Norges Bank's instrument for achieving the objective of low and stable inflation is the key policy rate--the rate of interest on banks' deposits in Norges Bank. But how do Norges Bank's interest rate decisions affect market interest rates? They work through liquidity policy. The aim of liquidity policy is to ensure that banks always have sufficient deposits in Norges Bank so that short-term money market rates remain just above the interest rate on banks' deposits in Norges Bank. Norges Bank uses auctions of F-loans--fixed-rate loans with varying maturities issued against collateral--as its liquidity policy instrument. The system for channelling government petroleum revenues into the Government Pension Fund--Global plays a major role in the implementation of liquidity policy. Liquidity policy also has a part to play in the event of turbulence in financial markets.
The Norwegian public's interest in monetary policy centres largely on Norges Bank's interest rate decisions and the effect of these decisions on banks' lending and deposit rates. Norges Bank sets the key policy rate, which is the rate of interest on banks' deposits in Norges Bank.
The theme of this article is how Norges Bank uses liquidity policy to ensure that the banking system as a whole has net deposits in Norges Bank so that short-term money market rates, including rates of interest on interbank loans, remain just above the key rate. In this way, Norges Bank ensures that changes in the key rate actually have an impact on banks' funding costs. In response to such changes in banks' funding costs, banks usually adjust their lending and deposit rates.
Norges Bank is both the government's bank and the banks' bank. Government revenues and expenditures result in daily transfers of deposits between banks' accounts and the government's account. This leads to major fluctuations in banks' deposits in Norges Bank during the year. The systems for the payment of petroleum tax and for channelling the government's petroleum revenues are particularly important for the implementation of liquidity policy and are therefore dealt with separately in the last part of this article. Liquidity policy helps to neutralise the effect of fluctuations in banks' deposits in Norges Bank. In this way, liquidity policy also helps to neutralise the effect of these fluctuations on short-term money market rates. (2)
Monetary policy objectives and instruments
The operational target of monetary policy in Norway is low and stable inflation, defined as annual consumer price inflation of approximately 2.5 per cent over time. Norges Bank operates a flexible inflation targeting regime so that both variations in inflation and variations in output and employment are taken into account. Interest rates should be set with a view to stabilising inflation close to the target in the medium term. The exact horizon will depend on the disturbances to which the economy is exposed, and on how they affect the path for inflation and the real economy going forward.
Norges Bank publishes a monetary policy report (previously known as the inflation report) three times a year. Since Inflation Report 3/05, the analyses have been based on the Bank's own forecast for the key policy rate. The interest rate forecast strikes a balance between the different considerations that should be taken into account. Every four months, the Executive Board adopts a monetary policy strategy for the coming four months based on the analysis in the Monetary Policy Report. This strategy is published at the beginning of the period to which it applies, and is conditional on economic developments being broadly in line with projections. The individual interest rate decisions are anchored in this rate-setting strategy. Norges Bank's Executive Board discusses and reaches decisions on the key rate at monetary policy meetings, which are normally held every six weeks.
The objectives of monetary policy and the process leading to Norges Bank's interest rate decisions are outlined above. (3) Besides publishing interest rate decisions and assessments of future developments, Norges Bank must ensure that changes in the key rate actually influence short-term money market rates. This is achieved through liquidity policy.
All banks established in Norway can have a sight deposit account with Norges Bank. It is the rate of interest on overnight deposits in such accounts which is Norges Bank's key rate, and that Norges Bank uses to achieve a broad impact on short-term money market rates. The key rate forms a floor for short-term money market rates, including the interest rate on short-term interbank loans. The reason for this is that if banks with surplus liquidity are able to deposit money with Norges Bank at this rate of interest, there is little incentive to invest this money in the market at a lower interest rate. The sum of banks' overnight deposits in accounts with Norges Bank is known as the banking system's liquidity. The role of liquidity policy is to ensure that there is sufficient liquidity, with the result that the banking system as a whole has a net deposit position with Norges Bank overnight, and short-term money market rates remain just above the sight deposit rate (see Chart 1).
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Market interest rates for longer maturities are affected by the current level of the key rate and by market key rate expectations. Market key rate expectations depend both on participants' understanding of the central bank's response pattern and on their view of the economic outlook. Norges Bank can influence these views through its communication. This includes press releases and press conferences in connection with interest rate decisions, monetary policy reports, and speeches by the Bank's management.
Norges Bank also has an automatic lending facility for banks: overnight loans (D-loans). The overnight lending rate serves as a ceiling for short-term money market rates. Overnight D-loans are used to only a very limited extent as liquidity policy brings banks into a net deposit position at the end of the day. The overnight lending rate therefore has no monetary policy significance under the current monetary policy regime. (4) Intraday D-loans are used by the banks to obtain liquidity when settling payment transactions (see Box 1).
BOX 1: Intraday and overnight D-loans and F-loans (1) Norges Bank's lending facilities have two purposes. First, they are to ensure that the Bank's interest rate decisions actually influence short-term money market rates. Second, they are to ensure that Norges Bank can fulfil its role as a settlement bank for banks established in Norway. Both D-loans and F-loans require the provision of approved collateral in the form of securities. While F-loans and overnight D-loans attract interest, intraday D-loans do not. The collateral provided determines the limit for a bank's overall access to borrowing from Norges Bank. The Bank uses loans with a fixed maturity and fixed interest rate--F-loans--to provide liquidity, in other words to ensure that the banking system as a whole has sufficient sight deposits at the end of the day. The interest rate on F-loans and the size of F-loans allotted are determined by auction (see Box 2). Normally, the interest rate on F-loans will be just above the key policy rate. A bank can use part of its overall borrowing access for F-loans and the remainder for D-loans. D-loans function as an overdraft facility, and banks can vary the size of their drawings on D-loans through the day. Since the interest rate on overnight D-loans is higher than short-term money market rates, a bank will not normally draw on overnight D-loans. Through the day, D-loans are used to settle payments. A bank's disposable funds in Norges Bank comprise the sum of a bank's sight deposits and unused D-loan access. Banks use these funds to settle interbank payments and make payments to the government's accounts with Norges Bank. There may be major variations in a bank's sight deposits and D-loan drawings through the day. Before the end of the day, banks normally ensure that their D-loans are repaid. To avoid being in a D-loan position overnight, a bank can, where necessary, borrow from other banks in the interbank market. Since Norges Bank ensures that the...