Inflation targeting--some theory with main focus on practice *.

Author:Gjedrem, Svein

Norway has had an inflation target for monetary policy since March 2001. This article explains 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. Views on monetary policy in Norway have changed since 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." (1)

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.

The prevailing view of 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 probably curb debt-financed investment. The question is whether this will eliminate the lowest priority investments. In the long run, we are dependent on long-term investment, interest rate changes may therefore have adverse effects in Norway that do not occur in other countries."

This stands in contrast to the current view, as expressed by Norges Bank's delegating authority, the Ministry of Finance (2):

"The new guidelines for economic policy also imply that monetary, policy, has been given a clear role in stabilising economic developments. This means that the scope for manoeuvre in monetary, policy should be used if the outlook for the economy changes."

In the 1950s and 1960s, a strong belief evolved that the economy could be controlled and steered in the desired direction. This optimistic view gradually lost favour in the face of developments. The way in which economic policy is oriented today reflects the experience gained and the lessons learned in the 1970s and 1980s. (3) Economic policy at that time was marked by coordination, control and regulation. Important elements were:

* fiscal policy oriented towards full employment

* credit regulation within limits specified in a separate credit budget

* channelling of loans through the state banks and regulation of capital movements

* low nominal interest rates stipulated by the government authorities

* a fixed, though adjustable, krone exchange rate

* use of price regulation

* an active business policy through state ownership and state grants and subsidies.

The use of price regulation was particular to Norway. The following description is by Petter Jakob Bjerve (4):

"A characteristic of postwar Norwegian economic policy compared with policies in other countries in the west, is that prices have largely been directly set by the authorities, while wages and other income have been determined by the market and by market organisations. With the high level of employment that the government sought to achieve in the 1970s, inflation was probably lower with price regulation than it would have been without it. Nonetheless, there was repeated evidence that freezing prices without freezing wages could not prevent a fairly sharp rise in prices. In 1978-1979, we witnessed a demonstration of the extent to which the rise in prices can be slowed, at least temporarily, when a price freeze is combined with a wage freeze. But even this combination, which can only be temporary, cannot in the long run prevent a sharp rise in prices if the gap between demand and supply is too wide--as demonstrated by the rise in prices after 1980."

In Norway, the efforts to develop an economy under strong centralised coordination and control culminated in the 1973 proposal (5) to establish an incomes policy council. According to the proposal, the social partners would undertake a commitment through the council to keep negotiated wage increases within specific limits. It was also stipulated that demand management policy should be included as part of incomes policy.

The proposal to establish an incomes policy council did not receive support. There was ultimately too much control and coordination. Now, only 30 years later, virtually nothing of this system remains. The structure was not solid enough. We know from experience that fiscal policy alone cannot ensure a high level of employment. The structure of the labour market and wage formation are probably of greater importance. The direct regulation of credit, interest rates and capital movements collapsed and was phased out in the 1980s. The krone is floating. Price regulation no longer plays a role as a macroeconomic instrument. The scope of business policy has become more general. State ownership in the Norwegian...

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