Monetary policy, forecasts and market communication.

• Author: Gjedrem, Svein
• Position: Central Bank Governor Svein Gjedrem's speech of June 7, 2001, to the Norwegian School of Management's Centre for Monetary Economics - Transcript - Statistical Data Included - Brief Article

Speech given by Central Bank Governor Svein Gjedrem at the Norwegian School of Management's Centre for Monetary Economics, 7 June 2001

The long-term objective of monetary policy is to contribute to low and stable inflation. Price stability is the best contribution monetary policy can make to economic growth and prosperity. A nominal anchor is also a necessary precondition for stable financial markets and property markets. We cannot achieve higher employment in the long run by accepting higher inflation. On the contrary, the experience of our country and that of others in the 1970s, 1980s and 1990s is that periods of high inflation are followed by downturns with high unemployment. High and variable inflation also leads to an arbitrary redistribution of wealth and income.

This spring, the Government assigned a new operational mandate for monetary policy to Norges Bank. Norges Bank shall set the key rate with a view to maintaining low and stable inflation. The inflation target is set at 2 1/2 per cent. I will use this occasion to elaborate on our interpretation of the mandate and to discuss how it will affect the conduct of monetary policy.

The inflation outlook is presented three times a year in Norges Bank's Inflation Reports, and forms a basis for the Bank's interest rate decisions. Further assessments are presented every six weeks in connection with the Executive Board's monetary policy meetings.

Mandate, interpretation and implementation

New Zealand was the first country to introduce an inflation target in 1989.(1) Chile followed in 1990, Canada in 1991, the UK in 1992, Sweden, Finland and Australia in 1993 (Finland until 1998), Spain in 1994 (until 1998) and Iceland and Norway in 2001. A number of emerging market economies like the Czech Republic and Poland, as well as Israel, South Africa and Brazil, have introduced inflation targets in the last few years.(2) The ECB shall direct its monetary policy instruments towards price stability, which the bank has defined as inflation of less than 2 per cent. The target of the Swiss central bank has a similar formulation. In the US, price and employment stability are equally important. Experience with inflation targets has generally been good. Low and stable inflation has underpinned economic growth and employment. The fact that conditions were favourable for low inflation and renewed growth in many countries following the downturn and high unemployment in the early 1990s may also have contributed positively.

Norway introduced an inflation target during a different phase of the economic cycle. We have experienced a prolonged upturn. The labour market is tight. High labour force participation and demographic conditions indicate that the possibility for further growth in the labour supply is limited. In addition, reforms that reduce the supply of labour were implemented. At the same time, because of our large petroleum revenues, the Norwegian authorities do not face the same budget constraints on their fiscal policy as other countries faced when they introduced inflation targets. Several of the OECD countries have substantial budget surpluses now, however. Finland expects a budget surplus of 5.3 per cent of GDP this year.(3) New Zealand and Ireland have introduced fund schemes where they invest their budget surpluses in anticipation of higher pension disbursements later in this century.

The new Regulation on Monetary Policy was adopted on 29 March 2001. Section 1 reads as follows:

Monetary policy shall be aimed at stability in the Norwegian krone's national and international value, contributing to stable expectations concerning exchange rate developments. At the same time, monetary policy shall underpin fiscal policy by contributing to stable developments in output and employment. Norges Bank is responsible for the implementation of monetary policy. Norges Bank's implementation of monetary policy shall in accordance with the first paragraph, be oriented towards low and stable inflation. The operational target of monetary policy shall be annual consumer price inflation of approximately 2 1/2 per cent over time. In general, the direct effects on consumer prices resulting from changes in interest rates, taxes, excise duties and extraordinary temporary disturbances shall not be taken into account. Storting Report no. 29 of 2001, "Guidelines for economic policy" states:

Consumer price inflation is expected to remain within an interval of +/-1 percentage point around the target. The inflation target of 2 1/2 per cent over time is slightly higher than the targets in Sweden, Canada and the euro area, but corresponds to targets in the United Kingdom and Australia. In the US, consumer price inflation has been somewhat higher the last ten years. The target is approximately in line with the average inflation rate in Norway in the 1990s.

In our view, with its change in monetary policy, the Government has recognised low inflation as a benefit in itself. History has shown that high inflation does not result in either sustained economic growth or lower unemployment rates. A track record of low inflation since 1990 has provided Norges Bank with a good basis for implementing monetary policy even though, as I mentioned, the inflation target was introduced during an upturn.

Higher interest rates curb demand for goods and services and reduce inflation. Lower interest rates have the opposite effect. If evidence suggests that inflation will be higher than 2 1/2 per cent with unchanged interest rates, the interest rate will be increased. If it appears that inflation will be lower than 2 1/2 per cent with unchanged interest rates, the interest rate will be reduced. There is symmetry here. It is equally important to avoid an inflation rate that is too low, or deflation, as it is to avoid an inflation rate that is too high. When the annual use of petroleum revenues is managed according to a long-term action plan, a policy for which there is currently fairly general political consensus, we should normally be able to use the interest rate as a policy instrument to prevent high inflation. Normally, monetary policy should also be a fairly effective means of countering a deflationary recession. Stagflation, ie stagnating output and rising unemployment combined with rapid inflation, which characterised economic developments in many countries in the 1970s and 1980s, originates in the supply and output side of the economy or in income determination. If the Norwegian economy should ever be threatened by stagflation tendencies, monetary policy must be directed towards maintaining low and stable inflation. At the same time, structural policy and incomes policy should contribute to improving the functioning of the economy, allowing economic growth and employment to pick up.

A change in interest rates is not expected to have an immediate effect on inflation. Our analyses indicate that a substantial share of the effects of an interest rate change occurs within two years. Two years is thus a reasonable time horizon for achieving the inflation target of 2 1/2 per cent. Therefore, the inflation outlook in two years may be viewed as a derived objective in monetary policy.

In some situations, where unexpected events lead to an inflation rate that is too high, it may be appropriate to apply a longer time horizon than two years. For example, reducing inflation to 2 1/2 per cent within this time horizon may be associated with unnecessary real economic costs. A precondition for applying a longer time horizon is that there is clear evidence of strong confidence in low and stable inflation over time on the part of economic agents. Gradually, as we gain experience with setting interest rates according to an inflation target, the possibilities for placing emphasis on stability in the real economy will probably increase.

Low and stable inflation is a necessary precondition for stability in the foreign exchange and financial market and the property market. However, there have also been episodes where bubbles have accumulated in these markets, in the form of sharp increases in asset prices, while inflation has been low. Price increases in property and financial markets may have a considerable impact on wage growth and consumer price inflation after a period. When the bubbles burst, the result may be an economic downturn. In this way, developments in financial and property markets may be a source of a more unstable inflation environment. In principle, it would be appropriate to use the interest rate to counter this. In practice, however, it is difficult to assess whether price trends in property and financial markets are sustainable.

When Norges Bank concludes that the key rate should be changed, the change will in most cases be made gradually. This is because there is normally uncertainty about the...