Speech

Monetary policy trade-offs in a small open economy - the
case of Norway

Introduction"

Good afternoon. Let me start by thanking the Peterson Institute for the invitation
and for giving me the opportunity to address this distinguished audience. It's a plea-
sure to be here.

[Chart: The tightening was synchronised across countries]

The tightening of monetary policy by central banks over the past few years has been
unprecedented in several respects. By some measures, this has been the most
globally synchronised of all tightening episodes in the past half century. [2]

In Norway, as in many other countries, global supply chain disruptions contributed
to arise in prices for a broad range of goods during the pandemic. When pandemic
restrictions were lifted, economic activity quickly rebounded. The high level of
household saving gave an additional impetus to demand. When Russia invaded
Ukraine in February 2022, energy and commodity prices soared. Since Norway is a
major exporter of oil and gas, those price increases constituted a positive terms-of-
trade shock, and they generated large inflows into the Norwegian government's
sovereign wealth fund, the Government Pension Fund Global. But at the same time,
the increases in energy prices contributed to pushing up domestic business costs
and spilled over into consumer prices.

[Chart: Policy rate at 4.5% to end of year, according to forecast]

Norges Bank started a gradual normalisation of interest rates in September 2021,
and our key policy rate now stands at 4.5 percent. The policy rate forecast in our lat-
est Monetary Policy Report in September implies that the policy rate will remain at
4.5 percent to the end of this year, before being gradually reduced from first quarter
2025.

The trade-offs we face as policymakers when setting interest rates depend not only
on the shocks that occur, but also on the relative strength of the different transmis-
sion channels of monetary policy. The transmission channels can vary both across
countries and over time depending on, among other things, institutional features of
labor and housing markets as well as the balance sheets of households.[3]

My remarks today will focus on one particular aspect of the monetary policy trans-
mission mechanism in Norway, namely the strong direct effect of monetary policy
on household spending operating through net interest expenses.[4] As I will return
to, the strong cash-flow channel combined with an unexpectedly large currency de-
preciation has created some particular trade-offs for monetary policy over the past
few years.

A strong cash-flow channel

[Chart: Large differences in pass-through of monetary policy to disposable income]

The cash-flow channel is likely to be stronger when households are more indebted
and when interest rates on outstanding debt are tightly linked to short-term rates.
Along both of these dimensions, there is a lot of variation across countries.[5]

Norway has over many years benefitted from revenues from our petroleum sector.
With more than 1.7 trillion dollars invested abroad through its sovereign wealth fund,
the Norwegian government is a large net lender. But Norwegian households are
among the most indebted in the world, with an average debt-to-income ratio of
close to 250 percent. Since the interest rate on 95 percent of home loans moves in
tandem with short-term money market rates, there is a fast and strong pass-through
of policy rate hikes to household disposable income.[6]

In the US, where fixed-rate mortgages account for more than 90 percent of home
loans, most of them with an initial 30-year fixation period, and the average house-
hold is less indebted than in Norway, the pass-through of higher policy rates to bor-
rowing costs can be expected to be much smaller in the short run. In fact, while the
policy rate has increased by more in the US than in Norway during the current tight-
ening cycle, interest payments as a fraction of income has increased by much more
in Norway.

[Chart: More indebted households respond more strongly to interest rate changes]

To gain more insight into the cash-flow channel, we have recently assembled a new
and unique dataset that combines rich information on household balance sheets
and income from tax returns with directly measured consumption expenditures
from individual electronic transactions for all residents of Norway. Using this
dataset, my colleagues have estimated how much the responsiveness of consump-
tion to interest rates varies with household indebtedness.[7] In the chart you can
see the change in consumption following a one percentage point unexpected in-
crease in the policy rate and how that varies with a household's gross debt-to-in-
come ratio. As we can see, the consumption response to a policy tightening in-
creases with indebtedness.[8] These effects set in a couple of months after the in-
terest rate hike and increase over the course of the first year. If we compare a
household with a debt-to-income ratio of three to a household with no debt, the in-
debted household will cut spending by around 1.5 percentage points more after one
year.[9]

[Chart: Households around the world have become more indebted]

We can use these results to understand how the monetary policy transmission
mechanism has changed over time. Households' debt-to-income ratios have in-
creased markedly in many countries over the past quarter century.[10] In Norway,
household debt increased from around 120 percent of disposable income in 1995 to
almost 250 percent in 2021. A back-of-the-envelope calculation based on our mi-
crodata estimates suggests that, due to this increased indebtedness alone, aggre-
gate consumption will fall by around 50 basis points more in reaction to a one per-
centage point contractionary monetary policy shock now than in the 1990s.[11] That
amounts to as much as a two-thirds increase in the interest rate effect on household
spending.[12]

Trade-offs in monetary policy

Now let me explain how a strong cash-flow channel can give rise to a particular
monetary policy trade-off in a small open economy that is hit by a cost-push shock
or an exchange rate shock that increases inflation. According to the textbook the-
ory, the central bank should respond to either shock by increasing the interest rate
to bring inflation gradually back to target. A higher interest rate dampens aggregate
demand directly, but also contributes to appreciating the currency. If the aggregate
demand channel is strong compared with the exchange rate channel, for instance

because cash-flow effects on consumption are important, a larger reduction in out-
put - anda larger increase in unemployment - are needed to achieve a given disin-
flation. That is because more of the disinflation will come through lower output and
employment and less through lower imported inflation. Hence, when the aggregate
demand channel is strong, the so-called sacrifice ratio of stabilising inflation is high
- lowering inflation sufficiently comes at the cost of a larger increase in unemploy-
ment.[13] In small, open economies where the effects of monetary policy on aggre-
gate demand are weaker, the central bank gets more help from the exchange rate in
bringing inflation down, and inflation can be stabilised at lower employment costs.

A weaker krone exchange rate

[Chart: The Norwegian krone has depreciated]

Against this backdrop, let me share some perspectives on the krone exchange rate.
Over the past three years, the Norwegian krone has depreciated by 10 percent
against an import-weighted basket of currencies. Against the dollar, the value of the
krone is 23 percent lower than it was three years ago.[14]

The newspaper The Economist has referred to the weakening of the krone since the
pandemic as "a mystery".[15] While it is challenging to explain all movements in ex-
change rates, we believe we do know something about the factors that have af-
fected the value of the krone over time.

First, over the longer term, real, structural factors matter. For example, research
suggests that the build-up of the Norwegian petroleum sector drove a stronger real
exchange rate from the beginning of the 1970s up until the beginning of the 2000s,
and that the subsequent decline in the importance of the petroleum sector has
pulled in the direction of a gradual exchange rate depreciation. [16]

Second, in recent years the pandemic, war and high inflation have led to heightened
geopolitical and economic uncertainty, and market volatility has increased. This may
have led to a flight by investors away from less liquid and more volatile currencies.
Rebalancing of Norwegian asset managers' hedging positions in response to de-
clines in international asset prices may also have contributed to the weakening of
the krone.[17]

[Chart: Trading partners' policy rates increased faster in 2022 and 2023]

Third, exchange rates react to monetary policy decisions. We have seen over time
that a tightening of monetary policy that is unexpected by the market normally leads
to an immediate krone appreciation.[18] And what central banks in other countries
do is alSo important. Through the spring of 2023, the interest rate differential
against Norway's main trading partners fell, and more than the market had ex-
pected. The differential gradually turned negative. The decline in the interest rate
differential coincided with the krone depreciation.

[Chart: Inflation has fallen more slowly in Norway]

The depreciation of our currency in the last few years has slowed the disinflation
process. While CPI inflation rose less in Norway than among our main trading part-
ners throughout 2022, inflation has since fallen at a slower pace in Norway. A weaker
currency directly pushes up imported inflation.[19] It also raises inflation for domes-
tically produced goods and services through the effect of the exchange rate on the
prices of imported intermediate inputs and on wage growth. In Norway we have a
system of coordinated wage determination in which the profitability of the manufac-
turing sector, which has a high export share, has a strong bearing on wage settle-
ments in the rest of the economy. We believe that this system of wage determination
in general contributes to counteracting wage-price spirals. However, a weaker
krone exchange rate normally results in higher export sector profitability. This could
lead to higher wage growth, which in turn may result in higher inflation.

Conclusion

Let me conclude. The cash-flow channel from interest rates to households' dispos-
able incomes is strong in Norway relative to many other countries. Combined with
the depreciation of the krone exchange rate, this has created some particular
trade-offs for monetary policy in Norway over the past few years. These trade-offs
have had a bearing on interest rate setting and the speed at which we aim to bring
inflation back to target.

[Chart: Inflation will slow and unemployment edge up]

At the time of our latest monetary policy meeting, our assessment was that the pol-
icy rate needed to be kept at today's level for a period ahead. At the same time, we
are approaching the time to lower the interest rate. With the September policy rate

path, inflation is projected to move down further and approach 2 percent towards
the end of 2027. Unemployment will likely edge up, to about the level prevailing be-
fore the pandemic.

Looking further ahead, the job of ensuring price stability may become more de-
manding. The consequences of climate change are becoming increasingly visible,
and a global transition to a low-carbon economy is imperative. Geopolitical tensions
and the desire to safeguard national supply lines are affecting trade and cross-bor-
der cooperation. At the same time, technological innovations and artificial intelli-
gence may lead to upheavals in the labour market.

These developments will pose a challenge to all aspects of economic policy, includ-
ing monetary policy. Large changes in relative prices may be necessary. With a flexi-
ble inflation targeting regime, we can look through temporary changes in inflation.
Still, the most important contribution monetary policy can make to support neces-
sary structural change and high employment is to ensure low and stable inflation.

Thank you.

Sources

Ahn, SeHyoun, Sigurd Galaasen, and Mathis Meehlum (2024) "The Cash-Flow
Channel of Monetary Policy - Evidence from Billions of Transactions". Forthcoming
Working Paper.

Alstadheim, R., K. B. Nordal, O. Syrstad, S. T. Ellen, and M. W. Wassas (2021) "Bond
market fire sales and turbulence in the Norwegian FX market in March 2020". Staff
Memo 2/2021. Norges Bank.

Bache, Ida Wolden (2023) Speech at the Centre for Monetary Economics (CME), BI
Norwegian Business School: Monetary Policy and the krone exchange rate. Norges
Bank, 9 November.

Ball, Laurence (1994) "What determines the sacrifice ratio?" The University of
Chicago Press, volume: Monetary policy, January, pages 155-193.

Bjornland, Hilde, Leif Brubakk, Nicolo Maffei-Faccioli, and O@rjan Robstad (2024)
"Piecing the puzzle: Real exchange rates and long-run fundamentals". Forthcoming
Working Paper.

Cerutti, Eugenio, Jihad Dagher, and Giovanni Dell'Ariccia (2017) "Housing finance
and real-estate booms: A cross-country perspective". Journal of Housing
Economics, 38, December, pages 1-13.

Cloyne, James, Clodomiro Ferreira, and Paolo Surico (2020) "Monetary policy when
households have debt: new evidence on the transmission mechanism." Review of
Economic Studies, 87 (1), January, pages 102-129.

Flodén, Martin, Matilda Kilstr6m, Josef Sigurdsson, and Roine Vestman (2020)
"Household Debt and Monetary Policy: Revealing the Cash-Flow
Channel". Economic Journal, 131 (636), May, pages 1742-1771.

Forbes, Kristin, Jongrim Ha, and M. Ayhan Kose (2024) "Rate cycles". The World Bank
Development Economics Prospects, Working Paper.

Carriere-Swallow, Yan, M. First, D. Furceri, and D. Jimenez (2023) "State-Dependent
Exchange Rate Pass-Throughz2. International Monetary Fund Working Paper No.
2023/086.

International Monetary Fund (2024) World Economic Outlook - Steady but Slow:
Resilience amid Divergence. IMF, April 16.

Ranaldo, A. and P. Séderlind (2010) "Safe haven currencies". Review of Finance, 14
(2), pp 385-407.

Romer, David (1993) "Openness and inflation: theory and evidence". The quarterly
journal of economics, 108 (4), November, pages 869-903.

Footnotes

[1] These remarks are based on Governor Ida Wolden Bache's remarks at the
Jackson Hole Economic Policy Symposium 2023 and on Norges Bank's Monetary
Policy Report 3/2024.

[2] Forbes, Ha and Kose (2024).

[3] IMF (2024).

[4] Flodén et al. (2021) and International Monetary Fund (2024) use similar definitions
of the cash-flow channel.

[5] Debt net of deposits more accurately captures how much a given change in pol-
icy rates affect disposable income, at least when both lending rates and deposit
rates closely follow short-term rates. Chart 3 shows gross debt due to a lack of ex-
tensive cross-country data on deposits.

[6] This does not take into account cross-country variation in the tax system and the
particular structure of adjustable-rate and fixed-rate mortgage contracts, both of
which can affect pass-through. First, long-term mortgages (e.g. 30 years) are more
common than shorter-term (e.g. 2-5 years) in some countries than in others.
Second, in some countries, households are allowed to deduct mortgage interest
payments from taxable income. How much this deduction amounts to varies sub-
stantially across countries (Cerutti, Dagher and Dell'Ariccia, 2017). A high tax deduc-
tion reduces pass-through of the policy rate to disposable income. Third, under the
terms of annuity loans - such as the ones common in Norway -- principal payments
are automatically reduced in the short run when the lending rate increases. This
might also lower the pass-through to consumption.

[7] See Ahn, Galaasen and Maeshlum (2024). Confidence intervals as well as estimates
for other horizons are included in the paper. Cloyne, Ferreira and Surico (2020) and
Flodén et al. (2020) also estimate how the effect of monetary policy varies along this
dimension.

[8] Ahn, Galaasen and Meehlum (2024) also provide estimates of the consumption
response along the dimension of (debt-deposits)/income.

[9] The estimated marginal propensity to consume out of interest expenses is
around 30 percent, which is within the range of MPC estimates out of other types of
income shocks.

[10] In the dataset of advanced and emerging economies shown in Chart 5, the me-
dian country - when ordering countries by the percentage increase in household
debt-to-income over the period - doubled its household sector debt-to-dispos-
able-income ratio between 1995 and 2021.

[11] This number is derived from the equation (% change in consumption due to
cash-flow effect) = MPC x (change in lending rate) x
(debt/income)/(consumption/income). We assume an MPC of 30% out of interest
payments (Ahn, Galaasen and Meehlum, 2024), close to full pass-through of policy
rates to lending rates, an average consumption/income ratio of 0.7 and an increase
in debt/income of 120 percentage points. This assumes that other parts of the
transmission mechanism, as well as the MPC, stay the same.

[12] Estimates based on Norwegian data from the mid-1990s until the early 2020s or
late 2010s indicate that the consumption response to a one percentage point mone-
tary policy shock peaks at around one percent after 1-2 years (see Norges Bank's
Monetary Policy Report 2/2022, p. 40, and 4/2023, p. 52). Assuming that the increase
in debt-to-income has increased this response by 0.5 percentage points over the
same sample period, the total response of consumption would have been around
0.75 percent in 1995.

[13] See Romer (1993) and Ball (1994).

[14] The numbers refer to the krone depreciation between September 2021 and
September 2024 for the krone against the I-44 index and against the US dollar.

[15] "Norway's weak currency presents a mystery." The Economist, 14 September,
2024.

[16] Bjornland et al. (2024).

[17] Alstadheim et al. (2021) find that rebalancing of hedging positions contributed to
the sudden, large weakening of the krone in March 2020. Research on the later time
period is work-in-progress.

[18] See the evidence cited in Bache, Ida Wolden (2023).

[19] The estimated pass-through of exchange rate shocks to inflation is slightly
higher in Norway than for an average of other advanced economies. See "A weaker
krone exchange rate pushes up inflation - but by how much?" in Norges Bank's
Monetary Policy Report 3/24 and Carriere-Swallow et al. (2023).

Published 24 October 2024 19:15