The Nordics in the EU - Fiscal similarities and monetary differences
Discussion by Deputy Governor Jan F. Qvigstad (1) at the seminar "The Nordics in the EU - Fiscal similarities and monetary differences" hosted by the European Commission. The Directorate General for Economic and Financial Affairs (DG ECFIN) in Bruxelles.
Thank you for giving me this opportunity to comment on the topic of the choice of exchange rate regime. This issue raises core questions for central bankers that need to be revisited regularly. Especially in these turbulent times, we need to be certain that we possess the best possible framework for the conduct of economic policy.
Credibility is key
Credibility concerning nominal stability is the key to sound monetary policy. This may be achieved by participating in a monetary union or through flexible inflation targeting. After the Norwegian people rejected EU and thus EMU membership in the referendum in 1994, it became clear that pegging to the euro was not an option for us.
Since 1986, Norway had tried to achieve price stability through a stable exchange rate. In the fall of 1998, the krone was allowed to float more freely, and it became clear that flexible inflation targeting is the realistic choice of regime for Norway as an EU outsider.
Costs and benefits of being an outsider
I would like to emphasize that the monetary policy regime that was formalized in the year 2001 has served us well. The theory on optimal currency areas is also an argument in favour of flexible exchange rates(2) . One important reason is our position as an oil economy, with a petroleum sector much more dominant than in many other countries rich in natural resources.
On the other hand, we miss out on significant benefits of belonging to a deeper capital market, as described by the European Commission(3). Another cost of being outside the monetary union is that the nominal exchange rate not only follows the long-term real exchange rate – it is also affected by noise, and noise has been predominant in recent months. We are now paying the price of being a small currency in the foreign exchange market. Volatility has increased markedly in the krone exchange rate, and the value of the krone has drifted below the normal level based on previous empirical patterns. Higher volatility has raised hedging costs in the foreign exchange market.
We believe that the noise will gradually disappear and that our currency will strengthen somewhat. In the meantime, the weaker exchange rate provides a cushion for the economy in addition to the stimulus from the reduction in the policy rate.
Experience with inflation targeting
Inflation targeting has a number of advantages as long as credibility about nominal stability is maintained. To the extent that we can measure inflation expectations, they are well anchored. This gives us some monetary policy flexibility that is useful in the current situation. As should be expected, we have experienced a deterioration in Norway’s terms of trade. The real krone exchange rate should be weaker now than in summer 2008, when oil prices reached USD 140.
The private sector perceives the published forecast for our key policy rate as conditional. For example, a very deep recession will be cushioned by low interest rates for an extended period. One graph is enough to express the policy stance in terms of current and expected future key policy rates, given the associated forecast of key economic variables. And this is helpful in making policy expectations part of our toolbox.
In addition, we are able to steer the “real-time” expectations of the private sector in the right direction by publishing our so-called “delta-accounting” of interest rate path changes. We explain previous changes in the forecast interest rate path in terms of exogenous shocks and variables. Thus, when conditions change, the private sector is able to reestimate our future behaviour with some accuracy.
Our system of communication has survived the turbulence of recent months well, although our interest rate forecast has not. Last summer, we forecast a key policy rate of more than 5 per cent one year ahead. The last forecast for the third quarter this year is 2 per cent. However, the accounting framework has enabled us to explain the changes in the forecast to the market in a consistent manner that is well understood by market participants.
Fiscal policy concern
Finally, I would like to remark on the link between fiscal and monetary policy.
Monetary policy can be used to counteract certain shocks if the goal of price stability in the long run is credible. Similarly, fiscal policy needs an anchor in order to achieve an effective stimulus in the short run.
In Norway, we are in the fortunate position to have monetary policy well supported by fiscal policy. In addition, consistency between monetary and fiscal policy is easy to achieve when the domain of fiscal and monetary authorities is the same.
In the EU, this point may become a challenge. The Stability and Growth Pact is intended to provide fiscal backing for the common monetary policy. From an outsider’s perspective, the proposal from the European Commission to the European Council, on 26 November, to initiate a budget stimulus in EU countries corresponding to 1.5 per cent of GDP seems challenging in light of the fiscal criteria.(4) For some EU members, this concern may be reflected in risk premia in their government bond markets.
1) Mail address: Norges Bank, P. O. Box 1179 Sentrum, 0107 Oslo, Norway. Email: firstname.lastname@example.org. Thanks to Ragna Alstadheim for her help in preparing this note.
2) See for example “Exchange Rate Target or Inflation Target for Norway?” By Lars Svensson, in Christiansen and Qvigstad (eds.) Choosing a Monetary Policy Target, Scandinavian University Press, 1997.
3) See “Costs and benefits of running an international currency”, by Elias Papaioannou and Richard Portes, European Economy No. 348, November 2008.
4) See Communication from the European Commission to the European Council, 26.11.2008.