The past 20 years have brought major changes in monetary policy, in Norway and abroad. Most central banks now have instrument independence, and price stability is the common objective of monetary policy. The organisation of the monetary policy decision within central banks has also changed. This decision is now typically taken by a committee. There have also been major changes in terms of transparency and communication.
These developments are the product of both economic theory and historical developments. Despite similar developments across countries, there are still differences, particularly in the composition, size and working methods of monetary policy committees, but also in how central banks communicate. Differences across countries are probably a reflection of different economies and different traditions. Theoretical and empirical research provide guidance as to the optimal framework, but do not give a clear answer.
In the late 1960s, Phelps (1967) and Friedman (1968) showed how economic agents' expectations can limit the authorities' options. The experience of the 1970s and 1980s, both in Norway and abroad, revealed that there is no long-term trade-off between unemployment and inflation. This acknowledgment has played a significant part in the shift in most OECD countries to price stability as a primary objective of monetary policy. Lucas (1972) showed that the relationships between economic variables are not stable but are affected by the design of economic policy. Only by studying individual agents' economic behaviour can one arrive at stable relationships for how economic policy works. Kydland and Prescott (1977) noted that authorities can achieve long-term policy goals only by making a credible commitment to them. They presented arguments for making central banks independent of political authorities and having binding monetary policy objectives.
Over the past 20-30 years, economic theory and historical experience have provided guidance on how monetary policy should be organised and implemented. There have been major changes in how central banks operate. Their implementation of monetary policy has many similarities, but there are also differences between countries. In this article, we look more closely at whether these differences are significant. We also present an overview of international practice and the recommendations from the monetary policy literature.
2 Recommendations from the literature
The economic literature provides some guidance on how countries today should organise and implement monetary policy.
The central bank should be independent
Economic theory suggests that responsibility for the day-to-day implementation of monetary policy should be delegated to an independent central bank. The work of Kydland and Prescott on rules of conduct for economic policy in the late 1970s was crucial to this conclusion. In their work, economic agents (enterprises and households) do not systematically misjudge what the authorities intend to do in the future. Economic agents look forward when they make their decisions so that expectations of economic developments influence actual economic developments. If wage-earners expect high inflation, they will demand higher wages than if they had expected low inflation. If enterprises expect high inflation, they will raise prices more than if they had expected low inflation. Thus, expectations of high inflation will in themselves contribute to high inflation. This means that there is no long-term trade-off between inflation and unemployment. It is important, therefore, for inflation expectations to be stable and low. This suggests that monetary policy should have price stability as a primary goal, as this will help to anchor inflation expectations at a low level. When there is confidence that inflation will remain low and stable over time, there is also scope for monetary policy to stabilise short-term fluctuations in the real economy. However, politically elected authorities might be tempted to pursue a too expansionary monetary policy in the short run, for example to secure re-election. Politicians' promises of conducting a monetary policy with the objective of price stability may, therefore, be seen as having little credibility, and economic agents may have reason to expect high inflation. One solution to this problem is to transfer responsibility for monetary policy to a body which is not exposed to this temptation, such as an independent central bank. (See, for example, Walsh (2003) and Dornbusch, Fischer and Startz (2004) for further details.)
Decisions should be transparent
From a democratic point of view, delegating the implementation of monetary policy--an important part of economic policy as a whole--from elected representatives to an independent body may be considered problematic. It is therefore important for the central bank to have a clear mandate and to be transparent, so that elected representatives, the press and the public can always verify that the central bank is managing monetary policy in line with its mandate (see, for example, Blinder (1998)).
Interest rate decisions should be taken by a monetary policy committee
Democratic arguments may also suggest that decisions by an independent central bank should be taken by a committee. If the mandate for monetary policy is formulated in general terms, this leaves room for interpretation. It may, therefore, be an advantage for monetary policy not to be shaped by just one person's interpretation.
Recent research indicates that decisions by a committee also have other benefits. A committee's decisions will be based on a broader range of information and assessments than those of an individual. Committees can also act as insurance against serious misjudgements. However, the literature does not give clear answers about the ideal size, composition and working methods of committees taking monetary policy decisions. Nor is it clear what might be the correct division of duties between the central bank's staff and the monetary policy committee. Maier (2007) provides an overview of the literature on monetary policy committees. (2)
The central bank should influence interest rate expectations through communication
In the monetary policy literature, the terms "transparency" and "communication" tend to be used interchangeably. However, it may be useful to reserve the term "communication" for central banks' active use of transparency as a means of influencing agents' expectations.
One important feature of modern monetary policy theory is that economic agents make their decisions on the basis of expectations of the future. The impact of monetary policy will, therefore, depend at least as much on agents' expectations of future movements in interest rates as on their current levels. Thus, for monetary policy to be as effective as possible, it is necessary for agents to understand the central bank's intentions in its rate-setting. In addition, it is important that the central bank makes its response pattern known, so that agents' reaction to new information has a stabilising effect. Thus, modern monetary policy theory suggests that the central bank should be open about (communicate) its response pattern and its expectations of movements in interest rates and the economy. (3) (See, for example, Woodford (2005) and Svensson (2007).)
Monetary policy theory implicitly assumes that decisions are made by a single person. The central bank can then easily communicate an explicit expected interest rate path by being completely open about the reasoning behind its interest rate decisions. If the decisions are made by more than one person (a committee), however, there may be some conflict between the need for transparency and the need to influence agents' interest rate expectations effectively. The central bank runs the risk of speaking with too many voices, with the result that its signals about monetary policy ahead become unclear. (4,5)
Empirical research suggests that the minutes of a monetary policy committee's discussions can provide indications of the orientation of monetary policy ahead (see, for example, Gerlach-Kristen (2004)). Some central banks communicate the orientation of monetary policy ahead directly by publishing an interest rate path.
3 Is there consistency between theory and practice? (6)
It is customary to compare Norway with the traditional industrialised countries in the OECD area. In this section, we look more closely at the frameworks in these countries (see overview in Table 1). We will look at the Norwegian system in more detail in Section 4.
Independent central banks
In all of these countries, it is the political authorities which define the overriding objective of monetary policy, often through legislation. The level of detail in which the authorities specify this objective varies somewhat, but the common denominator is that responsibility for the implementation of monetary policy is delegated to a central bank which is independent in its use of policy instruments to achieve the objective.
In most of the countries, price stability is the objective of monetary policy. This can either take the form of inflation targeting or be indirect through a fixed exchange rate, such as in Denmark, where the exchange rate is pegged to the euro. In some countries, such as the UK and Norway, the goal of price stability has been quantified by the political authorities. In Sweden and the euro area, the central banks themselves (Sveriges Riksbank and the ECB) have quantified the goal of price stability, although the general objective of price stability is laid down in law.
Today's monetary policy can be viewed as the result of a long learning curve to which both economic research and the authorities have contributed. The lesson learned from economic theory and economic policy in the 1960s, 1970s and 1980s was that unemployment cannot be reduced in the medium to long term by accepting...