Øystein Olsen: Monetary policy in turbulent times
Address by Mr Øystein Olsen, Governor of Norges Bank (Central Bank of Norway), at the
Centre for Monetary Economics (CME)/BI Norwegian School of Management, Oslo,
20 September 2012.
* * *
Please note that the text below may differ slightly from the actual presentation.
Central banks the world over are now conducting monetary policy in what must undoubtedly
be called turbulent times. My address today will focus on how and why new tools of monetary
policy are being deployed internationally and our response to these developments here in
Norway. The economic situation in Norway is quite different from that of surrounding
countries and we have been able to operate within the established monetary policy
framework.
Chart: GDP growth
Growth in the global economy has been weak since the 2008 financial crisis and has affected
some countries more severely than others. Countries with large imbalances when the crisis
began are now facing formidable challenges. The imbalances have been self-reinforcing.
Higher pricing of risk has resulted in increased yields on the government bonds of countries
with a high level of debt. Fragile government finances have become even weaker. A
decrease in the value of government bonds has also generated uncertainty concerning the
position of banks. Banks have had to consolidate their balance sheets and have curtailed
lending to firms and households, amplifying the decrease in economic activity.
Heavily indebted countries are now working to make banks more robust and strengthen
government finances. Cost competitiveness must be restored. The road will no doubt be long
and arduous.
Chart: Yields on 10-year government bonds
But the situation across countries differs considerably and is reflected in wide yield spreads.
Investors now demand substantial premiums for investing in less safe assets. Capital is
seeking safe havens, even though real returns on presumably risk-free investments are low
or negative. Wide yield spreads may persist for a period - it takes time for countries to
restore competitiveness and build up stronger balances, particularly when growth is also
weak in other regions. Substantial economic imbalances in Japan and the US also need to
be redressed. Turbulence and bad times in Europe are now dampening activity in these
countries and in emerging economies.
This situation has led to the emergence of new forms of monetary policy in many parts of the
world. Interest rates have been low - close to zero - for a long period. The Federal Reserve
has indicated that the federal funds rate will most likely be exceptionally low at least until
mid-2015. In the event, the US key rate will have been close to zero for almost seven years.
As key rates cannot be lowered further, several central banks have decided to apply other
methods. The methods fall into two main types:
The first method relates to communication. Statements concerning the future central bank
key rate are being employed as a new monetary policy tool. Here at Norges Bank, the
application of this method is not new - the interest rate forecast has been published by the
Bank since 2005. The aim is to influence interest rate expectations and thereby contribute to
achieving the objectives of monetary policy.1 The Federal Reserve has published board
members' expectations of when the first key rate increase will take place since January
2012.2
The second method is known as quantitative easing, or balance sheet policy, and consists of
measures to change the composition and size of central bank balance sheets. This use of
the balance sheet differs from the usual monetary policy operations in that instruments other
than the key rate are used to influence market rates and economic activity. Traditional
monetary policy operates through the commercial banking system: it influences the economy
because banks let their interest rate conditions in the central bank pass through to their
customers. Moreover, liquidity management is used to keep short-term rates close to the key
rate. In countries where the key rate is close to zero, this instrument has been exhausted. At
the same time, the effect of the key rate may be weaker than normal as many banks are
consolidating and are reluctant to engage in lending.
Using balance sheet policy, the central bank seeks to influence longer-term interest rates
and thereby funding costs in a more direct manner.3
Purchases of government or private sector bonds are intended to depress yields and push
up securities prices - the so-called portfolio effect.4 Studies from the past three or four years
indicate that the portfolio effect has been in operation in both US and UK markets - bond
prices have increased and long-term yields have fallen as a result of quantitative easing.5
The aim is to achieve lower long-term yields in order to boost lending and investment.
In addition to the portfolio effect, the new use of the balance sheet can have a signal effect:
central banks that engage in large-scale purchases of securities to pull down long-term yields
are sending a signal that the key rate may be kept low for a long period. In this sense,
balance sheet policy also contributes to anchoring expectations and supporting monetary
policy communication.
It is not easy to say what the situation would have been without these measures. However, it
is likely that central bank bond purchases have curbed the decline in output in the UK and
the US.
Chart: Central bank balance sheets, stylised
These measures, by their nature, have an impact on central bank balance sheets - in terms
of both size and composition.
2
See the Federal Reserve's "Monetary Policy Report to the Congress", February 2012, http://
www.federalreserve.gov/monetarypolicy/mpr_20120229_part1.htm.
3
For a description by the Bank of England of how quantitative easing works, see
http://www.bankofengland.co.uk/monetarypolicy/Pages/qe/default.aspx. For a description by the Federal
Reserve, see for example speech by Ben Bernanke, 31 August 2012, http://www.federalreserve.
gov/newsevents/speech/bernanke20120831a.htm.
For a theoretical description of the effects, see Michael Woodford (2012): "Methods of Policy Accommodation
at the Interest-Rate Lower Bound", http://kansascityfed.org/publicat/sympos/2012/mw.pdf?sm=jh083112-4 .
See also Economic Commentaries 1/2011: "Om nye virkemidler i pengepolitikken. Avgrensning mellom
pengepolitikken og finanspolitikken" (New monetary policy instruments. Delimitation between monetary policy
and fiscal policy), Ragna Alstadheim (Norwegian only).
4
Classic references are James Tobin (1965): "The Monetary Interpretation of History", American Economic
Review, Vol 55, pp. 464-85 and (1969): "A General Equilibrium Approach to Monetary Theory", Journal of
Money, Credit and Banking, Vol 1 (February), pp. 15-29. For a more modern presentation, see Javier Andres,
David Lopez-Salido and Edward Nelson (2004): "Tobin's imperfect Asset Substitution in Optimizing General
Equilibrium", Journal of Money, Credit and Banking, Vol 36 (August), pp. 665-90.
5
See for example Arvind Krishnamurthy and Annette Vissing-Jørgensen (2011): "The Effects of Quantitative
Easing on Interest Rates: Channels and Implications for Policy", Brookings Papers on Economic Activity, Fall,
pp 215-65 and Jonathan Wright (2012): "What does Monetary Policy Do to Long-Term Interest Rates at the
Zero Lower Bound?", NBER Working Paper Series 17154.
When a central bank purchases government bonds, it pays for the bonds with new electronic
money.
Chart: Central bank balance sheets - government bond purchases
The money ends up as increased bank deposits at the central bank - also known as central
bank reserves. This strengthens banks' holdings of liquid assets and may induce them to
increase lending. The pricing of government bond holdings in the private sector is also
affected.
Chart: Central bank balance sheets - private sector bond purchases
Private sector bond purchases can ease funding conditions for firms more directly than
purchases of government bonds by depressing interest rates on private sector market
funding. As with government bond purchases, central bank reserves also increase in this
case. The latest measure implemented by the Federal Reserve, known as QE3, is a plan for
the purchase of mortgage-backed securities.
Chart: Central bank balance sheets - foreign exchange purchases
A third form of balance sheet policy is interventions in the foreign exchange market. Central
bank foreign exchange purchases are also balanced by an increase in banks' deposits in the
central bank.
Chart: Central bank balance sheets. Index
In September 2011, the Swiss National Bank decided to announce a minimum exchange
rate, a floor, for the Swiss franc against the euro owing to the substantial appreciation of the
Swiss franc. Interest rates and inflation in Switzerland were close to zero and growth was
low. According to the Swiss National Bank, a further appreciation could have resulted in a
recession with deflationary developments. In order to defend the floor, the Swiss central bank
has purchased foreign currency in large quantities. This has led to a considerable expansion
of its balance sheet. The chart shows the wide swings in central bank balance sheets since
the 2008 financial crisis. Expansion of central bank balance sheets has been particularly
rapid in the UK, the US and Switzerland and somewhat more moderate in the euro area.
As I mentioned earlier, the purpose of balance sheet policy is to stimulate the economy by
lowering interest rates and funding costs in a situation where the key rate is close to zero.
Central banks themselves emphasise that the positive effects of balance sheet policy are
uncertain - and the effects must be weighed against possible problems.6 There are four
factors that can be highlighted here:
First, it may be difficult for central banks to exit the markets once they have built up large
bond holdings, and this would require considerable portfolio adjustments for households,
firms and banks. Postponing a reversal of the measures could generate expectations that
interest rates will remain very low for too long a period after the economy has recovered.
This could in turn generate expectations of high inflation further ahead.
Indeed, the connection between inflation and the money supply constitutes the second
challenge. When a central bank purchases securities or provides longer-term loans to banks,
the monetary base, i.e. banks' deposits at the central bank, increases. There is no direct
relationship between the monetary base and inflation. The risk of inflation can only arise if
growth in the monetary base coincides with an increase in the broader monetary aggregates
through higher customer deposits in banks. For the broader monetary aggregates to
increase, banks must increase lending or purchase securities from enterprises outside the
banking sector. Since the crisis in 2008, the monetary base in Europe and the US has grown
considerably more rapidly than the broader monetary aggregates. The risk of high inflation in
such a situation should be viewed in the context of central bank exit strategies. In the future,
central banks will want to reverse the extraordinary measures that have resulted in
substantial growth in the monetary base. This will normally be done when the crisis is over
and the economy is recovering.
Third, the large sums of money involved may also affect exchange rates. Even if central
banks do not intervene in exchange markets directly, the measures may in the short term
reduce the value of the currency issued by a central bank. This will, in isolation, strengthen
exchange rates in countries that were initially less severely hit by the crisis. Small, open
economies can be vulnerable to large capital movements when powerful instruments are
deployed by large countries.
A possible side-effect of balance sheet policy is that the private sector also takes longer to
strengthen equity capital and reduce risk than it would otherwise have done. With the low
price of capital, it costs little to postpone restructuring and put off debt repayment.
Finally, confidence in economic policy may be affected. The dividing line between monetary
and fiscal policy seems to be more blurred. Balance sheet policy may dampen the effects of
market volatility on interest rates and give heavily indebted countries a breathing space and
time to adjust. On the other hand, the measures may also reduce the incentive to carry out
necessary fiscal tightening.
In the euro area, different considerations are now being balanced in the new "Outright
Monetary Transactions" (OMT) programme. Under this programme, the European Central
Bank (ECB) may only purchase bonds from countries that have entered into a loan
agreement under the European Financial Stability Facility (EFSF) or the European Stability
Mechanism (ESM) - which in turn is conditional on a commitment to fiscal tightening.
Chart: Corporate borrowing rates
One reason for the ECB's decision to establish the OMT programme is the partial breakdown
of the monetary policy transmission mechanism in the euro area economy. There are wide
differences in interest rates facing banks and firms across Europe. Although the same key
rates apply to all the euro area countries, average corporate borrowing rates differ widely
from country to country. Some of the variation is due to differences in credit risk across
countries owing to very different economic situations. Additional risk premiums may reflect
fears that one or more countries might at some point have to replace the euro with a new
local currency. ECB President Mario Draghi has referred to these as convertibility risk
premiums. One of the objectives of the OMT programme is to reduce this premium and
restore the proper transmission of monetary policy.
The OMT programme can be regarded as an answer to the signs of financial market
fragmentation in the euro area. Differences in financial conditions across countries have
become considerable and the willingness to provide loans across national borders has
declined. The same picture is reflected in the so-called TARGET2 balances.
TARGET2 is the central interbank settlement system in the euro area. In all countries,
interbank payment settlement is carried out by the national central bank. One bank's
payment to another is settled by adjusting the two banks' deposits in the central bank.
Central bank reserves are the means of interbank payment.
In the euro area, interbank payment settlement takes place in two stages: banks have their
settlement account in the national central bank, while each country's central bank has, in
turn, an account at the ECB. If, for example, deposits are transferred from a Greek bank to a
German bank, the Greek bank's deposits in the Greek central bank are reduced, while the
German bank's deposits in the Bundesbank increase by the same amount. The Greek
central bank's debt to the ECB increases in turn, while the Bundesbank's claims on the ECB
increase accordingly. Such changes in claims and liabilities are expressed in the TARGET2
balances.
Chart: TARGET2 balances
In a well functioning market, the bank that had drained its central bank reserves would
borrow to replace them in the interbank market, balancing the transfer described above.
Imbalances in TARGET2 are a symptom of an interbank market that is not functioning
efficiently between all countries in the euro area. If banks in the north are no longer willing to
lend to banks in the south, the southern banks must meet their need for reserves by
borrowing directly from the central bank. The northern banks increase their reserves at the
central bank accordingly. In addition to increasing the claims in the TARGET2 system, this
inflates the Eurosystem balance sheet. The central banks are the hub of the system and are
required to receive deposits from areas where banks have a surplus of reserves and extend
loans to areas where banks as a whole need more funding. Imbalances between countries in
the TARGET2 system give no indication of who will bear the losses if a bank defaults and the
value of the collateral posted is not sufficient. Any losses are allocated among the
participating national central banks according to their relative shares in the ECB's paid-up
capital.
To sum up the international picture: over the past year, growth prospects have been lowered
for all the large advanced regions. In Europe, activity is likely to decline this year owing to
debt problems and fiscal tightening. Unemployment is on the rise. Fiscal and monetary policy
space is limited, or virtually exhausted. Many countries must tighten fiscal policy to reduce
debt to a sustainable level. Central banks have responded by communicating that interest
rates will be held low for an extended period. And they have stretched the limits of monetary
policy to counteract a deeper and more persistent downturn.
Chart: GDP growth
The economic situation in our external surrounding environment stands in contrast to that of
Norway. Domestic activity is particularly high in the oil industry and construction sector, and
both employment and the supply of labour are on the increase. Unemployment remains low
and stable. Public finances are healthy. Norway's terms of trade are favourable, with high
export prices and low import prices. At the same time, house prices and household debt are
still rising. Nonetheless, the Norwegian economy is not unaffected by the turbulence abroad.
Developments in Europe and a strong krone exchange rate are adversely affecting some
Norwegian export industries, such as the paper, metal, and furniture industries.
While other countries have used nontraditional instruments, we have managed to come
through by using our main instrument - the key policy rate - which is now 1.5 per cent. It is
low because inflation is low and because adverse conditions abroad are curbing growth in a
number of industry sectors in Norway. Very low interest rates abroad and high risk premiums
in money and capital markets underpin this picture.
Norges Bank's conduct of monetary policy is geared towards low and stable inflation. The
operational target of monetary policy is consumer price inflation of close to 2.5 per cent over
time. At the same time, monetary policy shall contribute to stabilising output and
employment. We also give weight to the risk that low interest rates may over time lead to
excessive risk-taking and debt accumulation in the household and business sector. Such
imbalances can give rise to negative ripple effects further ahead, with a considerable impact
on output and employment.
Chart: Criteria for an appropriate interest rate path and loss function
In Norges Bank's March 2012 Monetary Policy Report, the Bank clarified how the various
considerations are expressed in Norges Bank's response pattern. Adjustments were made to
the criteria for an appropriate interest rate path. In the Bank's system of analysis, the criteria
are expressed as a loss function for monetary policy.
Criterion 1, which states that the inflation target is reached, is covered by the first segment,
where the loss is higher the more actual inflation πt deviates from the target
π*. Criterion 2,
which states that for given inflation developments, the loss Lt will increase with fluctuations in
economic activity, is covered by the first and second segments. Criterion 3, which states that
monetary policy shall be robust, is covered by the second, third and fourth segments.
The adjustments made in March were expressed by slightly increasing the weight given to
the output gap, , because financial imbalances can often build up in periods of high capacity
utilisation. At the same time, weight was given to avoiding substantial deviations in the
interest rate from a normal level. This consideration is expressed in the final segment in the
loss function. This can help to mitigate the risk of a buildup of financial imbalances, even in
periods when capacity utilisation is not particularly high.
Chart: Key policy rate
Normally, the key policy rate cannot achieve several objectives simultaneously. In the case
of conflicting objectives, the choice of interest rate path will involve a trade-off between
different considerations.
If monetary policy only took into account the low level of inflation, the key policy rate would
be rapidly reduced and kept close to zero for a good while. Inflation might then pick up faster,
partly as a result of a weaker krone. In the light of the trade-off against other considerations,
however, the Bank does not want to accelerate the pace of inflation. The result would be a
pronounced impact on output and employment. A prolonged period of even lower interest
rates would increase the risk that debt and asset prices will be driven up to levels that are
unsustainable over time. We thus obtain a smoother interest rate path when we also give
weight to the other two criteria.
The criteria and loss function reflect the Bank's reaction pattern in the period following the
financial crisis. We are responding to new insight and lessons learned. The loss function is a
mathematical illustration and must be regarded as a simplified representation of the more
extensive assessments underlying interest rate decisions. Interest rate setting is based on
the Executive Board's assessment, not a model calculation. Mathematics and models can,
however, clarify the alternatives.
There is considerable uncertainty as to the effect of low interest rates over extended periods
on risk-taking behaviour and the buildup of financial imbalances.7 In this regard, we are in
quite uncharted waters. How financial imbalances build up is not explicitly considered in the
analytical apparatus. Work is in progress both in Norway and internationally to further
develop the economic models used in monetary policy analysis. As we gain new insight and
gather experience, our assessments of economic relationships may change. This will also
influence the formulation of our models.
Chart: Household debt burden and interest burden
In Norway, house prices and household debt have reached historically high levels. The rapid
growth in incomes has been a primary driving force. The high household debt burden in
Norway represents a risk of financial instability in the longer term. Households can be a
source of both direct and indirect losses for banks. Banks' loan losses will depend on
households' capacity to pay interest and principal, and to the value of the underlying
collateral, which is primarily in the form of dwellings in Norway. Banks are also exposed to
the economic repercussion effects that may occur in the event of a fall in household
consumption. In the short run, the risk of disturbances is probably small because interest
rates are low and the vast majority of households have job and income security.
Chart: Household financial wealth by debt burden
Household saving has been high in recent years, but households with the highest debt have
the lowest financial wealth. In 2009, only about ten percent of financial assets were held by
households with a high debt burden - that is to say those with debt that was more than five
times their disposable income. These households also accounted for around one third of total
household debt.
Chart: High population growth and low residential construction rate
In recent years, pressures in the housing market have been amplified by high population
growth. Despite rising housing construction, the number of housing completions remains low
in relation to population growth. The housing deficit has grown over several years and is
pushing up house prices. The housing shortage requires measures in the real economy - in
this case, an increase in housing construction. Monetary policy cannot aim to redress such
real economic imbalances.
Low interest rates over time can increase the risk of driving up debt levels and asset prices,
bringing them to a level that is unsustainable over time. This is an important lesson from the
financial crisis. We take account of this when setting the key policy rate, as has been made
clear in the most recent formulation of the loss function. At the same time, there is - with one
instrument available to us - the key policy rate - a limit to how many tasks can be assigned
to monetary policy. In order to counter financial imbalances, instruments in addition to those
available to monetary policy must come into play.
Macroprudential regulation of the financial industry will play a greater role in the years ahead.
The overall risk in the financial system is greater than the sum of the risk represented by
each individual bank. Which macroprudential instruments would be the most suitable is
currently being discussed in detail in various international fora and central banks. One
instrument that will be introduced is the countercyclical capital buffer for banks.
The purpose of this buffer is to reduce the procyclicality of bank lending. When banks are
required to hold more capital in a period of high credit growth, they will be more robust to
large loan losses. In addition, increased capital requirements could restrain credit growth.
The Ministry of Finance has the overriding responsibility for regulating the financial industry,
but Norges Bank will be given the primary responsibility for elaborating the basis for the
establishment of the countercyclical capital buffer.
With a buffer ceiling of 2.5 percent of banks' risk-weighted assets, the buffer will probably
have a limited downward impact on banks' lending enthusiasm in good times. But banks that
have solid capital reserves can take larger losses before having to limit lending to
creditworthy customers.
The countercyclical buffer comes on top of a new, comprehensive regulatory framework.
Equity capital requirements will be tightened. Banks will face stricter maturity requirements
for funding, limiting their share of short-term funding. They will be required to hold more liquid
assets. All in all, the new regulatory regime will contribute to a more robust financial system
and reduce fluctuations in credit growth.
The turbulence in Europe, which started with the problems in Greece, has now prevailed for
close to two and a half years. Financial market sentiment and banks' access to funding have
varied widely during the period. The nascent market optimism may continue, but it is fragile.
Should the economic situation abroad worsen again, and credit markets dry up, other tools
can be put to use in Norway. During the financial crisis in 2008, several measures were
deployed, such as the so-called swap arrangement, which provided banks with access to
liquid government securities in exchange for covered bonds. Smaller banks were given loans
with longer maturities. The measures aimed at improving banks' access to long-term funding.
The measures enabled banks to maintain virtually normal lending standards for Norwegian
households and businesses.
Norway's swap arrangement and quantitative easing have some common features: bonds
shift from private to public hands, and banks' funding costs become lower than would
otherwise have been the case. But there is an important difference. The swap arrangement
was reflected in the government's balance sheet - not the central bank's. Quantitative
easing, which increases the size of a central bank's balance sheet, as observed in the
US and the UK, is still not a relevant approach for Norway. Normally, the provision of capital
and liquidity by authorities is not to replace banks' own sound liquidity management and
long-term market funding. Any decision relating to the use of the creditworthiness of
government or taxpayers to finance banks and businesses rests with the Government and
the Storting (Norwegian parliament).
Chart: Liquidity and EUR/NOK exchange rate
International turbulence can push the krone in both directions.
On the one hand, in periods of severe market turbulence, investors have tended to shy away
from presumably less liquid currencies. The krone market is among the less liquid markets.
One indicator of liquidity is the so called bid-ask spread.8 An exit from the krone market may
be tight when many investors seek to shift out of krone positions at the same time. This can
trigger a considerable depreciation of the krone, as experienced in autumn 2008.
On the other hand, Norwegian securities can be perceived as safe havens because the
associated credit risk is perceived to be low. Experience has also shown that international
turbulence can in periods lead to an appreciation of the krone.
A krone that is too strong can over time result in inflation that is too low and growth that is too
weak. In that case, monetary policy measures will be taken. In Norway, the key policy rate is
the relevant instrument. We still have room for manoeuvre in interest rate setting - in both
directions. Foreign exchange interventions are not in principle an instrument suited to
influencing the krone exchange rate over a longer period. It would only be relevant should
the krone exchange rate move significantly out of line with that deemed reasonable in
relation to the underlying fundamentals of the Norwegian economy, and should
developments at the same time threaten the credibility of the inflation target. In addition, the
interest rate weapon must have already been exhausted.
Over the past decade, inflation has been low and stable. This shows that monetary policy
has functioned effectively. Transparency about the response pattern and key policy rate
forecasts reinforce the impact of monetary policy. With firmly anchored inflation expectations,
Norges Bank has also been able to give weight to economic stability when setting the key
policy rate. Further light is being shed on the interaction between monetary policy and
financial stability. Inflation targeting in Norway has become more flexible. At the same time,
we cannot overburden monetary policy. In weighing the various considerations, we will in our
interest rate setting adhere to the primary objective of monetary policy - low and stable
inflation.
Thank you for your attention.
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