Report on monetary policy in 2003 - the first eight months1)

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2 The implementation of monetary policy

2.1 Objective and basis for decisions
2.2 Trade-offs in monetary policy
2.3 The work on monetary policy

2.1 Objective and basis for decisions

The Government has defined an inflation target for monetary policy in Norway. The operational target is consumer price inflation of 2½ per cent over time. The monetary policy target implies that low and stable inflation is the best contribution monetary policy can make to achieving the objective of stable growth in output and employment. This is a necessary precondition for achieving stable exchange rate expectations and is thus also an anchor for developments in the krone exchange rate.

Norges Bank sets the interest rate so that future inflation will be equal to the inflation target of 2½ per cent. The impact of monetary policy occurs with a lag. The current inflation rate does not provide sufficient information to determine the level at which interest rates should be set now. Our analyses indicate that a substantial share of the effects of an interest rate change will occur within two years. Two years is therefore normally a reasonable time horizon for achieving the inflation target. This orientation of monetary policy will normally also contribute to stabilising output and employment. (For further discussion, see section 2.2.)

Monthly variations in consumer price inflation are influenced by random and temporary factors that cannot be affected by monetary policy. Therefore, Norges Bank shall not normally take account of direct effects on consumer prices of changes in interest rates, taxes, excise duties and extraordinary, temporary disturbances. Particular weight is placed on developments in consumer price inflation adjusted for tax changes and excluding energy products (CPI-ATE). In the period ahead, Norges Bank will also adjust for changes in day care rates following the introduction of maximum prices for day-care places.

Norges Bank normally takes a gradual approach to interest rate setting. This is because of the uncertainty associated with the economic situation, disturbances to which the economy may be exposed and the timing of the effect of an interest rate change on inflation. In some cases, however, one may proceed more rapidly. The interest rate may be changed rapidly and markedly if there is a risk that inflation might deviate considerably from the target over a lengthy period so that inflation expectations might be influenced, or when heightened turbulence in financial markets or a rise in costs as a result of negotiated wage increases indicate that confidence in monetary policy is in jeopardy.

Norges Bank has no set target for the level of the exchange rate. Developments in the krone are nevertheless of considerable importance in interest rate setting. The response to a change in the exchange rate will depend on its expected impact on inflation. This requires an evaluation of the reasons for and the duration of the change. Short-term fluctuations in the krone tend to have very limited effects on economic developments, while long-lasting changes may have an impact. However, it is difficult to determine whether exchange rate changes are permanent or temporary. This is why Norges Bank normally changes interest rates gradually in response to exchange rate movements.

The projections and analyses in Norges Bank’s Inflation Reports, combined with the ongoing assessment of the outlook for price and cost inflation, output and employment and developments in the money and foreign exchange markets, form the basis for monetary policy decisions. To improve the basis for its decisions, Norges Bank has established a regional network to gather information from the public and private sectors. (For further details on the regional network, see Norges Bank’s Annual Report for 2002.)

Developments in inflation, adjusted for some temporary factors, provide a basis for assessing the monetary stance. It is important in this context that the operational objective of monetary policy is a rise in consumer prices of 2½ per cent over time, and not such an inflation rate at any point in time. The precision in attaining the inflation target that can reasonably be expected from monetary policy must also be taken into account. Norges Bank expressed its views on the monetary policy mandate in its submission to the Ministry of Finance of 27 March 2001. The submission stated the following:

“If there are significant deviations between actual price inflation and the target, the Bank will provide a thorough assessment in its annual report. Particular emphasis will be placed on any deviations outside the interval of +/- 1 percentage point.”

There will always be some measure of uncertainty associated with economic developments and inflation. Professional judgment must therefore be exercised in interest rate setting. Empirically, the uncertainty surrounding inflation forecasts would indicate that when monetary policy is oriented towards reaching the target of 2½ per cent, inflation will remain within the interval of +/- 1 percentage point around 80 per cent of the time, which is consistent with the experience of other countries with an inflation targeting regime. However, these projections are based on the experience gained in a period that featured low and stable inflation in OECD countries. In periods of very high inflation abroad and periods where inflation is close to zero or negative, there will probably be a higher degree of uncertainty associated with the projections.

2.2 Trade-offs in monetary policy

When inflation deviates from 2½ per cent, a number of different monetary policy strategies may be used to bring inflation back to target. When the deviations are substantial, one of the key questions in monetary policy is how quickly to proceed.

The underlying premise is that monetary policy only has a limited effect on consumer price inflation over the first few months. Many prices are subject to price agreements that apply for a period ahead. If the objective of monetary policy were to bring inflation rapidly back to target, for example in the course of six months, the interest rate would probably have to be set to induce a substantial change in the exchange rate. At the same time, such a strategy could have a considerable impact on demand, on the production of goods and services and on employment. This is referred to in the literature as strict inflation targeting (see, for example, Svensson (2002).¹ A more flexible approach may be to apply a somewhat longer period to bring inflation back to target, so-called flexible inflation targeting. Such a policy will have less impact on demand and output than strict inflation targeting.

In many cases, a change in interest rates will contribute to steering both inflation and total demand in the desired direction. An unexpected fall in total demand for goods and services will, for example, lead to a fall in inflation, output and employment. Lower interest rates will then lead to a renewed rise in both demand and inflation. Other disturbances may, however, create a conflict between price stability and stability in the real economy in the short term. For example, marked wage growth as a result of wage negotiations could simultaneously lead to higher inflation and lower employment. A tighter monetary policy would then contribute to reducing inflation, but might at the same time result in a further fall in output and employment. Various kinds of unexpected events will often occur at the same time. The central bank must then weigh the effects on output and employment against the variability in inflation around the inflation target. If developments in wage growth indicate that there is no confidence in monetary policy or that wage formation is not anchored in the inflation target, the objective of low and stable inflation will be given considerable weight.

The choice of horizon for monetary policy implicitly sheds light on monetary policy trade-offs. A central bank that places considerable emphasis on smoothing variability in inflation, and little emphasis on stability in output and employment, will choose a short horizon. A central bank that places considerable emphasis on developments in the real economy will choose a long horizon.²

Normally, Norges Bank sets the interest rate with a view to achieving inflation of 2½ per cent at the two-year horizon. However, it would in general have been possible to attain the inflation target in the nearer term by changing the interest rate more rapidly and more markedly. Norges Bank has therefore chosen to operate a flexible inflation targeting regime where variability in both output and inflation are given weight. The choice of horizon is based on a perception of how interest rates influence the path of inflation and output, and the central bank’s approach to striking a balance between the variability in these two variables.³

The inflation target is a vehicle for, not an obstacle to, monetary policy’s contribution to stabilising output and employment. This objective is also expressed in the Regulation on Monetary Policy:

“Monetary policy shall be aimed at stability in the Norwegian krone’s national and international value, contributing to stable expectations concerning exchange rate developments. Monetary policy shall also underpin fiscal policy by contributing to stable developments in output and employment.”

Consequently, the path of inflation and the real economy in the period ahead will be taken into account when setting interest rates. In situations where the central bank’s forecasts indicate that inflation will be equal to the target at the two-year horizon, but that there is also substantial spare capacity, it may be appropriate, for example, to orient monetary policy so that the inflation projections temporarily overshoot the inflation target somewhat to remedy imbalances in the real economy. If financial and foreign exchange market participants have confidence in the inflation target, Norges Bank will have greater scope for promoting stability in the real economy. This scope will increase further as the inflation target is incorporated as an anchor for wage formation. When there is a risk that inflation may deviate considerably from the target over a period, or confidence in monetary policy is in jeopardy, pronounced and rapid interest rates changes may be appropriate.

2.3 The work on monetary policy

The Annual Report for 2002 included an account of the Executive Board’s work on monetary policy. As described in the Report, the Executive Board engages in a thorough discussion of monetary policy every sixth week. Any decisions concerning interest rate changes or other important changes in the use of monetary policy instruments will normally be taken at these meetings. In other contexts, when assessments are provided with regard to new economic developments that are of considerable importance for price developments and interest rate setting, such as the Governor’s annual address in February 2003 and his speech at the Centre for Monetary Economics (CME) in June this year, the members of the Executive Board are consulted in advance.

The Executive Board’s overall assessments and evaluations are expressed in the Strategy Document⁴ and in the introduction to the press conference that is held immediately following the monetary policy meetings.

Footnotes