Øystein Olsen: A decade of forward guidance in Norway
Speech by Mr Øystein Olsen, Governor of the Norges Bank (Central Bank of Norway), at a
seminar, held at Columbia University, New York City, 8 April 2014.
* * *
Accompanying charts can be found at the end of the speech or on the Norges Bank's website.
Please note that the text below may differ from the actual presentation.
Thank you for inviting me to Columbia University. Economists in Norges Bank have been
greatly inspired by researchers from this institution, and we have had the pleasure of hosting
scholars from Columbia at a number of conferences in Norges Bank. Some of our
economists have also been here as visiting scholars. It is therefore a particular pleasure for
me to be here today.
"Forward guidance" as an element of monetary policy has attracted attention in the aftermath
of the international financial crisis. With key policy rates in some countries constrained at a
lower bound, statements about central banks' future actions have been used to affect interest
rate expectations.
Norges Bank has published explicit numerical interest rate forecasts as a regular part of our
monetary policy communication for ten years. The interest rate forecast is our preferred way
of guiding economic agents' interest rate expectations. As such, our version of forward
guidance has been reasonably successful.
The topic of my talk is our framework for forward guidance and the experience gained over a
decade of practising our approach. Although circumstances differ, our experience may also
be of value to others.
Forward guidance in general
Up until the 1990s, the code of conduct among central bankers was one of secrecy. Today,
however, central banks strive to be transparent. This development reflects a general trend
towards greater transparency in modern societies. For some central banks, including Norges
Bank, a change from fixed exchange rates to an inflation targeting regime also highlighted
the importance of greater transparency.
Transparency is necessary for accountability. With accountability the central bank can build
credibility and trust, both by showing that the objectives are actually attained in the longer
run, and by explaining deviations from targets. Forward guidance, understood as information
about future policy intentions, may be viewed as a natural extension of this accountability
framework.
Economic agents are forward-looking, and hence the future stance of monetary policy
matters to them. As Michael Woodford has stated, "For not only do expectations about policy
matter, but, at least under current conditions, very little else matters."1
In macroeconomic theory, the importance of expectations has been appreciated since the
rational expectations revolution of the 1970s. In the early 1990s, theorists started to model
monetary policy as setting the interest rate.2 Central bankers have since had a theoretical
framework with both forward-looking agents and monetary policy specified in terms of the
key interest rate. Under this framework, monetary policy becomes more powerful if the
agents understand the reaction pattern of the central bank. When a disturbance hits the
economy, the policy response required to stabilise the economy is smaller if the central bank
can affect the whole term structure than if monetary policy only works through the short-term
interest rate.3 However, the importance of forward guidance depends on the degree to which
expectations are forward-looking.
In principle, economic agents may be able to calculate how the central bank will respond to
changing conditions if they know both the model of the economy and the objectives and
reaction pattern of the central bank. Expected future interest rates may then align well with
the central bank's own interest rate intentions, and there will be no need for the central bank
to communicate its policy intentions.
In practice, a model description of the economy is just that - a model, which always will be a
simplification. The central bank's reaction pattern may also be adjusted over time.
Judgement is applied when responding to shocks, and a specific reaction function will only
provide a simplified representation of the central bank reaction pattern. Regular information
about policy intentions is therefore necessary for the public to learn and revise their
expectations. This is also the rationale for forward guidance.
In theory, forward guidance may also work as a commitment device and help the central
bank stabilise the economy in a more efficient way.4 The merits of this are debated, and it
may be most relevant in a situation where the interest rate has reached a lower bound.
Forward guidance about how the central bank plans to reach its targets may nevertheless
help establish confidence among agents that the objectives will actually be achieved.
Forward guidance may thereby indirectly make an inflation target more credible, and thus
contribute to anchoring inflation expectations.
For forward guidance to work as intended, there are some preconditions. First, economic
agents must indeed understand the announced reaction pattern. A second, and related
issue, is that the conditionality of the guidance must be understood. A commonly raised
concern is that the public might perceive the guidance as unconditional promises rather than
conditional statements. Yet another requirement is that the guidance must affect the agents'
expectations. I will address these issues in more detail when I discuss our experience of
forward guidance in Norway.
Many central banks started to provide some kind of forward guidance in the late 1990s.
There is now a consensus view among central bankers that providing information about
policy intentions enhances the effects of monetary policy. However, no consensus has
emerged on how to provide it. We may distinguish between three main categories of forward
guidance:
The traditional form of forward guidance has been to give qualitative statements about future
intentions. For instance, some central banks have indicated the anticipated direction of the
next change in the policy rate. In 1999, Norges Bank started to make statements such as
"the probability that the next change in interest rates will be an increase is greater than the
probability of a reduction". Another example is the Federal Reserve, which has used "code"
words such as "bias towards" or "balance of risks", indicating the same.
A second approach to forward guidance has been adopted by some central banks when key
policy rates have been at a zero lower bound. With a constrained room for maneuver in
monetary policy, central banks have found it useful to communicate specific conditions likely
to be fulfilled before a change in the stance of monetary policy should be considered. In the
aftermath of the international financial crisis, conditional statements both related to the likely
time it would take before a tightening should be considered and statements about thresholds
for some variables have been used. Both the Federal Reserve and the Bank of England have
for instance been linking future policy actions to specific unemployment thresholds.
Publishing the central bank's own interest rate forecast as a regular part of monetary policy
communication is a third type of forward guidance. The Reserve Bank of New Zealand was
the first central bank to pursue this approach in 1997, followed by Norges Bank in 2005.5
This type of forward guidance is also conditional, and it is typically accompanied by a
consistent forecast for output and inflation. As the interest rate forecasts are revised, market
participants learn over time how the central bank normally responds to different types of
shocks. When the central bank explains how it plans to achieve its target, it may also
improve confidence and credibility.
Forward guidance in Norway
Before I present our version of forward guidance, let me give you a brief background on the
Norwegian economy and our monetary policy framework.
[Chart: The Norwegian economy]
Norway is a small, open, natural resource-rich economy. About a quarter of our GDP is
related to oil and natural gas extraction. A large part of the petroleum production is exported
and the bulk of the revenues saved in a sovereign wealth fund.6 A strong fiscal position,
along with a well anchored inflation targeting regime, allowed us to use both fiscal and
monetary policy actively during the recent international financial crisis. The unemployment
rate has stayed around and below four percent during recent years, and the inflation rate has
been low and stable.
This picture seems rosy, but there are concerns: property prices have risen sharply over the
last 20 years and households are heavily indebted.
Norges Bank was given a formal inflation target for its monetary policy in March 2001. The
operational target of monetary policy is annual consumer price inflation of close to
2.5 percent over time. Monetary policy shall also contribute to stabilising output and
employment. In this respect, the inflation targeting regime is flexible.
Norges Bank's Executive Board comprises seven members, including the Governor, Deputy
Governor and five external members. The Board decides collectively on the key policy rate,
normally six times a year.7 Our Monetary Policy Report with financial stability assessment is
published on a quarterly basis. Analyses and discussions on interest rate decisions are
reflected in the Report. Together with press conferences after our monetary policy meetings,
the Report is the main channel for our communication of monetary policy. Since 2013, the
Report also includes an evaluation of financial stability conditions, which is also used as a
background for Norges Bank's recommendation on a countercyclical capital buffer for banks.
[Chart:Timeline: The first years of Norges Bank forward guidance]
In 2004, we started to publish our first quantitative guidance in the form of a "strategy
interval" for the key policy rate four months ahead. In November the following year, we
published for the first time our own interest rate forecast for the next three years. Prior to
that, we had established and published criteria for an appropriate interest rate path.8
Up until November 2005, the analyses and forecasts in our reports had been based on either
a constant interest rate path or an interest rate path as implied by the forward market. At this
point however, our conclusion was that it would be easier to interpret, evaluate and
communicate our view of the economy when it was based on a path for the interest rate that
we considered to be appropriate. In addition, it made our communication better aligned with
our analytical framework and with theory.
[Chart: Our interest rate forecast is conditional]
Our forecast for the key policy rate9 is presented in a panel together with forecasts for
inflation and the output gap. The chart shows the forecasts in the most recent Monetary
Policy Report, published just two weeks ago. There is substantial uncertainty associated with
the projections, as illustrated by empirically based fan charts. The fan chart for the policy rate
also illustrates the conditionality of the forecast: Although we control the key interest rate, the
forecast for the interest rate is conditional on the outcomes for other variables, which are
uncertain.
[Chart: The system for monetary policy analysis and forecasting]
When we decided to publish our own interest rate forecast, more transparency and
documentation were required regarding our models. Our core policy model, NEMO
(Norwegian Economy MOdel), is used as a starting point to derive our interest rate forecast.
Over time, we have also established an apparatus for nowcasting10 in order to steadily
improve our assessment of initial conditions. In addition we collect information about the
current economic situation from our regional network of business contacts. A set of models
are used for cross checks and the assessment of exogenous assumptions.
Our core policy model NEMO is a New Keynesian dynamic stochastic general equilibrium
(DSGE) model for a small open economy. The model has many features that are similar to
corresponding models in other central banks. Recently we have extended the model to
include financial frictions and also an explicit banking sector and a housing market.
As soon as we abandoned an exogenous assumption of future key policy rates, we had to
take a stand on how to formulate monetary policy within our core model. Analytically, deriving
the monetary policy reaction pattern with a loss function is a useful and practical approach.
We have developed an improved apparatus for solution algorithms for DSGE models in order
to be able to solve for the endogenous interest rate path in different ways and under different
assumptions.
The interest rate path that we derive from the model analysis serves as a benchmark for the
policy discussions of the Executive Board. The analytical loss function that we use in NEMO
to solve for this path reflects our criteria for an appropriate interest rate path.
The first criterion is 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 second criterion is that
our inflation targeting regime should be flexible. Hence, the interest rate path should provide
a reasonable balance between the path for inflation and the path for overall capacity
utilisation in the economy.
We have learned that stabilising inflation involves important trade-offs in a small open
economy. Let me elaborate a bit on this point: Shortly after we adopted inflation targeting in
2002-2003, efforts to dampen inflationary pressures resulted in a strong krone appreciation,
with strong impacts on the economy. Later, in the mid-2000s, when inflation was low while at
the same time growth was strong, low interest rates at home and abroad contributed to
amplifying the cyclical upturn in Norway.
In the light of our experience, it is fair to say that our inflation targeting regime has become
more flexible over time.
The third criterion is that the interest rate path should reflect a robust monetary policy. By this
we mean that the interest rate should be set so that monetary policy mitigates the risk of a
build-up of financial imbalances. Moreover, acceptable developments in inflation and output
should be likely under alternative assumptions about the functioning of the economy.
Implementing these concerns analytically is not straightforward, however. We are working
intensively to refine our approach to these concerns in our analytical framework.
[Chart: Criteria for an appropriate interest rate path]
This chart illustrates how the forecasts for the key policy rate, output and inflation evolve
when the various criteria are taken into account. The illustration is from our third Monetary
Policy Report in 2012. If monetary policy at that time had given weight only to the low level of
inflation, the key policy rate should have been lowered sharply and kept close to zero for
some time, as indicated by the red dotted line in the upper left panel. Inflation would then
have been predicted to pick up relatively fast, partly owing to a weaker exchange rate.
Taking into account our second criterion for an appropriate interest rate path, the key policy
rate would have been somewhat higher in the short term, as indicated by the blue dotted line.
Inflation would have been predicted to take somewhat longer to rise towards the target, but
developments in output and employment would have been more stable.
Finally, taking into account considerations of robustness (criterion 3), we reached the interest
rate forecast indicated by the black dotted line.
[Chart: Decomposition of change in the interest rate path]
Our communication of interest rate decisions is aided by a decomposition of changes in the
interest rate path. This is a model-based illustration of how the change in the interest rate
forecast from one report to the next can be decomposed into contributions from exogenous
disturbances. The intention is to communicate the driving forces behind any changes in the
interest rate path.
The chart illustrates the different forces behind the change in the interest rate path from the
last report in 2012 to the last report in 2013.11 The key policy rate was kept at a lower level
through 2013 than projected at the end of 2012. At the same time, the forecasts for 2014 and
2015 were revised downwards. The primary reason for the revision was
weaker-thanexpected developments in the Norwegian economy. Capacity utilisation and cost growth
were both lower than projected. At the same time, there were prospects that growth ahead
would be lower than previously assumed. Moreover, growth among Norway's trading
partners and interest rates abroad were lower than projected, and banks' lending spreads
were higher than expected. Conversely, a substantial depreciation of the krone through the
year, which was viewed mainly as due to an increase in the risk premium, kept the interest
rate forecast from falling further. A decline in premiums in the money market also pulled in
the same direction.
Experiences
So far I have discussed the motivation for forward guidance and how we implement it in
Norges Bank. Let me now share some of our experiences with you.
As a starting point, let me again address the preconditions for forward guidance to enhance
the effect of monetary policy that I mentioned previously. I will try to illuminate two questions:
1) Is our reaction pattern and the conditionality of our interest rate forecast understood? and
2) Do we affect the expectations of economic agents?
[Chart: Decomposition of change in the interest rate path: Forecasts]
Prior to the announcement of a new interest rate forecast, many of the market analysts
publish their own forecast of our interest rate path. These forecasts are usually accompanied
by a discussion of the factors pushing the expected revision of our path in either direction.
Some analysts even publish their own assessment of our decomposition of the interest rate
change, quantifying the estimated effects from different factors. The charts show the
forecasts of the change in our interest rate path provided by three different macroanalysts
prior to the publication of the October 2011 Monetary Policy Report. Our published change in
the path and its decomposition are shown in the lower panel to the right.
As shown in the chart, the forecasts are quite accurate, which is a typical pattern. We take
this as an indication that market participants in general understand our reaction pattern. It
also indicates that the agents correctly perceive our interest rate path as a conditional
forecast, and not as an unconditional promise.
[Chart: Changes in money market rates after monetary policy announcements]
The next chart shows the changes in money market rates on the day of a new monetary
policy announcement. It indicates that market movements around monetary policy meetings
have been marginally smaller since we introduced our own interest rate forecasts in October
2005. Announcing the whole interest rate path has not resulted in more pronounced market
reactions than before. Instead, the graph could be taken to mean that we have become
somewhat more predictable overall. But other factors may also have contributed to smaller
market movements: reduced volatility may also be related to the very low level of interest
rates during recent years.
[Chart: December 2013: Small market reactions after policy announcement]
As I noted earlier, in a world of perfect and symmetric information, where the reaction pattern
of the central bank is known to all, there would be no need for forward guidance. Agents
would not pay any attention to our forecasts, as these would already be internalised in
expectations and reflected in asset prices. But it is also the case in the real world that the
better we are at communicating our reaction pattern, the less attention our forward guidance
will receive. For this reason, it will be hard to identify the contribution of publishing the
interest rate forecast.
This chart shows a typical example of an announcement where our new path had been
anticipated. The market interest rate path prior to our meeting in December last year (blue
dashed line) was already well aligned with the new interest rate path to be published (the
purple solid line).12 On this occasion, our new interest rate forecast just confirmed what the
market had already learned and expected from our reaction pattern. In such a case, the
market interest rate path works as an automatic stabiliser: If the market expects the outlook
for the economy to change, and it - correctly - anticipates the central bank's reaction to it,
the appropriate tightening or loosening will be reflected in market rates even before any
action is taken.
The example illustrates an important point: By being transparent and by regularly and over
time providing information about the revisions of the forecasts, economic agents are kept up
to date with the central bank's reaction pattern.
Since the world changes, our interest rate forecast may at times come as somewhat of a
surprise. And in situations where we observe that market participants are not well enough
informed about our reaction pattern, we do not hesitate to surprise the market.
The huge shock to the international - and hence the Norwegian - economy during the
financial crisis in 2008 may serve as an example. In this case, we were able to guide the
market and affect expectations when we presented a new interest rate forecast.
[Chart: December 2008: Market rates shifted down markedly after policy announcement]
As shown by the black line in this chart, we cut the key policy rate substantially at the
monetary policy meeting in December 2008. The dashed blue line, which shows the market
path the day before we announced the rate cut, indicates that a significant cut was
anticipated by the market. However, in addition to cutting the policy rate, we also published a
new interest rate forecast, shown by the solid purple line, which was considerably lower than
our previous forecast, shown by the dashed purple line. The market had not fully anticipated
this, and forward rates shifted down markedly after the meeting, as indicated by the solid
blue line. The interpretation could be that we provided news to the market about the strength
of the action deemed necessary by Norges Bank as a response to the financial crisis. On this
special occasion, when uncertainty was larger than usual, we believe that publishing the
interest rate forecast was particularly helpful in making monetary policy more effective. This
example suggests that we can indeed guide the market and affect expectations.
[Chart: Interest rate expectations one year ahead]
Further evidence supporting our ability to affect expectations comes from household survey
data. In this chart, the purple line shows a diffusion index of households' bank rate
expectations one year ahead.13 The index correlates well with our forecast for the change in
the key policy rate over the coming year, derived from each vintage of our interest rate
forecast. The chart is consistent with households being well informed about the interest rate
changes predicted by Norges Bank.
Concluding remarks
Let me summarise:
Norges Bank has provided forward guidance through publishing conditional forecasts for the
key policy rate for almost a decade. Our overall experience is positive. We have indications
that our reaction pattern is well understood, that agents understand the conditionality of our
forecast and that they do pay attention to our predictions of future rates.
Over time, however, we should be measured on whether we meet our overriding objective,
price stability. A credible interest rate forecast shedding light on the reaction pattern of the
central bank provides a clear commitment to price stability and contributes to anchoring
expectations.
How forward guidance is best provided will depend on economic and institutional factors. A
decade of forward guidance in Norway indicates, however, that regularly publishing our own
interest rate forecasts is a robust strategy.
However, there are unsolved issues. After the international financial crisis, robustness and
the interaction between monetary policy and financial stability have become more pressing
concerns for monetary policymakers.
This issue is on our research agenda. We have initiated a three-year research project, where
we will seek to review different aspects of our inflation targeting framework, including the
question of how to take financial stability into account. Moreover, for a small open economy,
large terms of trade shocks may represent a particular challenge, also for monetary policy.
In our search for answers and our efforts to steadily improve our implementation of flexible
inflation targeting, we look to academia. Therefore, let me again emphasise how much I
appreciate the opportunity to be here today.
Thank you for your attention.
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