Jarle Bergo: The basis for inflation targeting
Speech by Mr Jarle Bergo, Deputy Governor of Norges Bank (Central Bank of Norway), at the Foreign
Exchange Seminar of the Association of Norwegian Economists, Sanderstølen, 21 January 2005.
Please note that the text below may differ slightly from the actual presentation. The speech does not contain new assessments
of the economic situation or of current interest rate setting.
The references and the Charts in pdf-format can also be found on the website of the Norges Bank.
* * *
In 2004, the Norwegian Finn Kydland and the American Edward Prescott were awarded the Nobel
Prize in economic sciences. They received the prize for their theoretical studies in the 1970s on
economic policy rules and the importance of anchoring economic agents' expectations. Norway's
current economic policy, with an inflation target for monetary policy and a fiscal policy rule, is partly
based on the insights of Kydland and Prescott. But it is not just theory that has brought us here.
Practice and experience over the last 30 to 40 years have perhaps been just as important. In his book
"Doctrines and economic management in retrospect", Hermod Skånland, former Governor of Norges
Bank, points out that until the 1980s, the perception that government had to assume responsibility for
employment and that borrowing should be inexpensive contributed to both the currency crisis and the
banking crisis.1 Today's economic policy can be seen as a result of a long learning process where
academicians and the authorities have contributed.
First, I will discuss the historical and theoretical basis for the current monetary policy. I will then move
on to discuss monetary policy in practice and will also look more closely at the requirements inflation
targeting imply for our analytical tools.
Historical and theoretical basis for inflation targeting - lessons and experiences
In particular, two fundamental lessons from the last 30-40 years have taken on considerable
importance for economic policy in general and monetary policy in particular. We can, perhaps, say that
these lessons have led to a paradigm shift in economic policy.
One lesson is that if the authorities do not take into account that economic agents are forward-looking
when they make decisions about consumption and investment, wages and prices, this may have
adverse consequences. Agents take into account their expectations concerning future economic
policy, not only today's economic policy. It is thus important that the authorities do not sow doubt about
their objectives. They must act in a predictable and credible manner within a long-term framework.
There must be consistency between the stated objectives of economic policy and what is actually
done to achieve these objectives.
This is exactly what Kydland and Prescott pointed out in their pioneering work from 1977.2 Their work
was based on insights from the theory of rational expectations, an area where Robert Lucas, who
received the Nobel Prize in 1995, made a significant contribution.3 Economic agents will not
systematically misjudge what the authorities plan to do in the future. Kydland and Prescott showed
that room for manoeuvre in economic policy may have a price. The insight they provided was that
economic policy can achieve better results if the authorities can commit themselves to a
pre-established set of credible policy rules, rather than give themselves the possibility of changing
policy at any given time in the future. This was a fundamentally new insight compared with the belief
that the authorities had unlimited possibilities for managing the economy, a view that had dominated
economic policy in previous decades.
One example used by Kydland and Prescott is what can happen when the authorities impose heavy
taxes on capital today at the same time as they promise to lower taxes in the future. If firms believe
this, they will increase investment now. However, when the increased real capital stock becomes a
fact, the authorities may be tempted to disregard their promise of lower taxes. The purpose of reducing
taxes has already been achieved. A breach of promise may be accepted once. Having learned by
experience, however, economic agents will not believe this kind of promise unless the authorities
commit themselves to delivering what they promise. In order to function, policy must therefore be
timeconsistent and credible.
In Norway, the devaluation decade from 1976 to 1986 may be an example of economic policy that did
not fully recognise the role of expectations and the significance of credible policy rules. During this
period, the krone was devalued ten times if we also include "technical adjustments", which also implied
devaluation. The many exchange rate adjustments in this period were in part aimed at remedying the
deterioration of Norway's relative cost level, which in turn was related to the government's attempt to
take responsibility for employment also when the social partners failed to do so. Gradually,
expectations of a continued exchange rate policy that would maintain manufacturing's cost
competitiveness became widespread. This weakened the incentives for the social partners to keep
wage and cost inflation at a reasonable level. The devaluations contributed to high inflation. When it
finally became clear that this could not continue, it took many years before inflation was brought under
control and interest rates in Norway could be reduced to the level of interest rates in other countries.
The other lesson drawn from economic theory and economic policy in the 1960s, 1970s and 1980s
was that in the medium and long term it is not possible to reduce employment by accepting somewhat
higher inflation. An attempt to increase output beyond the level that is consistent with stable inflation
will over time lead to steadily rising inflation. Economic agents will eventually incorporate higher
inflation into their inflation expectations. In the long run, the result will only be higher inflation, not
higher employment. Output and employment will return to their supply-determined level. In the long
term, output is determined by the supply of labour, capital, technology and adaptability. Monetary
policy has little effect on these factors. In other words, there is no permanent trade-off between
inflation and output.
Very high inflation is a wartime phenomenon and a phenomenon of the 1970s and 1980s. Substantial
real economic losses have followed in the wake of high inflation. High and variable inflation impairs the
function of prices as an information vehicle. Over time, monetary policy can determine the inflation
rate. Low inflation is monetary policy's contribution to stable, high economic growth over time.
The responsibility for interest rate decisions was delegated to Norges Bank pursuant to the
amendment to the 1985 Norges Bank Act and through the change in its application in 1986. The
interest rate would no longer be an instrument of industrial or social policy. The last devaluation took
place in 1986 after a fall in oil prices. We then shifted to a fixed exchange rate regime. The Norwegian
economy had to go through an extensive turnaround operation. The objective of monetary policy was
to provide the economy with a nominal anchor. Confidence in the Norwegian krone had to be restored
in order to avoid persistently high inflation. This required very high interest rates. The fixed exchange
rate regime resulted in a gradual reduction in inflation and succeeded in providing the economy with a
nominal anchor.
However, fine-tuning the exchange rate proved to be an extremely demanding task. We had to
abandon the fixed exchange rate regime in December 1992. Important reasons were freer capital
flows, deeper financial markets and hence a surge in cross-border capital movements. Initially,
however, the krone exchange rate showed little change and quickly found a new range.
The exchange rate remained stable until autumn 1996, but gradually began to show wider fluctuations.
Developments in international financial markets led to more pronounced fluctuations. And more
fundamentally, exchange rate developments no longer provided signals to wage formation and fiscal
policy when labour market pressures mounted and incomes policy failed. High petroleum revenues,
fiscal slippage and expectations of increased use of petroleum revenues contributed to this. The
exchange rate was no longer appropriate as a nominal anchor. Norges Bank therefore placed
increasing emphasis on low and stable inflation in its conduct of monetary policy.
Petroleum revenues posed particular challenges to stabilisation policy. It became increasingly
challenging to smooth cyclical fluctuations by means of fiscal policy. The pressure on fiscal policy
made it appropriate to tie oneself to the mast to a further extent to protect petroleum revenues from
special interest groups. But this meant that monetary policy had to be given greater responsibility for
stabilising inflation, output and employment.
The response to this challenge was the revision of economic policy in spring 2001. The most important
policy change was the plan for phasing in petroleum revenues - the so-called fiscal rule. An inflation
target for monetary policy was introduced at the same time. We can now say that inflation targeting is
normal in small and medium-sized economies with financial markets that function relatively smoothly.
The fiscal rule and the inflation target can be seen as an answer to the problems raised by Kydland
and Prescott.
Inflation targeting in practice
Norges Bank operates a flexible inflation targeting regime, so that weight is given to both variability in
inflation and variability in output and employment in setting interest rates. Thus, we take into account
that monetary policy affects output and employment in the short term and that it is appropriate to take
this into account when setting the interest rate to reach the inflation target over time. Flexible inflation
targeting builds a bridge between the long-term objective of monetary policy, which is to keep inflation
at bay, and the task of real economic stability. The inflation target is a vehicle for, not an obstacle to,
monetary policy's contribution to smoothing fluctuations in the real economy.
The effect of monetary policy depends on market participants' expectations concerning future policy as
much as the central bank's interest rate decisions. It is primarily economic agents' interest rate
expectations that influence consumption and investment decisions - and consequently inflation. To be
successful, monetary policy must be capable of influencing expectations. Michael Woodford, a leading
academician in modern monetary theory, states the following in his book "Interest and Prices": "For
successful monetary policy is not so much a matter of effective control of overnight interest rates as it
is of shaping market expectations of the way in which interest rates, inflation, and income are likely to
evolve over the coming year and later. (...) It follows that, insofar as it is possible for the central bank
4
to affect expectations, this should be an important tool of stabilization policy."
As long as the central bank's behaviour is credible and predictable, an inflation target for monetary
policy can contribute to anchoring expectations of future inflation. This also contributes to providing a
basis for economic agents' interest rate expectations.
In the Inflation Report, Norges Bank provides its assessments of the outlook for economic
Inflation Report
developments. The chart shows Norges Bank's projections from 3/04, which was
published in November. The projections are conditional on the market's interest rate expectations.
This interest rate path is then assessed by the Executive Board on the basis of the derived projections
for inflation and the output gap. Since summer 2004, the Inflation Report has presented the Executive
Board's assessments of monetary policy in the next four-month period.
In the last Inflation Report, it was the Executive Board's assessment that the projections conditional on
the market's interest rate expectations seemed to provide a reasonable balance between the objective
of bringing up inflation, while avoiding excessive growth in output and employment. The previous
"the most appropriate alternative now seems to be that the
Inflation Report, from July 2004, stated that
interest rate should be kept unchanged for a longer period than indicated by market expectations."
After this, we saw that interest rate expectations fell.
By communicating our view concerning interest rate expectations, Norges Bank seeks to influence
interest rate expectations. The objective is for interest rate expectations to be consistent with
economic developments where inflation is on target over time and output is stable around its potential
level. Most often, however, there will be a number of ways to achieve this. We need some references
that provide some indication of whether a given interest rate path is reasonable. It is natural to turn first
to monetary policy theory.
In the theoretical literature, the trade-off between price stability and stability in the real economy is
often described as a problem of minimisation, where the central bank wants to minimise a loss
function, which includes variations in output and variations in inflation. The central bank shall then
choose the path for the interest rate ahead that minimises the expected discounted "losses" in all
future periods. In practice, no inflation-targeting central bank uses a loss function of this kind directly.
However, what they do contains elements of theoretical thinking. We try to set the interest rate so that
it provides a "reasonable balance" between the objective of stabilising inflation around the target and
the objective of stable developments in the real economy.
The theoretical framework provides limited concrete and easily communicable guidance. In practice, it
may be useful to have some simple points of reference that can help us to evaluate whether an
interest rate path seems reasonable in relation to the monetary policy objective.
The most important task of monetary policy is to provide an anchor for inflation expectations. Norges
Bank sets the interest rate with a view to stabilising inflation at the target within a reasonable time
horizon, normally 1-3 years. Therefore, when evaluating the interest rate path, the most important
criterion is whether inflation reaches the target within this time horizon and remains there. If we do not
reach the target within this time horizon, there may be a risk that inflation expectations will gradually
move away from the target. This could weaken confidence in monetary policy and the inflation target
as a nominal anchor. For the same reason, inflation should also be moving towards the target well
before the end of the three-year period.
The inflation gap and the output gap should be in reasonable proportion to each other until closure.
This assessment must also take account of the substantial uncertainty surrounding the calculation of
the output gap, and of Norges Bank's mandate which specifies that inflation shall be 2.5 per cent over
time.
The inflation gap and the output gap shall normally not be positive or negative at the same time further
ahead. If, for example, both gaps are positive, a higher interest rate path would be preferable as this
would bring inflation closer to the target and contribute to stabilising output.
Depending on the initial situation for inflation and production, it may be difficult to meet these criteria
simultaneously. How easy it is to meet these criteria will depend on the disturbances to which the
economy has been exposed.
There are also other important considerations when assessing the interest rate path. We must assess
whether the interest rate path, at least in the next few months, results in acceptable developments also
under alternative, but realistic assumptions concerning economic developments and the functioning of
the economy. In other words, is the strategy robust? We must also evaluate the consequences for
financial stability.
Last, but not least, a successful monetary policy requires a reasonably good understanding of the
state of the economy and its functioning. I will now discuss this in more detail.
Analyses and models at Norges Bank
The Executive Board's assessments of various interest rate paths are based on projections of
economic developments, supplemented by other information and discretion. To provide you with some
insight into how we work when we make projections for the Norwegian economy, it may be practical to
use a tripartite approach: the short-term or current situation, the medium-term or projection period and
finally what we call the long-term. The dividing lines are not clearly defined, but are to some extent
overlapping as indicated in the chart.
Knowledge about the current economic situation is absolutely essential to making projections of
economic developments that are useful for monetary policy. We must form a picture of capacity
utilisation in the economy and whether it is increasing or decreasing. We must also try to identify the
driving forces or disturbances that influence developments. A macroeconomic model will be a useful
tool in this connection. Nevertheless, thorough analyses of available economic statistics are the most
important source when we are assessing the current situation.
To obtain a good picture of the current situation, it is important to consider developments in context
and to distinguish between genuinely new information and noise. There is always uncertainty
associated with statistics and the quality can vary depending on the source. Frequency and the time
from measurement to publication also vary considerably. Economic data are published with a time lag
and are often revised. A very useful cross-reference and alternative information channel to official
statistics is therefore our own regional network which consists of enterprises, organisations and local
authorities throughout the country. We engage in five rounds of talks each year with business and
community leaders concerning economic developments in their industries. All of this information
provides a basis for our analysis of the current situation. A large share of the overall resources used
for analyses and projections of the Norwegian economy is devoted to this work.
Based on experience and economic theory, we can assume that certain relationships will hold in the
long term. There is fairly broad agreement that monetary policy cannot affect the level of output and
employment over time. Therefore, it is reasonable to assume that output and employment over time
are determined by supply-side factors. At the same time, inflation is determined over time by monetary
policy. Both theory and experience indicate that in the long term, the real interest rate must be positive
and consistent with the growth potential of the Norwegian and international economy. Experience
shows that the real interest rate has generally ranged somewhere between 2 and 4 per cent. In
keeping with experience, we can assume that wage income, consumption and investment as a share
of production are fairly stable over time. Hence, we have some fairly robust reference points for the
economy in the long term.
In the work on medium-term forecasting, short-term developments are linked to our assessments of
long-term developments. In this context, a macroeconomic model can function as a bridge. Moreover,
a macro model can ensure consistency between important economic variables. As an alternative and
a cross-reference, we also make medium-term projections using a more detailed analysis of a number
of economic variables. Simple equations where the parameters are econometrically determined and
smaller systems of equations are used in this work. The baseline scenario that is published in the
Inflation Report is based on a discretionary overall assessment of the projections derived from the
model and the projections from the more detailed analysis. Thus, we do not use a macro model
mechanically. But a macro model can function as a reference and a guide while ensuring consistency
in the projections over time.
The value of a macro model depends on how useful it is for monetary policy assessments. Under an
inflation targeting regime, the focus is largely on risks, on understanding what type of disturbances to
which the economy may be exposed and on analysing the monetary policy response to various
disturbances. The recurrent question that we seek to answer is at what level the interest rate should
be set to bring inflation back to target and stabilise economic developments around trend. In the policy
analysis and the risk analysis, we look at the consequences for economic developments of alternative
assumptions about the interest rate, the current economic situation and the functioning of the
economy. Such analyses of alternative scenarios must be based on a macro model.
What are the requirements we set for a macro model? First, it is of particular importance that the
mechanisms in the model can be interpreted and communicated so that the model is perceived as a
sound tool, both in the internal process and in the Bank's external communication. In the policy
analysis, we also need a framework where the various disturbances can be interpreted and described.
The importance of analysing risks also means that we must be able to change the various model
mechanisms in a straightforward way. Moreover, the model must reflect the lessons that led to a
paradigm shift in economic policy. Expectations must therefore play an explicit role in the model. The
model must reflect that inflation is a monetary phenomenon in the long term and that monetary policy
provides the economy with a nominal anchor.
Norges Bank's macro models have played a key role in forecasting work over many years. The
models satisfy many of the requirements for a sound model, but the introduction of inflation targeting
revealed new needs that these models were not designed to meet. Developments in economics and
computational technology have also provided new possibilities for constructing and solving
macroeconomic models. Norges Bank has therefore started work on developing a new macro model.
An important purpose of constructing a new model is to expand our tool kit so that we are better
equipped to conduct policy analyses. I would therefore like to devote some attention to this model
here, also because it may help explain our thinking as to the functioning of the economy.
We have called the new macro model "Norwegian Economy Model", or abbreviated "NEMO". In the
work on developing the model, we have benefited greatly from our close cooperation with the IMF and
the Federal Reserve Bank of New York. We have also been inspired by and learned from the work of
a number of other central banks, for example in the UK, Sweden and Canada. In addition, we have the
benefit of a long history of model-building in Norway.
NEMO belongs to a class of macroeconomic models that tends to be referred to as DSGE models,
which stands for "Dynamic Stochastic General Equilibrium". The term dynamic means that the entire
path from the short term to the long term is modelled. The model is stochastic in the sense that the
economy is exposed to random disturbances. Such disturbances can, for example, stem from a
change in preferences, technology and market structure. General equilibrium implies that supply
equals demand at all times in all markets, but there may be considerable temporary deviations from
the long-term growth path.
A prominent feature of this type of model is that the behaviour of different economic agents is
modelled explicitly. Each model parameter therefore has its own economic interpretation. Households
maximise utility and choose the optimal distribution between work and leisure and between
consumption and saving. Firms maximise profit. The authorities have defined specific economic policy
objectives.
The first DSGE models were developed in the early 1980s, and were closely linked to real business
cycle theory which Kydland and Prescott pioneered. These models included elements of classical
theory such as perfect competition, flexible prices and market clearing. A main thesis of real business
cycle theory is that not only is long-term economic growth, but also the business cycle, driven from the
supply side, specifically by an uneven development in technology. Lags in the economy were linked to
real variables in these models, for example that it takes time to install new capital. A result of this
theory was that stabilisation policy is superfluous. The one-sided focus on technology shocks as a
driving force of the business cycle drew criticism from many economists.
The DSGE models have been further developed over the past decade and they have gained a more
prominent role. Important additions are Keynesian elements such as monopolistic competition and
nominal rigidities. Monopolistic competition means that firms have market power and set prices as a
mark-up on their marginal costs. In the more recent DSGE models, prices and wages are also rigid in
the short term, partly reflecting contracts and costs associated with price adjustments. These two
assumptions imply that production is determined by demand in the short term and that monetary policy
affects the real economy. Therefore, more recent DSGE models have features that combine elements
of both Neoclassical and Keynesian models. This body of theory is often referred to as the "New
Neoclassical Synthesis", but these types of models are also frequently called "New Keynesian". The
long-term properties of the models can be qualified as classical: Monetary policy can only influence
nominal variables, while production is determined by technology, preferences and the supply of factor
inputs. In the short term, the model has Keynesian features: Production is determined by demand.
Monetary policy can influence production and employment because it takes time to change prices and
wages.
NEMO will be quantified so that it reflects our perception of the central mechanisms that apply to
today's economy. In this process, we must combine our overall theoretical and empirical insight.
Econometrics and other empirical methods are used as an aid in providing us with insight into the
functioning of the economy. The strategy and methods that we use in this work are broad-based and
include traditional econometrics, insight gained from many years of work on the RIMINI model and
other Norwegian macro models, structural VAR models, Bayesian estimation techniques, analyses of
stylised facts and micro observations. Different approaches can yield different results. Discretion must
therefore always be exercised in quantifying the model.
We have not completed the work on quantifying the model parameters. I would nevertheless like to
illustrate how NEMO can already be qualitatively used as input in analysing the Norwegian economy.
During most of the 1990s and until 2002, inflation was close to the current inflation target. Consumer
price inflation in Norway declined sharply, however, through 2003 and into 2004. It is important to
understand the background for these developments. The most appropriate - or optimal - monetary
policy response will depend on underlying shocks or disturbances.
A number of factors seem to have contributed to pushing down inflation to such a low level. The
appreciation of the krone through 2002 contributed to a sharp fall in prices for imported consumer
goods. A shift in trade patterns and the cyclical downturn in the world economy may also have
contributed. Since mid-2003, however, a more subdued rise in prices for domestically produced goods
Inflation
and services was primarily responsible for reducing overall price inflation. In our Report, we
have pointed out that intensified competition in retail trade and other service sectors in recent years
may have contributed. In the first round, increased competition affects companies' profit margins
because prices are pushed down. Many companies have probably responded by rationalising
operations in order to cut costs.
Although there is probably no model that would a priori have captured the considerable disturbances
to which the Norwegian economy has been exposed, it is useful to be able to analyse the effects of
the disturbances after they have occurred. Therefore, let us use the model to look at the qualitative
effects of a fairly long-lasting increase in competition in product markets. The magnitude and duration
of the shock has been adjusted so that inflation in the model illustration falls by around 1 percentage
point. In the charts, all the variables are shown as deviations from a baseline scenario, i.e. a path for
economic developments without such a disturbance. The figures on the X-axis indicate the number of
quarters.
Increased competition reduces companies' possibilities for setting prices higher than marginal
production costs. This contributes to a reduction in prices. Owing to nominal rigidities, however, it
takes time for prices to adapt to increased competition. Therefore, inflation falls gradually.
The interest rate is reduced to counter the fall in inflation and to bring inflation back to the target.
Lower real interest rates combined with lower price inflation contribute to higher consumer demand.
Output increases to meet higher demand. Higher output increases demand for factor inputs such as
labour and capital. Therefore, the number of man-hours increases. Investment also rises as a result of
lower real interest rates. Increased demand for labour results in a tighter labour market and upward
pressure on nominal wages. Lower price inflation has the opposite effect. Therefore, nominal wages
may remain relatively stable, while real wages increase sharply. Thus, real marginal costs increase.
This will gradually contribute to pushing up price inflation. The prospect of higher inflation leads to a
gradual increase in the interest rate. An increase in real interest rates curbs demand. Since increased
competition is assumed to be only temporary in this illustration, there will be no permanent effects on
output. Therefore, the economy will gradually return to the baseline scenario.
Of course, we do not believe that increased competition alone can explain developments in the
Norwegian economy in the last couple of years. There have been many driving forces behind low
inflation and developments in output. Nevertheless, the developments resulting from the model
analysis are fairly consistent in qualitative terms with the picture we seem to be observing for the
Norwegian economy. Inflation and the interest rate are low. Real wages have risen and consumption
growth is high. Mainland investment and in particular housing investment have gradually increased
substantially. The number of man-hours worked has also picked up markedly, although employment
growth measured by the number of persons has been more subdued.
The model can thus support an assumption that increased competition in the Norwegian economy is
one of several driving forces behind low inflation. The model may also provide an indication of the
appropriate monetary policy response to such disturbances. However, let me again emphasise that
this model is still in the development process and that in addition to this model, we are also working on
other empirically-based analyses to understand relationships in the Norwegian economy. It is
important to have an abundance of tools so that we can combine different models and theories in our
economic analyses.
Conclusion
The lesson from Kydland and Prescott was that economic policy can achieve better results if the
authorities can commit themselves to a pre-established set of credible policy rules. The conduct of
monetary policy in Norway, as in many other countries, is delegated to the central bank with an
objective of low and stable inflation. The inflation target can be seen as an answer to the problems
raised by Kydland and Prescott.
However, inflation targeting probably places greater demands on our understanding of the way the
economy functions than earlier. Macroeconomic models are useful tools that can combine our
empirical and theoretical insights. But models cannot provide definitive answers to all the questions
that we as decision-makers face on a daily basis. Nor can they reduce the uncertainty surrounding
economic developments. Therefore, it is necessary to analyse the economy from different angles. We
must also look out the window, we must be prag