Ida Wolden Bache: The conduct of monetary policy
Introductory statement by Ms Ida Wolden Bache, Governor of Norges Bank (Central
Bank of Norway), at the hearing of the Standing Committee on Finance and Economic
Affairs of the Storting (Norwegian parliament) in connection with the Storting's
deliberations on the Financial Market Report, Oslo, 7 May 2024.
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Charts accompanying the speech
Thank you for this opportunity to provide an account of the conduct of monetary policy.
The global economy has been shaped by the turbulence of recent years. In the wake of
the pandemic and Russia's full-scale invasion of Ukraine, inflation reached
multidecade highs. Central banks worldwide responded by sharply raising policy rates. It has
long been feared that the fight against high inflation would lead to a sharp increase in
unemployment. Inflation has now slowed considerably, while employment is still running
high.
Much the same can be said to describe the Norwegian economy. When I spoke here in
May last year, the preceding year had been marked by a surge in inflation, and the
policy rate had been raised sharply and rapidly. Today, the situation is different.
Inflation is still higher than our 2 percent target but has slowed materially from its peak.
At the same time, economic activity has held up better than we had anticipated, and
unemployment remains low. These are welcome developments and make us more
confident that we can bring down inflation without a pronounced rise in unemployment.
Let me turn to the year behind us and the assessments we have made.
Chart: Wide differences across industries
The economy gradually cooled down through 2023, and growth is now low. Labour
market pressures have eased, and recruitment difficulties have diminished. At the same
time, there are wide differences across industries. The construction industry has been
particularly hard hit by the interest rate increases. Construction activity fell sharply last
year and has continued to fall so far this year. On the other hand, petroleum sector
investment remains buoyant. Industries supplying goods and services to the petroleum
sector are still faring well. Strong growth in public demand has also contributed to
sustaining economic activity.
Chart: Inflation markedly above target
Consumer price inflation hit 5.5 percent last year. The rate of increase in electricity and
fuel prices gradually fell, but excluding energy prices, consumer prices continued to rise
rapidly up to summer. Prices for both imported and domestically produced goods and
services increased sharply, and inflation turned out to be higher than we had expected.
In the wage settlement, the social partners agreed on a wage norm of 5.2 percent for
2023, which also turned out to be the rate of overall annual wage growth. By a good
margin, wage growth reached its highest level since 2008. Given the low growth in
productivity, the pay increases led to higher business costs.
Chart: The krone depreciated
In spring of last year, international interest rates reached the highest levels since the
2008 financial crisis, and main trading partners' policy rates rose to higher levels than
our policy rate. This likely contributed to a depreciation of the krone. Measured against
a basket of currencies of countries from which we import goods, the krone has
gradually lost value over recent years. If we look at developments against individual
currencies, the picture is more mixed. The US dollar has appreciated against many
currencies, including the krone. This illustrates that the krone depreciation is due not
only to conditions specific to Norway.
In many situations, a floating exchange rate can act as a cushion for the Norwegian
economy, as was the case when oil prices plummeted in 2014. At that time, the krone
depreciated markedly and contributed to lifting activity in the tradable goods sector. The
Norwegian economy could move on a different path than surrounding countries in the
future too, and a floating krone will be of benefit to our economy. A floating exchange
rate can reduce the cost of structural adjustments. Last year, however, amid weaker
growth prospects and already too high inflation, the krone depreciation made the
monetary policy trade-offs more challenging.
We do not have an exchange rate target for the krone. When we are concerned with the
exchange rate, it is because a weaker krone means an increase in prices for imported
goods. Moreover, a weaker krone can lead to higher activity and increased profits in the
export sector, which can in turn lead to stronger wage growth and contribute to a longer
period of high domestic cost inflation.
Chart: We have raised the policy rate more than envisaged
Our assessment at the beginning of 2023 was that we were approaching the policy rate
peak. But, in the course of spring, it became clear that a higher rate was required.
Unemployment had increased less than feared, while inflation had remained higher
than expected. At the same time, high wage growth and a weaker krone would continue
to push up inflation going forward. Towards summer, we therefore raised the policy rate
further and adjusted up the policy rate forecast.
Chart: We are not seeking to bring down inflation as fast as possible
Norges Bank is tasked with keeping inflation low and stable, while helping to keep
employment as high as possible. Low inflation and high employment are not conflicting
objectives in the long term. Low and stable inflation over time is a precondition for a
well-functioning economy, and in the long run it is not possible to achieve higher
employment by accepting higher inflation. But in the short run, when setting the policy
rate, there may be a conflict between the two objectives. Higher interest rates contribute
to reducing inflation, but rate increases also contribute to dampening economic activity
and can lead to higher unemployment. We are not attempting to bring down inflation as
fast as possible. We have consistently emphasised the aim of avoiding a sharp rise in
unemployment. The strong weight we give to employment is reflected in our forecasts
where it takes a long time for inflation to come down to the target.
We know that the interest rate increases have a cost and that they can have uneven
effects on different groups. Since we started raising the policy rate after the pandemic,
interest rates on housing loans have roughly tripled. On top of higher interest rates,
borrowers have faced steadily rising prices for most goods and services. Many people
might feel that we have made the burden even heavier.
When we have raised the policy rate, it is because the cost of not doing so would have
been greater. High and variable inflation entails substantial costs and adversely affects
low-income groups in particular. Norges Bank must react when there are prospects of
high inflation, independently of the source of the rise. If firms and the social partners
become accustomed to high inflation, and it becomes embedded in their price and
wage setting behaviour, inflation may become entrenched. If the FX market loses
confidence in inflation returning to target, the krone exchange rate could depreciate
substantially. More forceful tightening may then be needed later, with the risk of a
severe downturn with an increase in job losses. By maintaining confidence in low and
stable inflation over time, we are better equipped to deal with new shocks and periods
of turbulence in the future.
Since last autumn, inflation has slowed, to a large extent due to the reversal of the
conditions that triggered the rise in prices in the first place. International trade in goods
is flowing close to normal again, and freight rates, energy prices and prices for many
other commodities have fallen. But a tighter monetary policy has also contributed. If we
had not raised the policy rate, inflation would have been higher, among other things,
because the krone would have been weaker.
And, we have not yet reached the target. We still have a way to go before inflation is
back to 2 percent. High wage growth and the krone depreciation are contributing to
keeping inflation elevated. We must be prepared for the possibility that the last mile of
disinflation may take time and that headwinds may arise.
Chart: Global disinflation has slowed
Global disinflation has slowed. This has led to a change in financial markets'
assessment of interest rate prospects. While a few months ago there were expectations
of early and rapid rate cuts, the market now expects major central banks to leave policy
rates unchanged for longer in order to bring inflation down to their targets.
In December, we raised the policy rate to 4.5 percent, where it has since remained.
When we set the policy rate, we seek to strike a balance between different
considerations. An overly tight monetary policy will contract the economy more than
necessary. That is something we want to avoid. But if the policy rate is lowered
prematurely, prices may continue to rise rapidly, among other reasons, because the
krone could depreciate.
In our assessment, the policy rate is sufficiently high to tackle inflation. At the same
time, there will likely be a need to maintain the policy rate at today's level for some time
ahead. If a further rate increase is judged necessary to bring inflation down to target
within a reasonable time horizon, the Committee is prepared to raise the policy rate
again.
As inflation recedes further and economic conditions so warrant, we can gradually lower
the policy rate. Our latest forecast implied a policy rate of just below 3 percent at the
end of 2027, which is a good deal higher than it was before the onset of the pandemic.
Developments in recent years have reminded us that the outlook can change abruptly.
The future will also see unexpected events. Moreover, we must be prepared for the
eventuality of larger and more frequent shocks than we experienced in the decades
prior to the pandemic. The security policy backdrop is serious. Russia's war against
Ukraine is a threat to peace and stability in Europe. A humanitarian catastrophe is
unfolding in Gaza. Conflicts and political tensions between countries heighten the
uncertainty surrounding economic developments. At the same time, the economy and
financial markets are increasingly being impacted by climate change and measures to
reduce climate emissions.
These trends will pose challenges to all areas of economic policy, including monetary
policy. In my view, Norges Bank's mandate, with flexible inflation targeting, provides a
sound basis for meeting potential challenges ahead. Extreme weather and measures to
accelerate the climate transition can have a large impact on individual prices. With
flexible inflation targeting, we can see through temporary changes in inflation. But
ensuring low and stable inflation over time will continue to be the most important
contribution monetary policy can make to supporting the transition.
Last week, we published an update of our monetary policy strategy. The strategy
describes how the Committee interprets its mandate and how monetary policy will
respond to different shocks that could hit the economy. When the strategy was first
adopted in 2021, global interest rates and inflation had been low for an extended period
of time. In recent years, monetary policy has faced a different set of challenges. The
updated strategy articulates that we interpret our mandate to mean that considerable
weight shall be given to employment - also at times when inflation deviates significantly
from the target. Both this clarification and the overall strategy are consistent with our
conduct of monetary policy in response to the cost shock that hit the economy two
years ago and does not entail a change in the conduct of monetary policy.
Chart: Revised forecasts
Notwithstanding, there are lessons that both we and other central banks can take
forward. We must acknowledge that our forecasts have not been that accurate in recent
years. We are therefore exploring how we can improve our models and analyses. We
are in the process of establishing a new data platform that will enable us to make better
use of new data sources in our analytical work. We will also continue to reach out and
listen to feedback going forward. The goal is to establish the best possible basis for
making good decisions also when uncertainty is high, and to adapt monetary policy
rapidly to a shift in the outlook.
Let me conclude.
Chart: In our assessment, the policy rate is sufficiently high
The past years have served as an important reminder. We cannot take low and stable
inflation for granted.
Since inflation surged in the wake of the pandemic, we have raised the policy rate
significantly, and it now appears that the inflation peak is behind us. Interest expenses
will be high for a period, but most people will likely see an improvement in their
purchasing power and an easing of debt burdens. Nonetheless, we must be prepared
for a modest increase in unemployment and challenging times for some industries
before the situation turns around. But our current assessment is that inflation will return
to target without a pronounced increase in unemployment.
We consider that the policy rate is sufficiently high to bring inflation back to target within
a reasonable time horizon. But the outlook is highly uncertain - not least amid elevated
global political tensions. We can never make a promise as to the future path of the
policy rate. What we can promise is to do our utmost to reach the objectives assigned
to us.
I now look forward to answering any questions you may have.