Mr Gjedrem focuses on monetary policy challenges in Norway
Article by Mr. Gjedrem, Governor of Norges Bank, the Norwegian central bank, published in
the Norwegian daily Aftenposten on 3 May 1999.
In Norway, fiscal policy has a prominent role in stabilising growth in production and
employment. The Government Petroleum Fund shall serve as a buffer so that fluctuations in
the government's oil revenues do not influence the mainland economy, but only have an effect
on capital exports. The local and centralised income settlements determine wage growth.
Monetary policy instruments are oriented with a view to maintaining a stable krone exchange
rate against European currencies.
If the government budget stabilises the domestic economy, wage growth is kept on a par with
the level in Europe, and fluctuations in oil revenues are absorbed by the Petroleum Fund,
Norges Bank stands a good chance of ensuring exchange rate stability through monetary
policy.
However, this has not been the case since 1996. The government budget has not made a
sufficient contribution to smoothing growth in domestic demand and production, wage growth
has been substantially higher than in other countries, and oil revenues have fluctuated widely.
Furthermore, it seems that the krone is easily exposed to the contagion effects of turbulence in
international markets. The krone exchange rate has fluctuated in spite of Norges Bank's active
use of instruments. Developments in recent years indicate that Norges Bank cannot fine-tune
movements in the krone exchange rate.
Instruments
Extensive and persistent exchange-market interventions to influence the krone exchange rate
have, in Norges Bank's experience, yielded poor results. Market participants may perceive
such transactions as an interesting opportunity to make a profit, which may trigger enormous
capital movements.
The interest rate is therefore Norges Bank's most important instrument. Higher interest rates
normally lead to a strengthening of the krone exchange rate. However, interest rates may reach
such a high level that this contributes to a cyclical downturn. This would undermine the
credibility of monetary policy and result in downward pressures on the krone. In this situation,
lower interest rates may contribute to stability and strengthen the krone.
Along the same lines, lower interest rates will normally lead to a weakening of the krone. But
if interest rates are so low that this contributes to inflation, this will also undermine monetary
policy credibility, and the krone will be unstable.
The objective and the mandate
Monetary policy can provide a nominal anchor for the economy. Since 1986 the authorities
have focused on exchange rate stability. Price inflation has been low. Yields on long-term
securities indicate no expectations of rising inflation. The perception of market participants
seems to be that Norway will not resume a policy resulting in high inflation.
The political authorities formulate Norges Bank's mandate for the conduct of monetary
policy. The mandate, formulated in the regulation issued in the spring of 1994, states: "The
monetary policy to be conducted by Norges Bank shall be aimed at maintaining a stable
exchange rate against European currencies, based on the range of the exchange rate
maintained since the krone was floated on 10 December 1992. In the event of significant
changes with a view to
in the exchange rate, policy instruments will be oriented returning the
exchange rate over time to its initial range. No fluctuation margins are established, nor is there
an appurtenant obligation on Norges Bank to intervene in the foreign exchange market" (my
italics).
The regulation is based on the fact that we have a floating exchange rate. The first sentence
means that this is a managed float. Instruments are to be oriented towards maintaining a stable
krone exchange rate against European currencies. Norges Bank chose to define the reference
European currencies as the euro from 1 January 1999.
The last sentence in the regulation distinguishes our system from a fixed exchange rate regime
in that no fluctuation margins have been established around a central rate. To the extent this
system calls forth associations with a fixed exchange rate regime, the concept initial range
should be interpreted as a broad indication of a central rate around which the krone can
fluctuate.
The second sentence refers to significant changes in the exchange rate in relation to the initial
range. It is important to note that no specific values have been defined for significant changes,
such as the fluctuation margins of 21⁄4 per cent, 6 per cent and 15 per cent used by the EU
countries in their exchange rate regime. Significant must be given an economic content. A
reasonable interpretation is that exchange rate movements must not influence expectations
concerning price and cost inflation to the extent that changes in the exchange rate become
self-reinforcing.
The expressions with a view to, over time, aimed at and based on also show that Norges Bank
has considerable scope for exercising discretion.
Exercising discretion
In exercising this discretion, Norges Bank places emphasis on the fundamental conditions for
achieving exchange rate stability over time. Price and cost inflation must be brought down to
the level aimed at by the euro countries. At the same time, monetary policy must not in itself
contribute to a deflationary recession.
The regulation's requirement with regard to returning the exchange rate to its initial range
may - if stretched - imply an element of "parity For example, in a scenario with a
policy"*.
sharp and prolonged fall in oil prices, the krone exchange rate may remain outside the initial
range for a longer period. If Norges Bank responds by raising interest rates in order to force
the krone back to its initial range, monetary policy could lead to a recession that will
undermine confidence in the krone. Similarly, after an appreciation a situation may arise
whereby a movement of the exchange rate back to the initial range may require that interest
rates be reduced to such a low level that this results in higher inflation. However, this would
weaken the basis for exchange rate stability over time. Hence, Norges Bank cannot with open
eyes orient its policy instruments towards triggering higher inflation or a deflationary
recession. If a situation arises whereby Norges Bank is not able to return the exchange rate to
its initial range without such consequences, the Bank will inform the government authorities
that measures other than those available to the central bank are required.
The present exchange rate range has more or less prevailed for more than ten years. On the
basis of its analyses, Norges Bank does not find grounds to maintain that this range is not the
appropriate one.
Interplay between policy areas
There are considerable differences between Norway and other industrial countries in the
structure of the economy, the organisation of decision-making processes and the formulation
of economic policy. In Norway, income and wage determination is fairly centralised; a
number of fora to foster cooperation between the social partners have been established, as has
special legislation which makes it easier to resolve labour conflicts than in many other
countries. The central government budget is used more actively to stabilise economic
developments, partly because the Norwegian state has substantially greater economic leeway
than other countries.
A salient feature of the Norwegian economy is the importance of oil revenues, which may
fluctuate considerably from year to year. The Government Petroleum Fund was established to
serve as a buffer against fluctuations in oil revenues. It dampens the impact of changes in oil
prices on the Norwegian krone.
In recent years, a number of countries have switched to a monetary policy regime based on a
target of low inflation. With a passive fiscal policy, monetary policy then in practice assumes
a greater role in the stabilisation of economic developments.
In Norway, we have a different institutional structure and monetary policy objective. When
the krone has been stable and inflation shows signs of rising, Norges Bank's first reaction is to
inform the political authorities that measures other than those available to the central bank are
required. Norges Bank would do the same if the requirement of returning the krone to its
initial range could no longer apply. In a country with an inflation target, the central bank
would deal with this itself, without first consulting with the government authorities. However,
as mentioned, Norges Bank cannot with open eyes inflate or deflate the economy.
Norges Bank's mandate must be viewed in the light of the emphasis placed by the government
authorities on conducting a disciplined, but active fiscal policy. The mandate gives Norges
Bank a basis for conducting a monetary policy that provides a nominal anchor for the
Norwegian economy.
*
As used in the Norwegian debate, "parity policy" refers to the monetary policy of the 1920s, when the
Norwegian krone was forced back to its former gold parity by means of highly deflationary policies.
(Footnote not included in Norwegian text).