Øystein Olsen: A flexible inflation targeting regime
Speech by Mr Øystein Olsen, Governor of Norges Bank (Central Bank of Norway), at the
Centre for Monetary Economics (CME) / BI Norwegian Business School, Oslo, 11 October
2016.
* * *
The accompanying charts can also be found on the Norges Bank's website.
Introduction
Inflation targeting was formally introduced in Norway 15 years ago. The changeover to a new
monetary policy regime was a consequence of the fact that the exchange rate regime had
outlived its role. It no longer yielded the desired result for a small open economy in a world of
free capital movements. Through the 1990s, a number of central banks were mandated to
aim for low and stable inflation. Since then, many countries have followed suit.
Inflation targeting has become more flexible with time, both in Norway and other countries. In
the conduct of monetary policy, greater weight is now given to achieving a reasonable
tradeoff between the path for inflation and the path for output and employment. Monetary policy
cannot be strictly rule-based - it must be flexible and robust. At the same time, we are
continuously mindful of the main objective of monetary policy - low and stable inflation over
time.
The evolution of inflation targeting reflects the practical experience gained since it was
introduced. The trade-offs have been challenging at times. In these past 15 years, the
economy has been exposed to different types of shocks. The supply side has been
influenced by increased labour immigration following EU enlargement in 2004. The financial
crisis and its still prevailing legacies have posed challenges that monetary policy has had to
address. And not least, the Norwegian economy has had to contend with wide fluctuations in
the terms of trade - in both a positive and a negative direction.
Chart: Performance
Inflation targeting has performed well over the past 15 years taken as a whole. When
inflation targeting was introduced, inflation had already come down after years of high
inflation and has since been low and relatively stable. At the same time, monetary policy has
contributed to moderating fluctuations in the real economy. Flexible inflation targeting has
functioned well. The monetary policy framework has provided sufficient flexibility to address
the shocks that have hit the economy.
Long-term interest rates have fallen
Chart: International interest rates
In recent years, monetary policy has faced a new challenge in many countries. The interest
rate level that is consistent with balanced developments in the economy has fallen. This is
reflected in the low level of global interest rates. The decline in real interest rates has been
particularly marked over the past 15-20 years. In 2001, when inflation targeting was
adopted, real long-term interest rates were around 3 percent. Now, those same interest rates
are around zero.
Chart: Forces driving the fall in the global real interest rate
The causes of the decline in interest rates are complex. In recent years, extraordinary
measures by many central banks have pushed down long-term rates. Over a longer time
horizon, the factors behind the decline in interest rates are more structural in nature. The
savings glut in emerging economies, particularly China and oil exporting countries, has been
one important factor. In many countries, savings have probably also increased as a result of
demographic developments and a more uneven distribution of income. At the same time,
investment in many advanced economies has been low. A factor may be prospects for low
returns on investment in productive capital. In the wake of the financial crisis, conditions of a
more cyclical nature have also contributed to the fall in interest rates. While deleveraging has
pulled up savings, greater uncertainty may have dampened the willingness to invest.
These developments have consequences for monetary policy. The level of the real interest
rate that is consistent with balanced developments in the economy has fallen in pace with
increased savings and lower demand for capital. This level is usually referred to as the
neutral interest rate.
The difference between the actual real interest rate and the neutral real interest rate provides
an indication of whether monetary policy is expansionary or contractionary. A real interest
rate that is below the neutral interest rate stimulates economic growth, while a higher real
interest rate dampens growth.
The neutral interest rate is not fixed, but will over time move around a level determined by
long-term productivity, population growth and saving preferences.1 Fluctuations around this
level may be partly attributable to factors such as transient changes in saving and investment
behaviour.
The neutral interest rate is not directly observable. Central banks must nevertheless form a
perception of how expansionary or contractionary monetary policy is and of the interest rate
that is consistent with balance in the real economy. The forecasts for the key policy rate
move towards this level as different economic shocks unwind.
In the past few decades, international estimates of the neutral real interest rate have fallen
and are now at 1 percent or below in many countries (see Rachel et al (2015), Laubach et al
(2015), Hamilton et al (2015), Constâncio (2016) and Zhu (2016)). Norway is part of a global
market, and international interest rate developments affect interest rate setting at home,
particularly through the exchange rate channel. Norges Bank's estimate of the neutral
interest rate has been gradually revised down in pace with international developments. The
Bank's forecasts are now based on the assumption that a neutral nominal money market rate
in Norway will be between 21⁄2 percent and 31⁄2 percent in the coming years. The associated
neutral nominal key policy rate is somewhat lower.2
Norges Bank's projections imply that the key policy rate at the end of 2019 will be lower than
the estimate for the neutral interest rate. This partly reflects the shocks to which the
Norwegian economy has been exposed in recent years, primarily the pronounced fall in oil
prices. Prospects for continued expansionary monetary policies abroad pull in the same
direction.
The low level of the neutral interest rate raises a number of issues that I want to discuss
today. First, I would like to focus on two aspects that have been given weight in recent years
in Norges Bank's assessment of a robust interest rate path. The first concerns the effect of
changes in the policy rate, which are more uncertain when the rate falls to levels where our
experience is very limited. The second relates to the challenge persistently low interest rates
pose to financial stability. I will then touch upon the ability of monetary policy to address a
future downturn against the backdrop of global economic developments.
Greater uncertainty about the effect of the policy rate?
Monetary policy decisions are made under uncertainty. Central banks operate in an
environment of uncertainty regarding the current situation, the driving forces in the economy
and the functioning of the economy.
Much of this uncertainty is associated with conditions beyond the influence of monetary
policy, such as the oil price and economic developments among trading partners. In recent
years, the uncertainty related to these conditions has at times been higher than normal, as
was the case this summer, when the UK vote to leave the EU fuelled uncertainty regarding
the EU economic outlook. When faced with this type of uncertainty, the policy rate will
normally be based on projections of economic variables as if they were known with certainty,
an approach that is supported by economic theory.3
The uncertainty associated with the effect of monetary policy is of a different nature in that it
relates to the functioning of the economy - and the effect of the policy rate in particular.
For monetary policy to function normally, changes in the policy rate must pass through to the
bank lending and deposit rates faced by households and enterprises. In Norway, the latest
policy rate cuts have had a broad impact on banks' interest rates. Lending and deposit rates
for households are both approximately one percentage point lower now than when the key
policy rate was reduced in December 2014. Rates facing enterprises have also fallen. Banks'
profitability and net interest income have remained solid in the same period.
At the same time, given the current low interest rate level, we are navigating in uncharted
waters. Banks' response to changes in the policy rate may differ from their usual behaviour.
In normal times, when the policy rate is well above zero, changes in the policy rate can pass
through fully to lending rates without affecting banks' margins as banks can then change
deposit rates in tandem with lending rates. The pass-through is more uncertain when interest
rates are already low. Banks risk losing deposits if deposit rates are lowered in tandem with
the policy rate. If banks do not hold back on lending rates at the same time, an important
source of banks' income will be affected.
Households and enterprises may also respond differently to interest rate changes when
interest rates are already at a low level. Our empirical models are quantified on data from a
period when the interest rate level was higher. So far, there is no clear indication that
historical relationships have collapsed, but nor do we have experience of such low interest
rates over such a long period of time. The relationship between the interest rate and
consumption may change when interest rates approach zero. Households that save will find
that their savings yield a lower return. This may provide incentives to increase saving to
secure a sufficiently high pension.
It may also be difficult to predict financial market reactions to very low and negative interest
rates. With the growing realisation that bank savings yield a negative real return, the interest
in alternative investments may increase. Financial market volatility may increase.
As early as 1967, US economist William Brainard discussed how central banks should
respond to economic shocks when there is uncertainty about the impact of the policy rate on
the economy. He concluded that the policy rate should be used with greater caution when
uncertainty about its effect increases (Brainard (1967)).
The result can be illustrated within a simple model where the central bank sets the policy rate
with the objective of minimising the deviation of inflation from the target.
Chart: Uncertain effect of policy rate
In the model, as shown in the chart, the central bank minimises a quadratic loss function.
Under a flexible inflation targeting regime, the inflation gap and the output gap will both be
included in the loss function. For the sake of simplicity, we use only one target variable, y.
With the help of a little algebra, we can rewrite the loss function. We then see that both the
expected deviation from the target and increased uncertainty surrounding the target variable
result in a higher loss. The uncertainty is represented by the variance of the target variable.
The relationship between the target variable, the policy rate (r) and the part of the economy
that is not affected by the policy rate (x) may be described using a linear model - also
simplified. If a shock to the economy leads to a change in x, the policy rate is adjusted to
counteract the shock. The effect of the policy rate on the economy is given by parameter α.
In this model, there is uncertainty about the effect of the policy rate. The effect will vary
around a level, here denoted α0. The total effect of the policy rate depends on the size of ε,
which is uncertain. The uncertainty is given by the variance in the effect of the policy rate,
represented by σ^2. As shown in the chart, the interval within which the effect of the policy
rate varies will increase with the degree of uncertainty.
Within this framework, uncertainty about the effect of a change in the policy rate will influence
how a central bank is to react to economic shocks. For the sake of comparison, the chart
shows the monetary policy response with and without uncertainty about its effect.
The model illustrates two important points.
First, the higher the uncertainty about the effect of the policy rate, the more cautious
monetary policy should be, as illustrated by the more cautious monetary policy response in
(a), where there is uncertainty, compared with (b), where there is no uncertainty. The intuition
behind the result is that uncertainty about the effect of an interest rate change will introduce
additional uncertainty into the economy. This warrants a cautious approach.
Second, the uncertainty that is introduced into the economy must be weighed against the
benefit that can be achieved. If the effect of the policy rate is expected to be limited, greater
weight should be given to the uncertainty.
The model results rest on an important trade-off: the expected size of the target variable's
deviation from the target is weighed against the uncertainty of the target variable estimate.
This central trade-off is expressed by the loss function.
Chart: Monetary policy and uncertainty - active response
The trade-offs can be illustrated graphically. The next charts show a situation where the
policy rate is used to counteract the effect of a negative shock to the real economy. The
effect of rate cuts is associated with uncertainty. In this instance, it is assumed that the
central bank does not explicitly take this into consideration. The uncertainty has been
illustrated using relatively broad bands around the expected paths for inflation and the output
gap.
Chart: Monetary policy and uncertainty - a more cautious response
A slightly more cautious monetary policy response as a result of the central bank's
recognition of the uncertainty results in a different path. This chart describes a path where
the key policy rate is reduced by somewhat less. The assumed real economic costs - as
measured by the output gap - are somewhat higher, and inflation moves further from the
target. In that respect, this is a less appropriate path for the policy rate. But there is also a
benefit - the uncertainty about the future path is substantially reduced. When choosing
between the two paths, the benefits must be weighed against the costs.
A robust monetary policy should take account of uncertainty regarding the functioning of the
economy. The policy rate in Norway has come down to a low level, approaching a lower
bound. This has increased the uncertainty about the effect of monetary policy. Over the past
year, Norges Bank has therefore reacted somewhat less to new information, whether the
information has pulled in the direction of a lower or a higher policy rate, than it would have
done in a more normal situation. It has been appropriate to proceed with caution.
Low interest rates could be a precursor to financial instability
The neutral interest rate level will likely remain low for several years ahead. This has brought
to the fore the question of how far monetary policy should go in taking responsibility for
financial stability. For Norges Bank, the consideration of restraining the build-up of financial
imbalances has long been an element of a robust monetary policy. The aim is to mitigate the
risk of particularly adverse economic outcomes further ahead.
A period of low interest rates can engender financial imbalances. The risk that growth in
property prices and debt will become unsustainably high over time is increasing. With high
debt ratios, households are more vulnerable to cyclical downturns. In the event of a reduction
in household income, debt burdens may become heavy to bear, forcing households to
reduce spending on consumption, with a deeper downturn as a result.
Chart: Estimated path for total consumption during recessions
A recently published study by Norges Bank examines developments in private consumption
during recessions. The analysis is based on data from 61 international recessions in the past
four decades (see Hansen et al (2015)). An important outcome is shown in this chart. The
chart compares two different paths for consumption during a recession. The blue line shows
the average path, while the yellow line shows the path following a period of high debt growth.
The results confirm that high debt growth ahead of a recession leads to a deeper downturn. It
also takes longer for the economy to recover.
Chart: Monetary policy and financial stability - financial imbalances give rise to tail risk
The next chart illustrates the tail risk that can arise when financial imbalances build up. The
uncertainty bands around inflation and the output gap are highly asymmetrical. The
probability of a deep recession increases later in the projection period.
Chart: Monetary policy and financial stability - consideration of financial imbalances reduces
tail risk
When financial imbalances are building up, monetary policy can contribute to dampening
vulnerabilities by keeping the interest rate somewhat higher than would otherwise have been
the case. The risk of a deep economic downturn is reduced. The benefit can be illustrated
graphically. The uncertainty bands become narrower and the tail risk diminishes when the
key policy rate follows the purple line and not the blue line. But, as we can see, this policy
also entails a short-term cost. Capacity utilisation is lower, and it takes somewhat longer to
stabilise inflation around the target.4
In Norway, household debt ratios have been increasing for several years. House price
inflation has accelerated recently. High house price inflation could fuel debt accumulation
and make households more vulnerable. This suggests in isolation a somewhat higher key
policy rate than would otherwise have been the case. The aim is to achieve an improved
path for inflation, output and employment over time. "Leaning against the wind" is therefore in
line with our central bank mandate. Flexible inflation targeting with a sufficiently long horizon
should take financial stability into account if the situation so allows and so warrants.
But it is not the primary responsibility of monetary policy to head off an emerging storm.
Regulation and surveillance of financial institutions are the first line of defence against
shocks to the financial system. In the years following the financial crisis, the regulatory
framework has been strengthened. That does not mean that our work is done. The financial
system is in constant flux. Economic agents in search of yields will seek out new
opportunities. Today's regulations are not necessarily well suited to meet tomorrow's
challenges. We still need more knowledge about the use of macroprudential tools. The
prospect of a persistently low neutral interest rate has made this work even more important.
In the work on constructing an appropriate interest rate path, Norges Bank uses advanced
models. They are useful and necessary tools for arriving at a good decision. But even with
steadily improved models, no model is capable of fully capturing the complexity of the
tradeoffs. It is particularly demanding to model and quantify how the risk of a build-up of financial
imbalances may influence developments in inflation, output and employment over time. In
coming to our policy decision, we also take into account the uncertainty associated with the
functioning of the economy, including the effect of the policy rate. Given this uncertainty, it is
neither possible nor desirable to fine-tune economic developments. Any attempt to actively
fine-tune the economy could do more harm than good. The choice of interest rate path must
therefore be based on judgemental assessments, which reflects the fact that the world and
the trade-offs are more complex than even the most advanced models can reproduce.
The role of monetary policy
I will now turn to the role of monetary policy and take a look at international developments.
Several observations can be made. First, many countries have experienced the heavy
burden of undoing the damage caused by the financial crisis. The interest rate level among
many of our trading partners has been very low for a long time. Additional ammunition in the
form of unconventional measures has also been needed, which reflects the fact that the real
economic challenges following the crisis have been far greater than those associated with
more normal cyclical downturns.
Though the headwinds have been strong, other policy areas have provided little support.
Fiscal leeway has been limited by high debt levels. Monetary policy has become
overburdened. Despite stretching the limits of monetary policy, central banks have not been
able to underpin growth and inflation. Monetary policy in many countries has sought to
prevent an even deeper and more persistent downturn.
A number of international studies indicate that the overall growth potential of advanced
economies has weakened. The fall in the neutral interest rate is one of the consequences.
An expansionary monetary policy has required a lower interest rate level than earlier.
The structural challenges associated with low underlying growth cannot be addressed by
monetary policy. Long-term economic growth is determined by labour input and productivity.
Both factors are beyond the control of central banks.
This does not mean that monetary policy is without importance for economic activity. A
credible monetary policy that delivers low and stable inflation sets the stage for stable
economic developments. By conducting a monetary policy that stimulates employment in the
short term, we can also avoid unemployment becoming entrenched at high levels. But
monetary policy easing and low interest rates do not pave the way for durably higher growth.
Emergence from a situation of low growth, low inflation and low interest rates requires an
improvement in the growth potential of the economy. Leading central banks and key
institutions, such as the IMF and the BIS, have highlighted the urgency of implementing
structural reforms (see Carney (2016), Draghi (2016), Praet (2015), IMF (2016), BIS (2015)).
Structural reforms could boost the growth potential of many economies. At the same time,
many factors suggest that the period of low interest rates is far from over. Many of the forces
that have pulled down the interest rate level will continue to prevail. A low neutral interest
rate level implies a lower key policy rate also in more normal times, limiting the scope for
reducing the interest rate in order to counter a downturn. The question has been raised as to
whether monetary policy will have sufficient capacity to cope with a severe downturn.
In recent years, central banks have moved into unknown territory. Many countries have
experienced that the effect of rate cuts does not necessarily end at the zero bound. Where
the lower bound lies and how fast the effect unwinds is uncertain. The experience gained so
far shows that the lower bound depends on the prevailing situation and that it varies across
countries, partly as a result of differences in banking systems.
Recent years have also shown that central banks' toolkits can contain more than policy rates.
We have gained new insights into the effect of quantitative easing, liquidity provision and
policy rate guidance. The measures have been implemented both to maintain the monetary
policy transmission mechanism and to loosen monetary policy as the room for further rate
cuts has gradually narrowed.
Loose monetary policies have contributed to pushing up growth in advanced economies. The
US economy has been recovering for some time, and unemployment has declined. In the
euro area, the upturn remains moderate. As cyclical conditions improve in more countries
and the after-effects of the financial crisis unwind, the international interest rate level will
move upward, but most likely to a new and lower "normal". This gives rise to a number of
challenges, partly because it affects the room for manoeuvre in monetary policy.
Conclusion
In spite of the demanding task monetary policy has faced in many countries, it is difficult to
find alternative strategies to today's flexible inflation targeting framework. A lower neutral
interest rate level does not stand in the way of monetary policy's role as the first line of
defence in managing the economy. Monetary policy has been able to respond rapidly to
cyclical variations. The framework did not hinder a powerful response when the financial
crisis erupted. Inflation expectations were firmly anchored. This enabled central banks to
reduce the amplitude and length of the downturn. Here in Norway, the monetary policy
regime also functioned effectively in the face of the sharp fall in oil prices.
But what is viewed as a good monetary policy framework is not static and can change with
experience and research. The Ministry of Finance will now assess the need for modernising
the regulation on monetary policy in Norway. After 15 years of the current regulation, a
review is in order. I would, however, emphasise that our experience of the current framework
is positive. This suggests a need for adjustments rather than a regime change.
Inflation targeting was introduced in 2001 and has functioned effectively. Confidence in low
and stable inflation is firmly anchored. The primary task of monetary policy must always be
price stability. When inflation is firmly anchored, monetary policy can also contribute to stable
developments in the real economy. The flexibility and room for the exercise of judgement
provided by our mandate has strengthened monetary policy and the Norwegian economy.
References
Baker, D., J. B. Delong and P. R. Krugman (2005): «Asset returns and economic growth»,
Brookings Papers on Economics Activity, 1/2005, 289-330.
BIS (2015): «85th Annual Report».
Brainard, W. (1967): "Uncertainty about the effectiveness of policy", American Economic
Review 57, 411-425.
Carney, M. (2016): «Redeeming an unforgiving world», Bank of England, speech delivered
on 26 February 2016.
Constâncio, V. (2016):«The challenge of low real interest rates for monetary policy», speech
delivered on 15 June 2016.
Draghi, M. (2016): «On the importance of policy alignment to fulfil our economic potential»,
ESB, speech delivered on 9 June 2016.
Gerdrup, K., Hansen, F., Krogh T. and J. Maih (2016): «Leaning against the wind when credit
bites back», Norges Bank Working Paper 9/2016.
Hamilton, J. D., J. Hatzius, E. S. Harris and K. D. West (2015): «The equilibrium real funds
rate: Past, present, and future», Hutchins center on fiscal & monetary policy at Brookings,
Working Paper 16.
Hansen, F. and K. Torstensen (2016): «Does high debt growth in upturns lead to a more
pronounced fall in consumption in downturns?», Economic commentaries 8/16, Norges Bank
IMF (2016): «IMF Note on Global Prospects and Policy Challenges», Group of Twenty IMF
Note - Finance Ministers and Central Bank Governors' Meetings, 23- 24 June 2016.
Laubach, T. and J. C. Williams (2015): «Measuring the natural rate of interest redux»,
Hutchins center on fiscal & monetary policy at Brookings, Working Paper 15.
Lund, K., K., K. Tafjord and M. Øwre-Johnsen (2016): «What drives the risk premium in
Nibor?», Economic commentaries 10/2016, Norges Bank.
Praet, P. (2015): «Structural reforms and long-run growth in the euro area», ESB, speech
delivered on 15 June 2015.
Rachel, L. and T. D. Smith (2015): «Secular drivers of the global real interest rate», Staff
Working Paper 571, Bank of England.
Zhu, F. (2016): «Understanding the changing equilibrium real interest rates in Asia-Pacific»,
BIS Working Papers 567.
BIS central bankers' speeches
BIS central bankers' speeches
BIS central bankers' speeches
BIS central bankers' speeches