Norges Bank 1 Monetary policy framework in Norway Øistein Røisland Norges Bank.

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Norges Bank

Monetary policy frameworkin Norway

Øistein RøislandNorges Bank

Norges Bank

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Agenda

• What do we do?

• Why do we do it?

• How do we do it?

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What do we do?

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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)

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30% 50% 70% 90%

Key interest rate

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Output gap

CPI CPI adjusted for taxes and energy

Baseline scenario in Monetary Policy Report 1/07

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Alternative scenarios in Monetary Policy Report 1/07

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Lower inflation

Higher capacity utilisation

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Lower inflation


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4Lower inflation


Key interest rate

Output gapCPI-ATE

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Decomposing changes in the interest rate path

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IR 1/06

IR 2/06

IR 3/06

MPR 1/07

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Isolated effect on the interest rate of lower inflation (red line).

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830% 50% 70% 90%

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Isolated effect on the interest rate of higher output gap and weaker

exchange rate (red line).

Decomposing changes in the interest rate path

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Norges Bank

Why interest rate forecasts?

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Changes in Norges Bank’s interest rate assumption

• 2001 - 2002 Constant interest rate

• 2003 - 2005 Markets’ interest rate expectations

…with comments

• 2005 Our own interest rate forecast

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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)

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Experiences

• Communication– More precise than verbal deliberations alone

• Market participants– Well understood

• Internal organisation– Close link between analysis and policy makers

• Competence– New analytical challenges

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a. March 2006 b. July 2006

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Implied forward rates before report (shaded)

Implied forward rates day after report (black)

NB forecast (red)

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NB forecast (red)

Market reactions after publication of Monetary Policy Reports

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a. March 2006 b. July 2006

c. November 2006

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NB forecast (red)

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NB forecast (red)

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NB forecast (red)

Implied forward rates month after report (green)

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NB forecast (red)

d. March 2007

Market reactions after publication of Monetary Policy Reports

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Norges Bank

How do we do it?

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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

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Core model

• Currently– Simple 4 equation ”new-keynesian” model

• Implementing– NEMO, a modern DSGE model– Down-scaled version of GEM

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Modelling monetary policy: two approaches

• Simple interest rate rule

rt = rt-1 + (1-)[1(Ett+k-*)+2yt +3yt]

• Optimal policy – Minimizing a loss function

L = (π - π*)2 + λy2 + δ(r - r-1)2

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Simple rule

rt = rt-1 + (1-)[1(Ett+k-*)+2yt +3yt]

• Iterate towards optimal policy through choices of coefficients

• No unambiguous relationship between coefficients and preferences (loss function)

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Inflation and output gaps in the baseline scenario

Output gap

Inflation gap

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”Lambda”-consistency

• Preferences should be consistent over different strategy rounds

• Used to apply an indirect method to estimate ”lambda”– ”Revealed preferences”– Compare loss with higher and lower interest rate than

reference path– Gives an interval for ”lambda” in Norges Bank’s loss

function– However: This method is only valid under a discretionary

policy!

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Output gap

Inflation gap

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Inflation gap

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Inflation gap

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Output gap

Inflation gap

2011

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Output gap

Inflation gap

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Discretion, Commitment and

Timeless Perspective

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• Discretion– Re-optimize each period– Take expectations as given

• Commitment– Commit oneself to a specific reaction pattern– Seek to affect private expectations– Not time-consistent (incentive-consistent)

Discretion vs commitment

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CommitmentTwo main types:

• 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

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• The interest rate path in MPR 1/07 only consistent with commitment

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2010


Output gap

Inflation gap

2011

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Ramsey and Timeless (baseline scenario)

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Sources: Statistics Norway and Norges Bank

Ramsey

Timeless

RamseyRamsey

Timeless and Ramsey:- λ=0.30- Weight change in interest rate=0.2

Output gap

Key policy rate

Timeless

Timeless

CPI-ATE

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Sources: Statistics Norway and Norges Bank

Timeless and Ramsey:- λ=0.30- Weight change in interest rate=0.2

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Timeless with different λ’s

λ=0.20

λ=0.20 λ=0.20

Baseline scenario

Baseline scenario

Baseline scenario

λ=0.40

λ=0.40λ=0.40

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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

• However, not obvious – what the loss function looks like – what to assume about the degree of commitment.

Norges Bank 1 Monetary policy framework in Norway Øistein Røisland Norges Bank.

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