transitional costs will be in connection with a regime change to a consistent fixed exchange
rate policy."
This analysis shows that at the time there was a realistic understanding of the transitional costs
associated with bringing down inflation.
Inflation fell gradually, down to 2-3 per cent in 1991-1992. If inflation targeting had been an available
option in 1986, we might indeed have chosen to aim for just such a gradual fall in inflation.
Economic policy had to be anchored more firmly after 15 years of short-term fine-tuning. We had not
established a sufficiently clear institutional framework for a more discretionary monetary policy. We
could not then assume that a floating krone exchange rate regime and the exercise of our professional
judgment when setting interest rates would inspire confidence.
We had to abandon the fixed exchange rate policy in 1992. An important reason was the weakness
inherent in the fixed exchange rate regime in a world with free capital flows and deep financial
markets.9 When the fixed exchange rate policy was formally abolished, the Norwegian economy again
risked losing its nominal anchor. But the krone exchange rate showed little change to begin with and
rapidly found a new range.
Consumer price inflation in Norway
Percentage rise on previous year. 1987-2003
10 10
8 8
6 6
4 4
2 2
0 0
1987 1989 1991 1993 1995 1997 1999 2001 2003
SG CME 08.06..2004
2
Source: Statistics Norway
The exchange rate remained stable up to autumn 1996, partly because wage growth was low and
overall demand did not generate pressures in the economy. Gradually, the krone began to show wider
fluctuations. The experience of the last half of the 1990s demonstrated that monetary policy cannot
fine-tune the exchange rate. Developments in international financial markets led to more pronounced
fluctuations. And more fundamentally, exchange rate developments no longer provided signals to
wage formation and fiscal policy when labour market pressures mounted and incomes policy failed.
High petroleum revenues, fiscal slippage and expectations of increased use of petroleum revenues
contributed to this. Hence, the exchange rate was no longer appropriate as a nominal anchor.
Norges Bank therefore placed increasing emphasis on low and stable inflation. A formal inflation target
for monetary policy was introduced in the spring of 2001. The mandate for the conduct of monetary
policy is provided for in the Regulation on Monetary Policy, issued by the Ministry of Finance on
29 March 2001. The operational target of monetary policy as defined by the Government is inflation of
close to 2.5 per cent over time. The idea of an inflation target for monetary policy was not new. This
alternative for Norway was discussed in 1997 at the initiative of Norges Bank.10 Many countries had
already gained many years' experience in operating such a system. New Zealand was the first in line
towards the end of the 1980s. Canada followed shortly thereafter.
In New Zealand, the switch to inflation targeting was one component of a comprehensive public sector
reform aimed at addressing incentive problems associated with economic policy.
Canada, which is one of the industrial countries with the most experience of floating exchange rates,
had been seeking a nominal anchor for some time. Towards the end of the 1980s, the central bank's
communication increasingly emphasised price stability as a monetary policy objective. An inflation
target was officially introduced at the initiative of the finance ministry and in a joint statement issued by
the central bank and the finance ministry.11
Sweden introduced an inflation target in December 1992, inspired to some extent by the experience of
Canada and New Zealand. After the deep economic crisis at the beginning of the 1990s, reverting to a
fixed exchange rate policy was no longer deemed realistic. In this context, it must be added that the
central bank of Sweden, when it was seeking to motivate and firmly establish inflation targeting during
the 1990s, was able to draw on its own experience from the 1930s. Admittedly, Sweden did not have
an inflation target but a price target for monetary policy in the period 1931-1937. At that time, the
concept was inspired by the work of Knut Wicksell 30 years earlier. As early as in 1898, Wicksell
argued that price stability should be the central bank's objective.12
After the collapse of the ERM in 1992, a gradual shift towards today's system began in the UK, which
translated into Chancellor Gordon Brown's decision to transfer the authority to set interest rates from
the Chancellor to a monetary policy committee at the Bank of England in 1997.
Inflation targeting is now the norm in small and medium-sized open economies. Denmark is an
important exception. Since the mid-1980s, Denmark has conducted a very disciplined fiscal and wage
policy. Combined with ERM II membership, this has enabled Denmark to maintain a credible and
successful fixed exchange rate regime.
The new monetary policy system that has gained international support has essentially been developed
in concert by finance ministries and central banks, and through experience and practical application.
Inflation targeting is not a static system, but a system that is challenged by both reality and academia.
Subsequent economic literature has followed up where Knut Wicksell left off, and partly supports and
partly questions central bank policy.
More recent monetary policy theory is frequently based on a loss function, or a preference function,
which includes explicit targets for both inflation and output. Stabilising output is taken into account,
thus recognising that monetary policy has an impact on the real economy in the short to medium term.
It is the central bank's task to choose an interest rate path that strikes the best possible balance
between low and stable inflation and stable developments in the real economy over time.
Ragnar Frisch was pursuing a similar line of thinking. Frisch wanted to construct a quantitative form of
a preference function that could be applied in practical policy. Frisch delved into the matter. For
example, he devoted considerable time to interviewing politicians to identify the "true" welfare function.
His approach involved three phases. As to the first phase, Frisch stated:13
"...the econometrician uses his general knowledge of the political atmosphere in the country ... He will
then be able to form a temporary perception of the quantitative form of the preference function".
In the next phase, the preferences are identified by means of a system for interviewing politicians:
"This interview system must be designed so that the results, without the politicians necessarily having
to understand this, can draw certain conclusions as to the numerical nature of the preference
function."
In the third and last phase, the information derived from the interviews is combined with the data on
the structure of the economy and the formulated preference function.
"This will yield a solution in the form of an optimal path for economic and social development."
Professor Lars Svensson, one of the most prominent contemporary academics in the field of monetary
policy, expresses thoughts similar to those of Frisch. Svensson recommends the following:14
"...inflation targeting central banks should announce (an) explicit loss function with numerical weights
on output-gap stabilization... Simple voting procedures for forming the Monetary Policy Committee's
aggregate loss function... are suggested."
A practical approach, which is probably pursued by most central banks, is to produce projections for
the economy based on different, possible interest rate paths. Decision-makers can then strike a
balance between the various considerations and make decisions based on these projections.15
Both the formulation of a precise inflation target and the aim of striking a balance between the
objectives of stable output and inflation could invite a repeat of earlier attempts at fine-tuning. But here
it is important to adhere to the lessons drawn from the 1970s and 1980s. The uncertainty underlying
the decisions taken must not be underestimated. There is uncertainty as to the current state of the
economy, the underlying driving forces and the economy's functioning, including expectations
formation and the impact of monetary policy.
Economic models are tools that help us address some of this uncertainty. Inflation targeting places
new demands on our models and our use of models. In an uncertain world, risk analysis is a very
important part of the work. The aim is as much to understand the economics of the forecast as to
produce quantitative estimates. In central banks, dramatic developments in macroeconomic modelling
have taken place over the past 10 years. At Norges Bank, we have started work on developing
modelling tools for inflation targeting. We are inspired by and work closely with other central banks and
the IMF and draw on our long experience of model building in Norway. We are working on several
different models and we are assessing other building blocks that we need to support our work in
setting interest rates under an inflation targeting regime.
Part of the work involves developing a fairly small model that can serve as a reference and a basis for
discussions and deliberations within the Bank and the Executive Board. The thinking behind this is
that this model will contribute to disciplining and structuring discussions and to consistent
argumentation across issues and over time. Moreover, this model could serve as an aid in our external
communication on monetary policy and our view of the functioning of the economy. The model must
satisfy the following requirements:
1. The model must have a well defined equilibrium
The model must be predicated on the experience gained in the 1970s and 1980s, which showed that
we cannot increase employment in the long run by accepting higher inflation. In the long run, inflation
is a monetary phenomenon.
2. Inflation expectations must be modelled explicitly
We must have a line of reasoning and a model that takes account of the forward-looking behaviour of
economic agents when making decisions. Agents take account not only of today's economy policy, but
their expectations as to future economic policy. As mentioned, it may be difficult to form a perception
of how expectations are formed. An advantage of modelling expectations explicitly is that we can
analyse the effects of different views on how they are formed.
3. Monetary policy must have a defined role in the model
The model must address monetary policy's main task: providing a nominal anchor.
4. The model must be transparent and manageable
Norges Bank's administration, management and Executive Board must be able to interpret and
understand the model. It must not be perceived as a black box. It must have a theoretical structure so
that we can easily examine the effects of alternative views of the economy's functioning.
5. The model must reflect the Bank's view
As a result of the modelling work, the Bank's views on relationships in the economy will evolve. At the
same time, we are developing a model with relationships that we have confidence in.
Models will never provide us with a definitive answer. A model will always represent a simplification of
reality. We must be pragmatic and exercise a good measure of judgement in addition. In my view, the
most important role of models is to provide a framework and structure for the decision-making
process, and to ensure that we do not change our views on the functioning of the economy without
thorough reflection.
The use of models must also be seen in connection with the uncertainty associated with the actual
state of the economy and the driving forces that dominate at a given point in time. It can be a
demanding task in itself to find the balance between incorporating new information on the one hand
and making abstraction of pure noise on the other. Allow me to illustrate.
Norges Bank
Mainland GDP
Percentage rise on previous quarter
Seasonally adjusted
4 4
3 3
2 2
1 1
0 0
-1 -1
-2 -2
-3 -3
1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004
SG CME 08.06..2004
3
Source: Statistics Norway
The chart shows quarterly changes in mainland GDP, adjusted for seasonal variations. The figures
show wide quarterly variations. It is uncertain whether this reflects fundamental conditions or statistical
noise. Norway is a small economy, and extraordinary events can have a substantial impact on
aggregate figures.
Norges Bank
GDP mainland Norway, Sweden
and the UK
Percentage rise on previous quarter. Seasonally adjusted
4 4
3 3
2 2
1 1
0 0
-1 -1
-2 -2
Norway Sweden UK
-3 -3
1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004
SG CME 08.06..2004
4
Sources: Statistics Norway and EcoWin
These figures nonetheless fluctuate considerably less for Sweden and the UK. I will not comment on
whether the differences are real or merely statistical. Let us now contrast these quarterly figures with
our output-gap estimates using annualised figures.16 This estimation may provide a basis for
assessing the contours of cyclical developments.
Norges Bank
Output gap for mainland Norway, based on
annual figures
5 5
4 4
3 3
2 2
1 1
0 0
-1 -1
-2 -2
-3 -3
-4 -4
1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002
SG CME 08.06..2004
5
Source: Norges Bank
The following chart shows a similar estimation using the quarterly figures that I just showed you.
Norges Bank
Output gap for mainland Norway, based on
annual figures and quarterly figures
5 5
4 4
Annual Quarterly
3 3
figures figures
2 2
1 1
0 0
-1 -1
-2 -2
-3 -3
-4 -4
1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002
SG CME 08.06..2004
6
Source: Norges Bank
We must not and cannot fine-tune economic developments. We must therefore exercise caution in our
use of short-term statistics and quarterly figures. Changes in these figures may represent more noise
than news. The challenge facing us is to identify the contours of cyclical developments.
Allow me to conclude.
Today's monetary policy is based on the experience gained by Norway and other countries, over the
past 30 years in particular, and on the results of extensive macroeconomic research. Important
lessons are:
- Inflation is a monetary phenomenon. A country with a national currency can choose the level
of its own inflation. Inflation in a country is not something that drifts in with the wind from
abroad.
- If monetary policy is to function effectively, an institutional framework is required to reinforce
confidence that overriding weight is assigned to long-term objectives.
The institutional framework and guidelines for monetary policy in Norway reflect developments in other
countries. This is of particular importance for a small country because of the considerable influence
international operators have on developments in our country. Rules can anchor expectations, but they
must be credible and robust to disturbances to international and domestic economic developments.
Inflation targeting is in practice a flexible rule that can stabilise expectations and at the same time
provide room for adapting to the abrupt shifts our economy is exposed to.
Thank you for your attention.