Svein Gjedrem: The conduct of monetary policy
Introductory statement by Mr Svein Gjedrem, Governor of Norges Bank (Central Bank of
Norway), at the hearing before the Standing Committee on Finance and Economic Affairs of
the Storting (Norwegian parliament), Oslo, 14 May 2009.
Please note that the text below may differ slightly from the actual presentation. The statement is based on Norges
Bank's Annual Report for 2008, Monetary Policy Report 1/2009 and the Executive Board's assessments in the
period to the monetary policy meeting on 6 May.
* * *
I would like to thank the Chairman of the Committee for this opportunity to report on
monetary policy in connection with the Storting's deliberations on the Government's Credit
Report. My statement is based on Norges Bank's Annual Report, but is also updated based
on the Executive Board's assessments in the period to the previous monetary policy meeting
and new information received to date. I also refer to this year's report from Norges Bank
Watch, a group of experts that evaluates Norges Bank's conduct of monetary policy.
Monetary policy in Norway is oriented towards maintaining low and stable inflation. The
operational target is annual consumer price inflation of close to 2.5 per cent over time. The
inflation target is an anchor for inflation expectations in the foreign exchange market, for the
social partners in connection with wage settlements and for those setting prices for goods
and services. In recent years, average inflation has been fairly close to, but somewhat lower
than, the target of 2.5 per cent.
Consumer price inflation peaked in October 2008, and has since receded. In April this year,
CPI inflation was 2.9 per cent. Inflation measured by the CPI varies somewhat from month to
month, primarily reflecting wide fluctuations in energy prices, but also other temporary
disturbances amplify the variations.
CPIXE inflation shows developments in the consumer price index adjusted for tax changes
and excluding temporary changes in energy prices. This indicator provides a better picture of
underlying inflation. By this measure, underlying inflation peaked at 3 per cent last autumn.
Underlying inflation has since slowed somewhat and was 2.7 per cent in April.
Interest rates increase in favourable periods when inflation is expected to rise and when
growth and inflation recede. The interest rate is a rough instrument that we can use to keep
inflation in check over time and thereby contribute to smoothing fluctuations in output and
employment. We have seen that when the interest rate is increased to curb the rise in prices
for goods and services, interest rate-setting also contributes to stabilising asset prices. The
task of steering inflation is in itself a demanding one. The instrument at our disposable must
not be overburdened by too many tasks.
There is a division of responsibility for economic policy. Wage formation and economic
structures and incentives lay the basis for how efficiently labour and other real economic
resources are used in the long term. Monetary policy steers inflation in the medium and long
term and can in addition contribute to smoothing fluctuations in output and employment. The
central government budget - growth in government expenditure - influences the real krone
exchange rate and the size of the internationally exposed sector in the long term. The fiscal
rule - the fiscal policy guidelines - enhances the predictability of petroleum revenue
spending in the Norwegian economy even when the budget from one year to the next is used
to stabilise economic developments and even when the automatic stabilisers are allowed to
operate. A fairly steady phasing-in of petroleum revenues over time curbs the impact on the
krone and reduces the risk of abrupt and sizeable structural shifts between the international
exposed and sheltered sectors. In this way, the framework contributes to more stable
expectations concerning, among other things, developments in the krone exchange rate and
competitiveness.
The krone floats and fluctuates somewhat, and has shown a tendency to appreciate in
favourable times and fall in value in response to negative shocks. Nonetheless, budgetary
policy and the petroleum fund mechanism contribute to stability in the krone. This can be
seen clearly when comparing movements in the krone in recent years with currencies of
other open economies with substantial exports of raw materials, such as Australia and New
Zealand.
The economic turnaround in Norway occurred just over a year ago. House prices had started
to fall, growth in consumption subsequently came to a halt and housing starts declined. Up to
autumn 2008, it appeared that capacity utilisation in the Norwegian economy would most
likely decline to a normal level, inflation would stabilise around 21⁄2 per cent and the key rate
ahead could be held at what we consider to be a normal level - between 5 and 6 per cent.
But the outlook was regarded as uncertain. Commodity prices rose and pushed up inflation in
many countries. At the same time, wage growth in Norway had become high and productivity
growth was slowing. On the other hand, the financial turbulence, if it gained momentum,
could have a severe impact on the global economy and our exports.
In September 2008, the turbulence in financial markets erupted into a full-blown global crisis.
The failure of Lehman Brothers on 15 September last year triggered a confidence crisis in
financial markets.
The turnaround hit hard, with synchronised effects on virtually all financial and goods and
services markets, not only in the US but also in Europe, Asia, Latin America and Oceania.
The crisis abroad rapidly fed through to the Norwegian economy. Our banks and the flow of
credit and funds are tightly interwoven with foreign markets. Banks' foreign funding became
expensive and almost dried up. In response, banks increased interest rates on loans to
businesses and households, and they tightened the lending tap.
As autumn progressed, an increasing number of business sector segments were feeling the
impact of contraction. In August 2008, manufacturing enterprises in our regional network
reported that they expected growth to remain high. In November, they described the
turnaround as a "heart attack".
Government authorities worldwide have taken comprehensive measures designed to
improve banks' liquidity and solidity, boost demand for goods and services and restore the
smooth functioning of credit markets. In several countries, central bank benchmark rates
have been set at close to zero.
In Norway, a series of measures have also been implemented to mitigate the impact of the
financial crisis. Norges Bank has supplied more liquidity to banks and eased the collateral
requirements for loans. We have provided liquidity at longer maturities, introduced foreign
exchange swaps involving both the US dollar and the euro in order to supply Norwegian
krone liquidity, and loaned US dollars to Norwegian banks, which we ourselves procured
from the Federal Reserve. Norges Bank's key policy rate has been reduced by 4.25
percentage points to 1.5 per cent since 15 October 2008. To facilitate banks' access to
funding, the government has provided banks with access to liquid government securities in
exchange for covered bonds issued by mortgage companies. Moreover, the government has
increased loans and guarantees for Norwegian exports and raised state bank lending quotas.
At the same time, Folketrygdfondet has increased its bond purchases. In order to bolster
banks' solidity, the government plans to supply risk capital to Norwegian banks through the
Norwegian State Finance Fund. To restrain the decline in activity in the Norwegian economy,
central government expenditure will be increased by 10 per cent this year.
Pursuant to Chapter 1, § 3 of the Act on Norges Bank and the Monetary System, "the Bank
shall inform the ministry when, in the opinion of the Bank, there is a need for measures to be
taken by others than the Bank in the field of monetary, credit or foreign exchange policy".
On the basis of this provision, Norges Bank, in a letter of 6 October to the Ministry of
Finance, took the initiative to establish a swap arrangement. In a letter of 18 December, we
also proposed measures to strengthen banks' solidity.
The chart shows events and the measures and proposals at the initiative of Norges Bank. A
critical period was the end of September and the beginning of October with the collapse of
the investment bank Lehman Brothers, the savings bank Washington Mutual and the
insurance company AIG.
The extensive measures that have been implemented have worked.
The difference between Norges Bank's key rate and the money market rate - the premium -
has narrowed, but is still higher than prior to the crisis. The flow of interbank liquidity appears
to have been restored to some extent, but the money market is still segmented and the
central bank an important meeting place.
Even if premiums in the money market and credit market have been high and volatile, the
changes in central bank key rates have fed through to money market rates. Money market
rates, which were higher than 8 per cent for a period, are now around 21⁄2 per cent. Bank
lending rates have also been reduced markedly.
Monetary policy has influenced the level of economic activity through the real interest rate.
The real interest rate is equal to the key interest rate plus a risk premium less expected
inflation.
The anchoring of inflation expectations enables changes in the key rate to have an impact. In
some countries, there are prospects that inflation will approach zero. This causes the real
interest rate to remain high even though the key rate is reduced. In small countries where
confidence in stable inflation is lacking, the authorities have had to increase the key interest
rate substantially to prevent an uncontrolled currency depreciation. This amplifies the effects
on production.
Lower inflation abroad and lower capacity utilisation in the Norwegian economy will have a
dampening impact on inflation ahead. There are prospects that inflation will remain below 2.5
per cent for a period. It is therefore appropriate to set the interest rate at a low level so that
inflation does not fall too far below the target, and to prevent inflation expectations from
losing their anchor. It is also appropriate to set the interest rate at a low level to curb the
decline in activity.
We have already lowered the interest rate substantially. In the time ahead, we will take a
more gradual approach in order to assess the impact of the measures that have already
been introduced. If developments move in line with our projections, the key interest rate may
be reduced to 1 per cent in the latter half of this year.
However, the projections are uncertain. An economic turnaround may occur faster than
expected. The low interest rate level may lead to a situation where saving in Norway does
not pick up as expected or that the krone depreciates markedly. In that case, the key rate
may be set higher than projected at this time. On the other hand, there is a risk that the
downturn in Norway will be more pronounced and longer, or that krone appreciates
markedly. In that case, a stronger use of instruments may be appropriate.
The downturn abroad and the unusual conditions in the credit market will mark the
Norwegian economy for a period ahead. Mainland GDP is projected to decline by 1 per cent
between 2008 ad 2009.
Unemployment has increased since autumn 2008, but is still low. Unemployment is projected
to continue to rise to the end of the year and into next year. Pay increases are moderate as a
result of weaker corporate profitability, rising unemployment and lower inflation. Wage growth
will show a considerable decline between 2008 and 2009.
Households have a dimmer view of the future than earlier, but the pessimism is no longer
intensifying. This influences private consumption. Housing investment has also declined over
a period, but house prices now seem to have stabilised, and perhaps started to rise again.
Household saving is now rising rapidly from a negative level.
Banks' willingness to lend to households has stabilised after the tightening last autumn.
However, they are still tightening lending to enterprises. Banks are increasing their margins
and fees, and require higher equity capital levels of corporate loan applicants.
At the same time, funding in the securities market is expensive. The Government Bond Fund
facilitates funding primarily for enterprises with a moderate or high credit rating.
As a result of extensive official measures the banks now have fairly good access to
shortterm and medium-term funding. Norges Bank has supplied ample short-term liquidity to
banks. Loans with longer maturities have been widely used, and an increasing number of
banks are participating in the credit swap arrangement.
We see here an overview of various banks' and mortgage companies' use of this
arrangement as a percentage of their total assets. So far, there are 15 banks and mortgage
companies participating in the arrangement. Several participants report that the credit swap
arrangement is a good source of funding in today's market. The government receives, which
is reasonable, compensation for making Treasury notes available. The rate has been in the
order of a half per cent.
With a large volume of Treasury notes in circulation, we see the possibility of the formation of
an interbank market for loans in NOK, where government securities are used as collateral. In
the event, this would provide the Norwegian money market with greater insulation from the
shifting weather conditions in the US dollar market. We are not there yet.
Banks' equity capital accounts for 6 per cent of total assets. This is low from a historical
perspective, but not compared with banks in other countries. Banks are procyclical. They
amplify business fluctuations. During an expansion, loan losses are low and bank earnings
increase due to higher turnover. Capital is readily available. During a downturn, bank losses
increase, and earnings and access to equity capital may deteriorate, forcing banks to tighten
lending.
Norwegian banks need more capital in the period ahead to enable them to absorb expected
and any unexpected losses and to satisfy tighter counterparty capital requirements. The
government's offer to supply core capital through the Government Finance Fund will now
allow banks to improve their financial strength without rationing credit. There must be no
doubt that the banks have the capital they need.
The measures I have discussed have been implemented to lessen the effects of the financial
crisis. Another question is which lessons we can draw. The authorities in many countries are
now working towards increasing the robustness of financial markets. Four points stand out.
First, for a given risk assessment, banks must be subject to higher equity capital
requirements. Banks calculate their capital requirements based on internal risk models. The
models capture historical loan performance. The capital requirements are determined by the
degree of credit risk exposure as derived from this historical performance. One drawback is
that the historical basis for the models, and hence for the risk assessments, is too limited.
Banks must not be able to reduce capital below a minimum level even if they extend loans
that, according to the models, seemingly involve low risk.
Second, regulation must to a lesser extent contribute to amplifying cyclical fluctuations. With
losses now rising, as a result of the abrupt and pronounced turnaround, banks must increase
equity capital. Consequently, the rules governing capital requirements amplify cyclical
fluctuations. The rules must therefore require banks to build up strong capital buffers over
and above the minimum requirement in normal times. Then the banks would not have to
increase capital when a turnaround occurs, but on the contrary be able to absorb losses.
This will counteract the need for banks to ration credit in adverse periods.
Many Norwegian banks do not have sufficient buffers today to safeguard their own, their
shareholders' or the economy's best interests.
Third, banks' funding methods make them vulnerable. Earlier, the two main sources of bank
funding in Norway were retail and wholesale deposits. In recent years, banks have borrowed
heavily in both domestic and foreign markets. During the crisis, this proved to involve high
liquidity risk for banks. In the future, in regulations and in practice, deposits must again take
precedence as the largest funding source for banks. We also anticipate that bonds
collateralised by high quality mortgages will become important. The credit swap
arrangements can be seen as building a bridge to such a market.
Fourth, government authorities may be reluctant to apply stricter requirements to domestic
banks, fearing that their competitiveness may weaken. Such a drift in regulation towards a -
too low - minimum level is important to avoid. For Norway, it is essential that rules are
applied both strictly and equally in the Nordic countries.
Allow me to conclude.
The world economy is these days in the deepest recession in the post-war period, in spite of
the strong use of various measures. Most markets and countries, including Norway, have
been hit by the crisis.
Norges Bank has set the interest rate at a low level to curb the decline in activity and
counteract an excessive fall in inflation.
In accordance with its mandate, Norges Bank has given weight to anchoring and
strengthening expectations that inflation will be low and stable ahead. This enhances the
effectiveness of monetary policy.
Thank you for the opportunity to present these opening remarks.
BIS Review 60/2009
BIS Review 60/2009
BIS Review 60/2009
BIS Review 60/2009
BIS Review 60/2009
BIS Review 60/2009
BIS Review 60/2009
BIS Review 60/2009
BIS Review 60/2009
BIS Review 60/2009
BIS Review 60/2009