Effect of interest rate changes

Norges Bank's monetary policy instrument is the key rate. Norges Bank's key rate affects short-term money market rates, and expectations concerning future developments in the key rate are decisive for banks' deposit and lending rates and bond yields. It may be useful to distinguish between three channels through which monetary policy operates:
  • The demand channel
  • The exchange rate channel
  • The expectations channel

Effect of interest rate changes

The effect of changes in interest rates on inflation occurs with a lag and may vary in intensity. In the time it takes for a change in interest rates to feed through, other factors will also have an impact resulting in changes in inflation and output. The various relationships will not be stable over time.

As interest rates fall, household and local government consumption and investment will tend to increase. This is because they have more money left over after servicing their debt and because borrowing becomes less expensive. Corporate finances are strengthened and investment may become more attractive. Higher demand leads to higher output and employment. Wage growth may pick up. Higher wage growth combined with higher profit margins will result in higher inflation.

The effect of interest rate changes may be amplified because the interest rate also affects the krone exchange rate. When interest rates are lower, more people will borrow money and fewer will invest in NOK. Lower interest rates will thus normally lead to a depreciation of the krone. Imported goods will then become more expensive and inflation will accelerate. A weaker krone also boosts exports and improves profitability in the Norwegian business sector. The effect on the exchange rate of a change in interest rates will vary as themes and sentiments shift in the foreign exchange market.

Norges Bank believes that expectations play an important role when prices and wages are set. Expectations concerning inflation and economic stability are of crucial importance for the foreign exchange market. Inflation expectations also influence wage demands and have an effect when companies adjust their prices. It may be difficult to form an opinion about how expectations are generated. Confidence in the inflation target may provide an anchor. Past inflation rates may also influence what we think inflation will be in the future. There is thus an interaction between inflation expectations and inflation.

If there is confidence in monetary policy, expected inflation will be equal to or close to the inflation target. This contributes to stabilising inflation around the target. The expectations channel thus amplifies the effects of monetary policy. Therefore, Norges Bank places considerable emphasis on ensuring that households, companies, the social partners and financial market participants are confident that inflation will remain low and stable. The operational target of monetary policy in Norway is inflation of close to 2½% over time. Norges Bank operates a flexible inflation targeting regime, so that weight is given to variability in inflation as well as to variability in output and employment.

Published 7 September 2004 15:08