svein gjedrem : inflation targeting - some theory with main focus on practice speech by mr svein gjedrem, governor of norges bank ( central bank of norway ), given at the centre for monetary economics / norwegian school of management, oslo, 8 june 2004. the speech does not contain assessments of the economic situation or of current interest rate setting. * * * norway has had an inflation target for monetary policy since march 2001. in my speech today, i will attempt to explain why and how an inflation targeting regime was introduced. in a number of countries, including norway, short - term interest rates are now the lowest for generations. let us look back to the views on monetary policy in norway the last time interest rates were very low, in the postwar period up to the mid - 1950s. as part of the measures taken in february 1955, norges bank increased the discount rate, which had remained unchanged since the war, from 2. 5 per cent to 3. 5 per cent. in his annual address, central bank governor erik brofoss discussed this change : 1 “ in the longer run, the aim must be to bring interest rates down again. the outlook for achieving this is promising. saving is high and can be supplemented by foreign capital. this provides the basis for a low interest rate if moderation is shown in relation to an expansionary urge. ” in retrospect, we can safely say that the expansionary urge proved to be too strong. it took 50 years before the interest rate returned to this level, which we now regard as abnormally low. however, prevailing views on monetary policy at that time is probably of more interest. brofoss said the following : “ increasing the discount rate will probably be widely regarded as the most important monetary policy measure. the interest rate is, however, a controversial instrument, both in norway and in other countries. nonetheless, an increasing number of countries use it. whether the purported good results can be ascribed solely to interest rate policy is another question. the effects in norway may differ somewhat from the effects in other countries. countries with major currencies can influence short - term capital movements via the interest rate. this is only possible to a limited extent in norway. a substantial share of business investment is self - financed and is not affected by the interest rate. the same applies to shipowners that finance new ships built in other countries with their foreign exchange earnings. as a cost factor, the interest rate will

“ this interview system must be designed so that the results, without the politicians necessarily having to understand this, can draw certain conclusions as to the numerical nature of the preference function. ” in the third and last phase, the information derived from the interviews is combined with the data on the structure of the economy and the formulated preference function. “ this will yield a solution in the form of an optimal path for economic and social development. ” professor lars svensson, one of the most prominent contemporary academics in the field of monetary policy, expresses thoughts similar to those of frisch. svensson recommends the following : 14 “... inflation targeting central banks should announce ( an ) explicit loss function with numerical weights on output - gap stabilization... simple voting procedures for forming the monetary policy committee ’ s aggregate loss function... are suggested. ” a practical approach, which is probably pursued by most central banks, is to produce projections for the economy based on different, possible interest rate paths. decision - makers can then strike a balance between the various considerations and make decisions based on these projections. 15 see berg, clas and lars jonung ( 1998 ) : “ pioneering price level targeting : the swedish experience 1931 - 37 ”. conference on monetary policy rules, stockholm, 12 - 13 june 1998. frisch, ragnar ( 1971 ) : “ samarbeid mellom politikere og økonometrikere om formuleringen av politiske preferanser ” ( cooperation between politicians and econometricians on the formulation of policy preferences ). sosialøkonomen no. 6, 1971. cf. svensson, lars ( 2003 ) : “ the inflation forecast and the loss function ” in paul mizen ( ed. ), central banking, monetary theory and practice : essays in honour of charles goodhart, edward elgar. for a description of principles for inflation targeting, see lars svensson ’ s presentation “ what is inflation targeting? ” on norges bank ’ s website : www. norges - bank. no / english / monetary _ policy / workshops / 2004 / program - 03. html. both the formulation of a precise inflation target and the aim of striking a balance between the objectives of stable output and inflation could invite a repeat of earlier attempts at fine - tuning. but here it is important to adhere to the lessons drawn from the 1970s and 1980s. the uncertainty underlying the decisions taken must not be underestimated. there