øystein olsen : monetary policy and financial stability considerations speech by mr øystein olsen, governor of norges bank ( central bank of norway ), at the european banking & financial forum, prague, 27 march 2012. * * * the text below may differ from the actual presentation. this speech does not contain assessments of the current economic situation or interest rate setting. introduction the past few years have clearly shown the costs of financial instability. the near collapse of the financial system in autumn 2008 led to the most severe economic downturn of our time. there was a dramatic decline in international trade, and total world output fell from one year to the next for the first time in generations. when financial markets failed, the authorities had to intervene. bailout packages for banks shifted debt from private to public hands. governments increased spending in order to curb the fall in activity. many countries are now trying to rein in large deficits and rising government debt under difficult conditions. pension rules and tax systems are under review. the costs of such structural reforms would have been lower in good times. a financial crisis has to be met with appropriate measures, but the main objective in our work on financial stability must be to reduce the risk of crises emerging. history tells us that a financial crisis typically arises when debt has accumulated over a long period. an important task is therefore to contain the buildup of imbalances and secure a robust financial system. a decade of inflation targeting the norwegian economy emerged quickly and fairly painlessly from the recent global economic downturn. since 2001, economic policy in norway has been guided by a fiscal rule and a flexible inflation target. with solid government finances based partly on petroleum revenues and firmly anchored inflation expectations, there was room for manoeuvre both in monetary and fiscal policy when the financial crises hit. inflation in norway is currently low, but it has been close to target over the past decade. during this period, monetary policy has faced demanding trade - offs, and the application of judgment has been put to a test. we have gradually learned more about the functioning of our economy under an inflation targeting regime. let me touch upon some of these insights. fairly soon after we had adopted inflation targeting, we learned how demanding it may be to strike a balance between different monetary policy considerations in a small open economy. when the key policy rate is raised to restrain a pronounced rise in domestic inflation, it may strongly impact the exchange rate, as we experienced in the period 2002 – 2003. both the real

things stand now, the rise in prices will be notably higher than wage growth this year. indebted households will face both higher interest expenses and higher electricity and food prices. many households will be facing a tighter financial situation, and i am fully aware that some of them will also be facing a financial struggle. most households will be able to cope with higher interest rates on their loans. unemployment is very low. many will be able to cut down on other expenses or draw on their savings. chart : monetary policy meeting on 17 august we could have decided to raise the policy rate more gradually. but then we would have run the risk of inflation becoming entrenched at a high level. that would have made it more difficult to bring inflation down and could have required a sharper tightening of monetary policy somewhat further out, increasing the risk of an economic downturn. inflation has surprised to the upside in recent months. this is why the policy rate has been raised somewhat more rapidly than signalled earlier. and the economy might evolve differently from what we have envisaged. the level of uncertainty is high. limited spare capacity in the norwegian economy and persistent external inflationary pressures may lead to inflation accelerating further. on the other hand, the rise in interest rates and high inflation may cool down the housing market and curb household consumption faster than currently envisaged. there is also a risk of a sharper slowdown in global growth. the future path of the policy rate will depend on how the economy evolves. we cannot make any promises about the policy rate. the promise we can make is that we will continue our efforts to fulfil the mandate of keeping inflation low and stable and to promote economic stability. 1 a new set of forecasts was not prepared for the monetary policy meeting on 17 august. updated forecasts will be presented when monetary policy report 3 / 22 is published on 22 september. 3 / 3 bis central bankers'speeches