Norges Bank Monetary Policy
The Challenges of Globalisation for Small
open Economies with Independent
Currencies
Reykjavik, 31 May and 1 June 2007
Session 1: Challenges of globalisation to monetary
policy in small open economies
Audun Grønn:
Optimal monetary policy in a small open economy – the
Norwegian experience
Reykjavik_31 May 2007
1
Norges Bank Monetary Policy
Motivation for presentation
• Globalisation is a driving force for greater openness /
transparency
• Experience has led Norges Bank to adopt a monetary
policy regime marked by a high degree of
transparency
– Secrecy and surprises tried earlier – with mixed experience
– In 2005, introduction of endogenous interest rate path – the
central bank taking ownership of the interest rate forecast
– High degree of transparency viewed as ”optimal”
• Review of the monetary policy framework in Norway
Reykjavik_31 May 2007
2
Norges Bank Monetary Policy
Monetary policy framework in Norway
• What do we do?
• Why do we do it?
• How do we do it?
Reykjavik_31 May 2007
3
What do we do?
Norges Bank Monetary Policy
Monetary policy in Norway
Objective:
• Low and stable inflation
- close to 2.5 per cent over time
Implementation:
• A flexible inflation targeting regime
• Stabilise inflation in the medium term
Decision structure:
• Consensus seeking committee
(Governor, Dep. governor + 5 external members)
Reykjavik_31 May 2007
4
What do we do?
Norges Bank Monetary Policy
Three main ingredients of Norges Bank
communication
• The forecasts (baseline scenario)
• The uncertainty analysis (uncertainty
surrounding the projections – alternative
scenarios)
• The decomposition of changes in the interest
rate forecast
Reykjavik_31 May 2007
5
The forecasts: Baseline scenario in MPR 1/07
9
Key interest rate
8
7
6
5
4
3
30% 50% 70% 90%
2
1
0
2005 2006 2007 2008 2009 2010
9
8
7
6
5
4
3
2
1
0
4
Norges Bank Monetary Policy
Output gap
3
3
2
2
1
1
0
0
-1
-1
-2
2005 2006 2007 2008 2009 2010
-2
4
4
CPI
4
3
3
2
2
1
1
0
0
-1
2005 2006 2007 2008 2009 2010
Reykjavik_31 May 2007
-1
4
3
4
CPI adjusted for
taxes and energy
3
2
2
1
1
0
2005 2006 2007 2008 2009 2010
0
6
Norges Bank Monetary Policy
Uncertainty analysis: Alternative scenarios in MPR 1/07
CPI-ATE
4
4
3
2
3
Higher capacity
utilisation
1
0
2
1
Lower
inflation
0
4
Higher capacity utilisation
3
Lower inflation
4
3
2
2
1
1
0
0
-1
-1
-2
-2
2005 2006 2007 2008 2009 2010
2005 2006 2007 2008 2009 2010
9
8
7
6
5
4
3
2
1
0
Output gap
Key interest rate
Higher capacity
utilisation
Lower
inflation
9
8
7
6
5
4
3
2
1
0
2005 2006 2007 2008 2009 2010
Reykjavik_31 May 2007
7
Decomposition of changes in the interest rate path
Norges Bank Monetary Policy
8
8
7
7
6
5
5
MPR 1/07
4
3
6
IR 3/06
IR 1/06
IR 2/06
4
3
2
2
1
1
0
2004 2005 2006 2007 2008 2009
0
Reykjavik_31 May 2007
8
Decomposition of changes in the interest rate path
Isolated effect on the interest rate of
higher output gap and weaker
exchange rate (red line).
Isolated effect on the interest
rate of lower inflation (red line).
8
Norges Bank Monetary Policy
8 8
8
7 7
7
6
6 6
6
5
5 5
5
4
4 4
4
3
3 3
3
2
2 2
2
1
1 1
1
0
2004 2005 2006 2007 2008 2009
0 0
2004 2005 2006 2007 2008 2009
0
7
30% 50% 70% 90%
Reykjavik_31 May 2007
9
Norges Bank Monetary Policy
Why do we do it?
• Why interest rate forecasts?
• Previous practice of Norges Bank interest rate
assumptions
• Talking about the future – expectations
Reykjavik_31 May 2007
10
Why do we do it?
Norges Bank Monetary Policy
Why interest rate forecasts?
• A key rationale for introducing interest rate forcasts
as forward guidance has been to improve the
projections in the IR/PPR and simplify Norges Bank’s
communication of its monetary policy
• The backdrop to this is the evolution of the thinking of
Norges Bank, which has become based on the
recognition that an essential part of monetary policy
is ”management of expectations”
Reykjavik_31 May 2007
11
Why do we do it?
Norges Bank Monetary Policy
Previous practice of Norges Bank’s
interest rate assumption
• 2001 - 2002 Constant interest rate
• 2003 - 2005 Markets’ interest rate expectations
…with comments
• 2005
Reykjavik_31 May 2007
Our own interest rate forecast
12
Why do we do it?
Norges Bank Monetary Policy
Talking about the future…
– “In these circumstances, the Committee believes
that policy accommodation can be maintained for
a considerable period"
(FED, 2003-2004)
– ” the prospect of continued low inflation in Norway
also implies that we should lag behind other
countries in setting interest rates at a more normal
level”
(Norges Bank, 2004-2005)
Reykjavik_31 May 2007
13
Norges Bank Monetary Policy
How do we do it?
• Criteria
• Models
Reykjavik_31 May 2007
14
How do we do it?
Norges Bank Monetary Policy
Criteria for choosing a good interest rate
path
1. Inflation close to the target in the medium term.
2. Reasonable balance between the path for inflation and
the path for capacity utilisation.
Assuming the criteria above have been satisfied, the following
additional criteria are useful:
3. Robustness
4. Consistence
5. Cross-checks
Reykjavik_31 May 2007
15
How do we do it?
Norges Bank Monetary Policy
Forward-looking core model
• Currently 1A – ”pedagogical device”
– Gap model determining interest rate, inflation,
output, exchange rate
• Implementing NEMO
Reykjavik_31 May 2007
16
How do we do it?
Norges Bank Monetary Policy
Modelling monetary policy: two approaches
• Simple interest rate rule
rt = art-1 + (1-a)[b1(Etpt+k -p*)+b2yt +b3Dyt]
• Optimal policy
– Minimizing a loss function
L = (π - π*)2 + λy2 + δ(r - r-1)2
Reykjavik_31 May 2007
17
How do we do it?
Norges Bank Monetary Policy
Inflation and output gaps in the baseline
scenario
3
2
3
Output gap
2
1
1
0
0
-1
-1
Inflation gap
-2
-2
-3
-3
2005
Reykjavik_31 May 2007
2006
2007
2008
2009
2010
18
How do we do it?
Norges Bank Monetary Policy
Discretion vs commitment
• Discretion
– Re-optimize each period
– Take expectations as given
• Commitment
– Commit oneself to a specific reaction pattern
– Seek to affect private expectations
• Types of commitment
– Ramsey rule
• Re-optimize today, but commit in all future periods
• Exploit the initial conditions
– Timeless perspective
• As Ramsey, but act as if you committed long time ago
• Does not exploit the initial conditions
 The interest rate path in MPR 1/07 only consistent with
commitment
Reykjavik_31 May 2007
19
Experience
Norges Bank Monetary Policy
Effects on three-months forward interest rates1)
Change from the previous day to the day of publication of IR/PPR
0,50
0,45
0,40
0,35
0,30
0,25
0,20
0,15
0,10
0,05
0,00
IR
1/03
Reykjavik_31 May 2007
IR
2/03
1)Average
IR
3/03
IR
1/04
IR
2/04
IR
3/04
IR
1/05
IR
2/05
IR
3/05
IR
1/06
IR
2/06
IR
3/06
PPR
1/07
of absolute value of changes in htree-month implicit forward interest rates. Chang eof iterest rate on publication
20
and two years ahead (overall change for 9 three-month rates).
Norges Bank Monetary Policy
Experience
• Market participants
– Well understood
• Communication
– More precise than verbal deliberations alone
• Internal organisation
– Close link between analysis and policy makers
• Competence
– New analytical challenges
Reykjavik_31 May 2007
21
Norges Bank Monetary Policy
Final remarks
• Publishing an interest rate forecast requires
modelling monetary policy
• Simple rules and optimal policy both useful
approaches for internal analysis
• Moved towards optimal policy in a timeless
perspective as the benchmark
• Judgment will always be needed
Reykjavik_31 May 2007
22