svein gjedrem : monetary policy and wealth management address by mr svein gjedrem, governor of norges bank ( central bank of norway ), to the board of directors of the national insurance fund, oslo, 14 march 2002. this address is based on assessments presented at the press conference following the monetary policy meeting of norges bank ’ s executive board on 27 february 2002, and on previous addresses. accompanying charts can be found on the norges bank ’ s website ( www. norges - bank. no ). * * * the guidelines for economic policy were revised last year. the expected real return on the government petroleum fund is hereafter to be used over the central government budget, and monetary policy is to be oriented towards low and stable inflation. economic agents can act on the assumption that low and stable inflation will be a constant feature of economic policy. wide variations in the price level make it more difficult to predict the real content of agreements and budgets. unexpected fluctuations in the price level may easily lead to fluctuations in the real economy and instability in financial and property markets. high and variable inflation also leads to an arbitrary redistribution of resources and income. hence price stability is the best contribution monetary policy can make to economic growth, prosperity and appropriate distribution. low inflation is the objective, and the interest rate is the instrument. commercial and savings banks have accounts with norges bank, and the executive board decides the interest rate on these. the deposit rate forms the floor for the shortest money market rates. transparency about intentions, strategies and the implementation of monetary policy makes it easier for economic agents to assess monetary policy. if monetary policy is predictable, an important source of uncertainty is reduced, and – other things equal – the interest rate required to achieve the inflation target will be lower. if economic agents are to have confidence in monetary policy, transparency regarding the central bank ’ s response pattern is probably a precondition. the interest rate affects inflation through a number of channels. an increase in the interest rate will normally contribute to reducing inflation by curbing demand for goods and services and by strengthening the krone exchange rate against other currencies. an interest rate reduction has the opposite effect. monetary policy influences the economy with considerable and variable lags. our analyses indicate that a substantial share of the effects of an interest rate change occurs within two years. two years is therefore a reasonable time horizon for achieving the inflation target of 2½ per cent. interest rates are set with a view to

number of channels. when interest rates rise, it becomes more profitable to save and to postpone consumption. this reduces growth in household consumption. at the same time, a higher interest rate may increase the required rate of return, thereby reducing business investment. in addition to the direct effect on demand, a rise in interest rates may moderate demand through reduced access to liquidity, a decline in asset values and a stronger exchange rate. moreover, a stronger exchange rate will reduce the rise in prices for imports, which account for 40 % of goods and services in the consumer price index. an increase in interest rates may also have an effect through inflation expectations. expectations of lower future inflation will increase the real interest rate, and may therefore in itself have an impact on the real economy. inflation expectations may also influence price and wage formation as well as the exchange rate. see akram ( 2000 ). however, the relationships between the interest rate, expectations, demand and inflation must be expected to be unstable. analyses have been published showing how changes in interest rates affect the economy in various countries. in december 1999, norges bank presented an analysis based on calculations which showed that an interest rate rise of 1 percentage point reduces gdp growth and price inflation by just under half a percentage point. a considerable portion of the effect on price inflation is due to effects via the exchange rate, where it was assumed that the krone exchange rate moved in line with uncovered interest rate parity. the central banks of england and sweden have published calculations that show effects of roughly the same magnitude. in view of the uncertainty concerning the effects of the interest rate on economic developments, it is not possible to fine - tune price developments and the exchange rate. however, it is possible to conduct a monetary policy that reinforces confidence in nominal stability. the experience of norway and other countries shows that monetary policy can be effective, as seen by developments before and after the shift in economic policy in 1986. a monetary policy that results in an interest rate that is too low will unleash strong forces in financial markets. an inappropriate interest rate will generate erroneous price signals to households and financial institutions in the housing and property market. with interest rates that are too low and nominal price pressures, the buyer and seller will find it more difficult to discover the real change in value, and they will buy and sell on the basis of erroneous price signals. similarly, those extending loans will find it more difficult to assess the real value of collateral security and the