Svein Gjedrem: The role of the Central Bank
Address by Mr Svein Gjedrem, Governor of Norges Bank (Central Bank of Norway), to the Fafo
Institute for Labour and Social Research and the Norwegian Power and Democracy Project, Oslo,
6 September 2002.
* * *
The way in which economic policy is oriented today reflects the experience gained and the lessons
learned in the 1970s and 1980s. In Norway, efforts to develop an economy under strong centralised
coordination and control culminated in the 1973 proposal1 to establish an incomes policy council.
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 was logical. It was the last wall in the building that
was constructed after the war. Coordination and control were important key words. Other components
were:
• fiscal policy oriented towards full employment
• regulation of credit 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 proposal to establish an incomes policy council did not receive support. There was just too much
control and coordination. Now, only 30 years later, very little of this system remains. The building 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 of wage formation is probably of greater
importance. The direct regulation of credit, interest rates and capital movements broke down 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 the management of ownership has been
totally revised following the negative experience of companies in Kongsberg, Mo i Rana and
Syd-Varanger.
I would like to highlight two factors that have taken on considerable importance for economic policy.
One of these factors is that economic agents look to the future when they make decisions about
consumption and investments, wages and prices, and want to take account of economic policy not
only as it is today, but also as they expect it to be tomorrow and in the future. This is particularly
evident in foreign exchange and financial markets, where exchange 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 and interest rates, change. It is thus important that the
authorities do not sow doubt, but on the contrary act in a long-term and predictable manner. The
authorities must be credible and inspire confidence. There must be a good match 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 in 1986.
The other 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 plan for the use of petroleum revenues. Attempts to use the central
government budget to fine-tune economic activity may, at worst, have a destabilising effect if these
attempts are perceived as being a departure from the long-term plan for the phasing in of petroleum
revenues. It is necessary to show that fiscal policy can be applied symmetrically in periods of
economic expansion and contraction.
A year and a half ago, the Government and the Storting adopted new guidelines for economic policy,
which call for an annual use of petroleum revenues equivalent to the expected real return on the
Government Petroleum Fund. At the same time, the Government issued a new operational mandate
for monetary policy. Norges Bank shall set the key rate with a view to maintaining low and stable
inflation.
Monetary Policy Regulation (1)
• Monetary policy shall be aimed at stability in the
Norwegian krone's national and international value,
contributing to stable expectations concerning
exchange rate developments. Monetary policy shall
also underpin fiscal policy by contributing to stable
developments in output and employment.
Norges Bank is responsible for the implementation of
•
monetary policy.
Fafo og Makt- og demokratiutredningen 6. september 2002
Norges Bank's mandate reads as follows:
Monetary policy shall be aimed at stability in the Norwegian krone's national and international value,
contributing to stable expectations concerning exchange rate developments. At the same time,
monetary policy shall underpin fiscal policy by contributing to stable developments in output and
employment.
Monetary Policy Regulation (2)
Norges Bank's implementation of monetary policy
•
shall, in accordance with the first paragraph, be
oriented towards low and stable inflation. The
operational target of monetary policy shall be
annual consumer price inflation of approximately
2.5 per cent over time.
Fafo og Makt- og demokratiutredningen 6. september 2002
Norges Bank's implementation of monetary policy shall, in accordance with the first paragraph, be
oriented towards low and stable inflation. The operational target of monetary policy shall be annual
consumer price inflation of approximately 2.5 per cent over time.
The first paragraph of the mandate sets forth an objective. The last paragraph specifies what Norges
Bank shall do.
The first sentence in the mandate refers to the value of the krone. Stability in the national value of the
krone implies that inflation must be low and stable. Low and stable inflation fosters economic growth
and stability in financial and property markets.
The regulation also states that monetary policy shall be aimed at stability in the international value of
the krone. The krone exchange rate fluctuates from day to day, from week to week, and from month to
month. We have free international trade and free capital movements. We do not have the instruments
for fine-tuning the exchange rate. But when monetary policy is oriented towards low and stable
inflation, this will contribute to a stable krone exchange rate over time.
Relationships in monetary policy
Imported
Exchange rate
price inflation
Norges
Bank's
Consumer
interest
price
rates
inflation
Consumption
Wages and margins
Investment
Labour market
Fafo og Makt- og demokratiutredningen 6. september 2002
The interest rate influences inflation indirectly via domestic demand for goods and services and via its
effect on the exchange rate. When interest rates rise, it is more profitable to save and more costly to
borrow. This has a dampening impact on consumption and investment. Lower demand in turn curbs
the rise in prices and wages.
Higher interest rates also make it more attractive to take krone positions and borrow in foreign
currency. As a result, higher interest rates normally lead to an appreciation of the krone. This reduces
prices for imported goods. In addition, a strong krone curbs activity, profitability and the capacity to
cover labour costs in the internationally exposed sector.
Implementation of monetary policy
• If it appears that inflation will be higher than 21⁄2 per
cent, with unchanged interest rates, the interest rate
will be increased.
If it appears that inflation will be lower than 21⁄2 per
•
cent, with unchanged interest rates, the interest rate
will be reduced.
• It is just as important to avoid a rate of inflation that
is too low as it is to avoid a rate that is too high.
Fafo og Makt- og demokratiutredningen 6. september 2002
The mandate implies that the interest rate must be adapted to the outlook for the Norwegian economy.
If it appears that inflation, with unchanged interest rates, will be higher than 21⁄2 per cent, the interest
rate will be increased. If it appears that inflation, with unchanged interest rates, will be lower than
21⁄2 per cent, the interest rate will be reduced. This orientation of monetary policy will normally also
contribute to stabilising production and employment.
Monetary policy functions with considerable and variable lags. The current inflation rate does not
provide sufficient information to determine the level at which interest rates should be set now. Our
analyses indicate that a substantial share of the effects of an interest rate change will occur within two
years. Two years is therefore a reasonable time horizon for attaining the inflation target.
It is nevertheless conceivable that in a situation with a high rate of inflation and weak economic
developments, Norges Bank may decide to apply a somewhat longer time horizon than two years to
reach the target of 21⁄2 per cent. Nor do we need to be in any hurry to raise the level of inflation in a
situation where inflation is very low, while economic activity is high. By influencing inflation over time,
monetary policy will not in itself cause unnecessary disturbances in the economy. A precondition for
applying a longer time horizon is that financial market participants have strong confidence in low and
stable inflation over time, and that wage formation has a nominal anchor.
Flexible inflation targeting provides a framework for the use of monetary policy instruments that both
ensures that the economy has a nominal anchor and allows monetary policy to smooth fluctuations in
the economy that are due to changes in demand for goods and services. At the same time, the
budgetary guidelines state that "...[in fiscal policy] considerable emphasis must be placed on
stabilising fluctuations in the economy with a view to ensuring appropriate capacity utilisation and low
unemployment."2 We can see here that there is an overlap between the tasks monetary policy and
fiscal policy are intended to perform. This naturally raises the issue of whether there is after all a need
to coordinate fiscal and monetary policy decisions.
Is there, for example, a risk of a situation arising where Norges Bank tightens monetary policy to
achieve the inflation target, while at the same time the central government authorities increase the use
of petroleum revenues (more than implied in the fiscal policy guideline) in order to increase
employment and reduce unemployment?
There are various factors that can prevent the interplay between monetary and fiscal policy from
functioning.3 Interplay functions well when the decision-making bodies are conscious of how one
body's decisions influence the decisions of the other. Unless this fact is recognised, a decision will not
produce the result that was planned. The economy may move in a very undesirable direction, with
4
high interest rates, sluggish economic growth and deterioration in the state's financial position.
However, even without continuous coordination, a fairly good result may be achieved if fiscal policy
acts as "leader" and monetary policy as "follower", to use expressions taken from game theory.5 The
authorities determine fiscal policy knowing how monetary policy will react. Today's flexible inflation
targeting establishes a firm framework for monetary policy and provides clear guidelines on how
monetary policy is to respond in different situations. The fiscal policy authorities can internalise the
monetary policy response pattern. This is only natural, since the mandate for monetary policy was laid
down by the Government and the Storting.
In other words, the conditions exist for delegating the interest rate decision, but the central bank's
response pattern must be known, so that the fiscal authorities can take this into account.
When the response pattern in monetary policy is known and remains unchanged over time, the social
partners can also take any monetary policy response into account when wages are being determined.
The "leader" in this interplay - the social partners - can take the "follower's" - Norges Bank's - response
into account. This view is most relevant in centralised wage formation. In decentralised wage
formation, monetary policy will instead affect wage growth via market mechanisms by stabilising
aggregate demand. The current monetary policy guidelines will function well whether wages are
determined centrally, locally or individually.
The outcome of this year's wage settlement, and the debate that followed, may indicate that the social
partners have not yet internalised the response pattern in monetary policy ensuing from the mandate
laid down by the Government and the Storting. Perhaps a stumbling block has been the choice of
wage settlements at industry level and the large wage increases for employees outside the two largest
employer/employee organisations (NHO and LO). On the other hand, the choice of settlement type is
probably influenced by the participants' assessment of the economic outlook. The high wage growth
awarded to groups whose wages are determined through individual agreements indicates that the
labour market has been tight. However, the rise in salaries for white-collar workers may also reflect
weak cost control in enterprises and organisations following a long period of expansion.
A precondition for interplay that functions well is that monetary policy is known and remains firm. The
best thing Norges Bank can do to contribute to good interplay between the various components of
economic policy and wage formation is therefore to be transparent about its analyses and
assessments of economic developments.
Labour costs in Norway and among trading partners1)
Percentage growth
7 7
Norway
6 6
5 5
4 4
3 3
Trading partners
2 2
1 1
0 0
1993 1995 1997 1999 2001 2003
1) Hourly labour costs in manufacturing
Source: Statistics Norway, TRCIS/IMF and Norges Bank
Fafo og Makt- og demokratiutredningen 6. september 2002
For a long time, a stable exchange rate and labour costs among our trading partners formed an
anchor for wage determination. Since 1998, however, the rise in labour costs in Norway has been
around 2 percentage points higher than that of our trading partners. High wage growth, combined with
the global downturn and a strong krone, is having a severe impact on manufacturing.
Sustainable wage growth
The 'Solidarity Alternative' (Aukrust model)
•
Wage growth among trading partners 3-4 per cent
(+Productivity growth in Norway - productivity growth abroad 0
= Scope for wage growth in Norway 3-4 per cent
Inflation target
•
The Government's inflation target 21⁄2 per cent
+ "Normal" productivity growth 2 per cent
= Scope for wage growth in Norway 41⁄2 per cent
Fafo og Makt- og demokratiutredningen 6. september 2002
Over time, growth in real wages must be consistent with growth in labour productivity. An inflation
target of 21⁄2 per cent and trend productivity growth of around 2 per cent, according to updated national
accounts figures, imply annual nominal wage growth of about 41⁄2 per cent. These figures are
consistent with developments in the 1990s, when wage growth averaged 41⁄2 per cent. This resulted in
inflation of 21⁄2 per cent. The krone exchange rate was stable.
In general, an unexpected upward shift in labour costs will prompt an increase in interest rates in order
to avoid higher inflation. With a floating exchange rate and unchanged interest rates, an increase in
wage growth of one percentage point will eventually translate into a comparable increase in price
inflation, unless this increase is based on higher productivity. The magnitude of the interest rate
increase must be adapted to this. First, the nominal interest rate must be increased to maintain the
real interest rate. Second, the real interest rate must also be increased in order to prevent inflation
from accelerating.
2)
Key rates and rise in labour costs1)
Per cent
Key rates
September
2002
Iceland
8
Norway2)
6
Sweden
4 Denmark UK
Euro area Finland
2
US
Japan
0
0 2 4 6 8
Rise in labour costs, 1998-2002
1) Hourly wage growth in manufacturing
2) Figures for Norway from the Technical Reporting Committee on Income Settlements
Sources: OECD, TRCIS and Norges Bank
Fafo og Makt- og demokratiutredningen 6. september 2002
When wage growth reaches a level that is inconsistent with the inflation target, the result over time will
be higher interest rates, lower employment and higher unemployment. Similarly, lower wage growth
will normally result in lower interest rates, higher employment and lower unemployment. There is a
relationship between wage growth and interest rates. The lower wage growth is, the lower interest
rates will be, and vice versa. Japan represents the one extreme, with an interest rate of zero and no
wage growth. At the other extreme are Iceland and Norway, with high wage growth and a high key
rate.
Annual wage growth1) and unemployment2)
Per cent
8 8
Annual wage
growth
6 6
4 4
Unemployment rate
2 2
0 0
1 9 9 3 1 9 9 5 1 9 9 7 1 9 9 9 2 0 0 1
1)
Average for all groups, including the cost of additional vacation days
2)
Registered unemployed and on labour market programmes as a percentage of the labour force
Sources: TRCIS, Directorate of Labour and Norges Bank
Fafo og Makt- og demokratiutredningen 6. september 2002
High wage growth affects the exposed business sector in two ways. First, it erodes earnings and
reduces employment. Second, monetary policy has to be tightened. This leads to an appreciation of
the krone, with a further reduction in earnings and employment.
Annual wage growth in enterprises in the
Confederation of Norwegian Business and Industry
8 8
Salaried
employees1)
6 6
Total employees1)
4 4
2 2
0 0
1 9 9 3 1 9 9 5 1 9 9 7 1 9 9 9 2 0 0 1
1) Includes costs of additional vacation days
Sources: TRCIS and Norges Bank
Fafo og Makt- og demokratiutredningen 6. september 2002
It is combined wage growth for all groups that influences the outlook for inflation. However, substantial
wage increases for some groups can trigger wage spirals. Wages for salaried staff in the business
sector have exhibited sharp growth over several years. This year, it appears that wage increases will
be especially high in the public sector and in parts of the private service sector.
Although it is too early to draw final conclusions, there are some indications that wage formation in
Norway is changing:
• The social partners do not appear to be placing as much emphasis as previously on
developments in wage growth among our trading partners.
• There are also signs that the social partners may be placing less emphasis on the impact on
total unemployment when negotiating wages.
• Some features of this year's wage settlement point to a somewhat greater degree of
decentralisation in wage formation. An example of this is the municipal sector, where the
Federation of Professional Associations will, as from this year, hold local negotiations on pay
increases. On the other hand, centrally negotiated pay increases were very high this year.
• In public sector wage settlements, little emphasis appears to have been placed on the
assumptions concerning wage growth on which government allocations are based. This has
a negative impact on service production in many areas of the public sector.
The experience of this year's wage settlement also indicates that profitability in the internationally
exposed sector has been given less emphasis in wage negotiations than earlier. A shortage of labour
in more sheltered industries may thus have a greater influence than previously on overall wage
growth. Inflation would then be determined by domestic factors to a greater extent than in the past.
The Norwegian economic system has undergone substantial changes over the past ten to twenty
years. The model based on detailed control of capital, credit and interest rates and centralised
coordination has been abandoned. Less emphasis is placed on having discretionary scope for
manoeuvre and on using surprise decisions to influence economic developments. It is recognised that
the structure of the labour market and of wage formation has a decisive impact on developments in
employment. Monetary policy is delegated in Norway and in comparable countries. The monetary
policy guidelines provide a foundation for building credibility and creating confidence in economic
policy, thereby making it more effective.