Øystein Olsen: The purpose and scope of monetary policy
Speech by Mr Øystein Olsen, Governor of the Norges Bank (Central Bank of Norway), at the
Centre for Monetary Economics (CME) / BI Norwegian Business School, Oslo, 26 October 2017.
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Accompanying slides
On 23 June this year, the Central Bank Law Commission submitted its proposal for a new
central bank act and for the future organisation of Norges Bank and the Government Pension
1
Fund Global. I want to commend the Commission, headed by my predecessor Svein Gjedrem,
on its thorough work. Important issues have been thoroughly examined and deliberated. Norges
Bank has carefully scrutinised the Commission's proposals before submitting its response to the
consultation document. As our response was published today, this speech provides a good
opportunity to elaborate on Norges Bank's views on some of the key aspects of the
Commission's recommendation.
I will primarily focus on the Commission's proposal for an objects clause in the new central bank
act and in particular on one of the core functions of the central bank - monetary policy. What is
the main objective of monetary policy, and what scope is available to monetary policy for
pursuing other goals? Towards the end of my speech, I will also discuss the future organisation
of the central bank and the Government Pension Fund Global (GPFG).
Norges Bank's main functions
The current Norges Bank Act establishes that Norges Bank is Norway's central bank and
describes the Bank's functions and its role as executive and advisory body for monetary, credit
and foreign exchange policy. The functions described are in line with the customary functions of
a central bank and follow from the Bank's key role in financial markets. But there is little in the
current Act to indicate which long-term objectives the Bank should pursue. The Commission
wants to change this. The Commission proposes the introduction of an objects clause that
clearly defines the Bank's purpose.
Norges Bank supports this proposal. At the same time, the Bank would emphasise that the
interpretation of the objects clause must reflect the central bank's different degree of influence
over the various objectives. The central bank's toolbox is limited, and for some objectives, the
instruments available to other institutions may be more important for the result.
Chart: Section 1-2 Norges Bank's purpose - the Commission's proposal
The proposed objects clause contains two paragraphs. The first paragraph reads: "the purpose
of Norges Bank is to maintain monetary stability and promote the stability of the financial system
and an efficient and secure payment system", while the second paragraph reads: "the Bank shall
otherwise contribute to high and stable output and employment".
A well-functioning monetary system is a fundamental prerequisite for the efficient functioning of
an economy. Norges Bank plays a key role in this context. It naturally follows that the objectives
set out in the first paragraph of the objects clause are primary objectives for the Bank and fully in
line with the principles on which the Bank already bases its activities.
Trust in the stability of the value of money is the very foundation of the monetary system. In
addition, households and businesses must be confident that the payment system will allow them
to conduct transactions securely at all times. An efficient and stable interbank payment and
settlement system also provides a necessary basis for the stability of the financial system. With
financial system stability, investors can channel available capital to investments offering the
highest return.
Norges Bank also has a key role in the management of crises in the financial system. In a crisis,
the Bank can supply liquidity both to influence market interest rates and to stabilise the financial
system.
Flexible inflation targeting
The purpose of "maintaining monetary stability" sets a long-term objective for monetary policy.
The day-to-day conduct of monetary policy requires a more operational target. Most countries set
this target in the form of a regulation or a more time-limited mandate issued by the government.
The operational target is set to meet the primary objective, but is also a means of holding the
central bank accountable.
Chart: Emergence of inflation targeting
The objective of monetary stability is compatible with a range of operational targets. In the past,
central banks were expected to ensure that money would keep its value in precious metal. Later,
this was replaced by a fixed exchange rate regime whereby the currency was pegged to other
currencies. Various forms of fixed exchange rate regimes are still in use in many countries, but
since New Zealand introduced inflation targeting as a framework for monetary policy in 1990, an
increasing number of countries have chosen to link monetary stability to a numerical inflation
target. Today, more than 30 countries have adopted some form of inflation targeting.
International experience with inflation targeting has been predominantly positive. Both during and
after the global financial crisis, economic growth performance has been better in
inflationtargeting countries. One important reason may be that a floating exchange rate with a credible
anchor for inflation has had a stabilising effect on the economy.
Chart: Low and stable inflation
Inflation targeting has also worked well for Norway. After decreasing in the early 1990s, inflation
has since been low and stable. We can now look back on a quarter of a century of price stability.
At the same time, employment has shown less variation since 2001 than in previous periods, in
spite of the substantial shocks that have hit the Norwegian economy.
In some countries, particularly in emerging economies, exchange rate movements have at times
been a source of instability. This is less of a challenge in Norway. The Norwegian household,
banking and corporate sectors as a whole take on exchange rate risk to a limited extent.
Furthermore, government finances are solid and are not affected to any great extent by
shortterm exchange rate movements, allowing the exchange rate to play an important role in
absorbing shocks to the economy. Particularly in periods of falling oil prices, a weaker krone has
had a stabilising effect on the business cycle. With confidence in the inflation target, monetary
policy has been able to underpin such movements.
At the same time, in a world of high capital mobility and extensive trade, monetary policy's room
for manoeuvre is constrained by the exchange rate channel. In a small open economy with a
floating exchange rate, the domestic interest rate can differ from interest rates abroad. However,
an interest rate differential that becomes too wide can lead to considerable exchange rate
volatility, which will in turn feed through to inflation, output and employment. Thus, the domestic
interest rate cannot be set without regard to the level of external interest rates. The room for
manoeuvre in monetary policy is further constrained in periods when external interest rates are
close to or below zero.
Under an inflation-targeting regime, a numerical target is set for the inflation rate, either in the
form of a point target or a target range. In its conduct of monetary policy, the central bank aims to
keep inflation close to the point target or the midpoint of the target range over time.
Inflation can impose costs on society if it is too high and if it is too low. High inflation is often
variable, making economic planning difficult. The real economic costs of bringing high and rising
inflation under control have also proved to be substantial. But inflation should not be too low
either. Some degree of inflation can oil the wheels of the economy and at the same time increase
the monetary policy room for manoeuvre. The lower inflation is, the shorter the distance is
between the nominal interest rate and its effective lower bound in a normal situation. If inflation
moves into negative territory, the costs can be considerable. Deflation - a persistent fall in prices
- can amplify a downturn.
In the early years of inflation targeting, policymakers had high ambitions of micromanaging
inflation to meet the target and of achieving this goal within a clearly defined time horizon. But
with experience, useful lessons were learned and these ambitions were gradually toned down. In
the face of various kinds of shocks, small open economies in particular found that bringing
inflation rapidly back to target could have undesirable consequences for the real economy. It was
essential to practise flexibility in inflation targeting to address these shocks. The horizon for
achieving the target was lengthened. This has also been the case in Norway.
In Norway, inflation has over time been close to, albeit somewhat below, the target. Inflation has
at times deviated from 2.5 percent, undershooting or overshooting the target. However, inflation
has remained within a range where there is little evidence to suggest that deviations from the
target have involved appreciable costs to society. This is reflected in the Bank's conduct of
monetary policy. We have been able to take time to bring inflation back to target, which has
provided more leeway for giving weight to developments in output and employment in the
monetary policy trade-offs.
Even though there may be a range of "optimal" inflation rates, there may nonetheless be good
reasons to aim for a specific target rate, whether the inflation target is formulated as a point
target or as a target range. A clear target for inflation can contribute to anchoring inflation
expectations more firmly.
The Bank's response pattern with regard to deviations from the inflation target is
statedependent. First, the Bank's response will be based on a trade-off between the consideration of
low and stable inflation and the consideration of stable developments in output and employment.
If inflation is somewhat below target while the outlook for output and employment is favourable,
the Bank will be less concerned about inflation than if output and employment prospects are
weak. Second, the Bank's response will be affected by the size of the inflationary gap. If inflation
deviates considerably from the target, the costs over time can be substantial. There is also a risk
that the anchor for inflation expectations will then slip. In such situations, the Bank will therefore
give considerable weight in its conduct of monetary policy to bringing inflation back to target.
In the Bank's latest monetary policy report, inflation was projected to remain somewhat below
target in the years ahead, against the background of prospects for moderate wage growth in the
wake of the fall in oil prices and the need for economic restructuring, among other things. Rather
than operating a strict inflation targeting regime and lowering the key policy rate, Norges Bank
has chosen to bring inflation back to target more slowly, in the light of firming growth in the
Norwegian economy and decreasing unemployment. Higher capacity utilisation and prospects
for increased inflation abroad imply that the risk of too-low inflation is small. The Bank gives
weight to the expectation that inflation will pick up gradually from today's level.
Real economic considerations in the conduct of monetary policy
Since 2001, Norges Bank has gradually given more weight in its conduct of monetary policy to a
reasonable trade-off between the path for inflation and the path for output and employment. Over
this period, monetary policy has gone from "underpinning fiscal policy" to being the first line of
defence in stabilising the economy.
Norges Bank's role in stabilising the economy is clearly defined in the draft objects clause, which
reads "the Bank shall otherwise contribute to high and stable output and employment".
This formulation differs somewhat from the usual wording in other central bank acts. In most
central bank legislation, the central bank's primary purpose is limited to the responsibility for
maintaining price stability and for performing tasks relating to financial stability, in some cases
supplemented by a more general objective, such as underpinning the government's economic
policy.
In some central bank acts, however, high employment is included as one of the central bank's
primary objectives, as is the case in the US. A so-called dual mandate was established for the
Federal Reserve, where the objectives of full employment and price stability are put on an equal
footing.
In practice, monetary policy conducted by a central bank with a dual mandate will not necessarily
differ from that of a central bank operating a flexible inflation-targeting regime. A central bank with
a flexible inflation-targeting regime will also be concerned with the level of employment.
In the draft of the new central bank act, maintaining monetary stability is the primary objective.
The proposal does not provide for a dual mandate for monetary policy. This is a wise choice.
Even though the difference between inflation targeting and a dual mandate is probably small in
practice, there are good arguments for keeping price stability as the primary objective of
monetary policy. This will clearly define the main role of monetary policy. In the practical conduct
of monetary policy, the central bank will always be faced with a trade-off between different
considerations. The order of priority for these considerations does not dictate the weight the
central bank can give to stable output and employment in the short term.
Norges Bank does not interpret "high and stable output and employment" to mean that the
Commission is advocating that monetary policy should have greater responsibility for stabilising
the economy than it does today. Monetary policy cannot have primary responsibility for the level
of output and employment. There is broad consensus among economists that monetary policy
cannot influence the long-term growth potential of the economy.
The level of economic activity, and thereby employment, is a result of overall economic policy,
particularly with regard to more structural factors such as wage and income formation, the tax
and social security system and the functioning of the labour market. Monetary policy is only one
piece of this picture.
But monetary policy can make important contributions to stabilising the economy. First, the policy
rate can be rapidly adjusted in response to shocks to the economy, as for example in 2008 and
2014. Second, the policy rate has a direct and pronounced impact on many segments of the real
economy. This means that as long as there is no conflict with the inflation outlook, monetary
policy can be oriented to influence average output and employment over time.
Many countries, including Norway, have experienced that employment losses in connection with
an economic downturn are not fully reversed following a turnaround; for example, unemployment
may become entrenched at a high level or the labour force may be reduced. In the literature, this
is referred to as hysteresis. Research indicates that the costs of a downturn may be far higher
than the immediate output loss.
With a sufficiently flexible inflation targeting regime, it is possible to prevent a long-term reduction
in employment following a sharp fall in the level of activity. At the same time, this means
accepting that inflation will temporarily overshoot the target while labour market conditions
normalise. The benefit is somewhat higher average employment than under less flexible inflation
targeting.
But if the policy rate is kept lower than the level necessary to stabilise inflation for a considerable
period of time, there is a risk that inflation will accelerate. A monetary policy objective of achieving
the highest possible level of employment can therefore come into conflict with the primary
objective of "monetary stability". If that were to happen, the Bank will give precedence to its
primary objective - low and stable inflation. Delivering low and stable inflation is the best
contribution monetary policy can make to favourable and stable developments in the economy
over time.
Financial stability considerations
Monetary policy can also contribute to high and stable output and employment by giving weight to
preventing a build-up of financial imbalances. Experience shows that the likelihood of a severe
economic downturn increases when financial imbalances have built up. Economic downturns
caused by financial crises tend to be both deeper and longer than other downturns. If monetary
policy helps to restrain the build-up of financial imbalances, this may also mitigate the risk of
severe economic downturns further ahead.
The extent to which explicit weight should be placed on financial stability in interest rate setting is
state-dependent and must be based on an overall assessment of the outlook for inflation, output
and employment. In many situations, financial stability considerations will pull in the same
direction as the objectives of price stability and real economic stability. If the economy is
booming, with prospects for high inflation and a risk of a build-up of financial imbalances,
monetary policy tightening will accommodate all the considerations above. Likewise, lowering the
key policy rate in response to a severe downturn with increased bank losses will contribute to
sustaining activity and limiting bank losses.
In other situations, the different considerations will pull in opposite directions. If there are
prospects that inflation will be too low amid rising debt and house prices, it may be appropriate to
give weight to real economic stability considerations and bring inflation back to the target
somewhat more slowly.
In recent years, Norges Bank has kept its key policy rate somewhat higher than implied by a
short-term goal of inflation and output stability would in isolation suggest. This has occurred in an
environment of low global interest rates and where a build-up of financial imbalances has
increased the likelihood of inflation, output and employment volatility further out. This does not
mean that asset prices or debt have been given independent roles as target variables of
monetary policy. The decisive factor has been the consideration of economic stability over time.
A monetary policy that "leans against the wind" can entail costs in the form of lower demand and
inflation in the short run. In the practical conduct of monetary policy, these costs must be
weighed against the benefits. The main responsibility for counteracting financial imbalances
cannot lie with monetary policy. If monetary policy seeks to pursue goals beyond its reach, the
credibility of monetary policy will gradually weaken. Regulation and oversight of financial
institutions must therefore continue to be the first line of defence against shocks to the financial
system.
In the proposal on a new central bank act, Norges Bank is given a clear responsibility for
promoting financial stability. Norges Bank interprets the proposal to mean that the responsibility
the Bank already has for promoting financial stability in a broad sense will be formalised. The
Bank's responsibility and work in this field have evolved over time, but the work on financial
stability has gained importance particularly after the financial crisis, as it has for other central
banks.
As noted in the Commission's report, Norges Bank cannot alone ensure the "stability of the
financial system". The main responsibility for financial stability rests with the Government, while
the Ministry of Finance, the Financial Supervisory Authority of Norway and Norges Bank are
responsible for the use of the various instruments delegated to them. Norges Bank is among
other things lender of last resort and operates the interbank settlement system.
The overriding responsibility for macroprudential policy rests with the Ministry of Finance. Norges
Bank holds the view that a clearer framework for setting and using macroprudential instruments
is needed in Norway. Time-varying macroprudential instruments could to advantage be delegated
to an independent authority. Delegating instruments to an independent authority could facilitate
implementation and enhance predictability over time. It could also ensure that the decision is
taken in the interests of financial stability.
Today Norges Bank draws up the decision basis for the countercyclical capital buffer and
advises the Ministry of Finance on the level of the buffer. The Commission proposes that
decision-making responsibility for the level of the countercyclical capital buffer be delegated to
Norges Bank. Norges Bank supports this proposal.
The Commission also suggests that it may be appropriate for Norges Bank to assume
responsibility for other instruments to mitigate systemic risk in the financial sector. The
Commission refers in particular to the residential mortgage lending regulation. This regulation
also serves other purposes in addition to the mitigation of systemic risk. Norges Bank will
contribute with advice on the design of regulations in this area, but the Bank should not be
formally responsible for regulations that include provisions on banks' business practices and
consumer protection. This should be the responsibility of the Ministry of Finance.
Organisation of the GPFG and central banking functions
Chart: Number of employees in Norges Bank
The organisation of Norges Bank has changed considerably over time, particularly over the past
20 years. While central banking activities have been concentrated on core functions, Norges
Bank has built up an investment management organisation that is responsible for managing the
equity, bond and real estate portfolios of the GPFG.
The Central Bank Law Commission proposes to remove the GPFG from the aegis of Norges
Bank. The Commission recognises that the Bank has managed the GPFG and performed its
central banking functions in a satisfactory manner. At the same time, the Commission points out
that the GPFG would stand to gain from being placed under the management of a separate
organisation with a board whose sole area of responsibility is investment management.
In recent years, the investment mandate has been changed to give the Bank greater
responsibility for determining the GPFG's investment strategy. Investment management has also
become more demanding in terms of resources for both the Executive Board and the
organisation. In addition, the Bank has been given responsibility for decisions to exclude
companies or place them under observation for ethical reasons. The Bank has been able to take
on these tasks by further developing the governance structure and the organisation. If
responsibility for the management of the GPFG remains with the Bank, the existing investment
mandate could serve as a basis for the future development of the GPFG. Norges Bank is well
equipped to continue to carry out this task.
The future organisation of the GPFG should be assessed in conjunction with the future
development of the investment strategy. As noted by the Commission, a number of strategic
decisions can be left to the manager while at the same time expanding the investment strategy to
include new unlisted asset classes. Prospective developments along these lines could suggest
that the management of the GPFG should not be organised within the central bank.
In addition to proposing that the management of the GPFG should be placed in a statutory entity
separate from the Bank, the Commission also proposes substantial changes to the Bank's
governance structure. These changes include the establishment of a committee for monetary
policy and financial stability that would be responsible for the use of instruments in these areas
and would be chaired by the Governor of Norges Bank. Moreover, the Commission proposes the
establishment of a board of Norges Bank solely comprising external members. The Commission
proposes that this board should be responsible for central banking matters that do not fall within
the remit of the committee and for operational, budgetary and administrative matters.
The arguments for establishing a committee for monetary policy and financial stability are
weaker, in Norges Bank's view, if the GPFG is separated from Norges Bank. Without
responsibility for the GPFG, the Board's range of responsibilities will be substantially reduced.
In addition, dividing responsibility for central banking matters between the two bodies will pose
challenges, particularly with regard to the division of work and reporting. The central bank's core
functions are closely intertwined and must be viewed as a whole, as experienced during the
financial crisis. A solution where responsibility must be transferred from the board to the
committee in critical situations, as proposed by the Commission, could give rise to a lack of
clarity and conflicts of competence. An important point in this context is that in the
implementation of the committee's tasks, the Governor will not be responsible to the board, but
will report directly to the Ministry of Finance on central banking matters.
If the management of the GPFG is removed from the aegis of Norges Bank, the Bank's function
will be to exercise authority with regard to monetary policy, financial stability and the payment
system. A board with broadly the same composition as at present would then function well.
Combining responsibility for central banking matters and administrative matters in this board will
place responsibility with the same body in both normal and crisis times. The consideration of
central bank independence also points towards this solution.
If the GPFG remains under the aegis of the Bank, Norges Bank acknowledges that there are
arguments in favour of establishing a committee for monetary policy and financial stability. Such
a committee would take over the board's central banking matters, allowing the composition of the
board to be more closely tailored to tasks specifically related to investment management. If this
solution is chosen, the Executive Board is in favour of a model based on today's governance
structure for Norges Bank.
Conclusion
Norges Bank has been an important public institution, acting in the national interest, for over 200
years. Important core functions have been performed by the Bank from the very beginning.
Norges Bank is responsible for safeguarding the value of money and promoting economic
stability. At the same time, the Bank's mandate and the society in which the Bank operates have
changed over time. Some functions have been eliminated altogether over the years: there is no
longer any need for the Bank to follow up the strict credit and exchange rate regulation of the
past, and the manufacture of banknotes and coins has been outsourced. Other functions have
been added, one of which is the management of the GPFG.
Norges Bank is used to change. With 200 years of history behind us, the Bank has the
professional capacity and experience to perform its tasks efficiently, even when the Bank's
functions and the external environment change. No matter how the Commission's concrete
proposals are followed up, I am confident that Norges Bank will continue to be a useful public
institution.
Official Norwegian Reports 2017:13. New central bank act. Organisation of Norges Bank and the Government
Pension Fund Global.