Guidelines for monetary policy
The following letter was submitted to the Ministry of Finance on 27 March 2001
Norges Bank refers to the Ministry of Finance's letter of 26 March 2001 concerning the guidelines for monetary policy, enclosing a draft for a new regulation submitted to Norges Bank for comment.
The Bank does not object to the formal procedure, with the adoption of a joint regulation pursuant to Section 2, third paragraph, and Section 4, second paragraph, of the Act on Norges Bank and the Monetary System.
The draft regulation states:
"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 2.5 per cent over time."
The fundamental task of monetary policy is to provide the economy with a nominal anchor. Nominal stability is the best contribution monetary policy can make to economic growth and prosperity. A nominal anchor is also a necessary precondition for stability in financial markets and property markets.
Pursuant to its existing mandate, Norges Bank has oriented monetary policy instruments with a view to bringing price and cost inflation down towards the corresponding aim for inflation of the European Central Bank. There has been confidence in the conduct of monetary policy. The communication of Norwegian monetary policy may nevertheless be facilitated with the Government now quantifying an inflation target, in line with international practice.
The inflation target of 2.5 per cent is slightly higher than similar objectives for Sweden, Canada and the euro area, but corresponds roughly to targets in the United Kingdom and Australia. The target is also approximately in line with the average inflation rate in Norway in the 1990s.
Norges Bank is responsible for the implementation of monetary policy. In the light of developments in recent years, the application of the new guidelines will not result in significant changes in the conduct of monetary policy. Norges Bank's key rates will be set on the basis of an overall assessment of the inflation outlook. In the following, Norges Bank presents its understanding of the regulation and the consequences for its implementation of monetary policy.
Monetary policy affects the economy with considerable and variable lags. Consequently, the Bank must be forward-looking in its interest-rate setting. The effects of interest rate changes are uncertain and vary over time. Changes in the interest rate will be made gradually so that the Bank may assess the effects of interest rate changes and other new information on economic developments. If price inflation deviates substantially from the target for a period, Norges Bank will set the interest rate with a view to gradually returning consumer price inflation to the target. Norges Bank will seek to avoid unnecessary fluctuations in output and demand.
Consumer price inflation normally varies from month to month. Substantial changes in the inflation rate may at times occur as a result of extraordinary fluctuations in certain product markets or changes in direct and indirect taxes. In its analyses of different measures of underlying inflation, Norges Bank will assess the effects of changes in the interest rate level, taxes, excise duties and extraordinary temporary disturbances. Deviations between actual and projected underlying inflation will normally be in the interval +/- 1 percentage point.
Norges Bank places considerable emphasis on the transparency and communication of monetary policy. Analyses carried out by the Bank and the background for the Bank's decisions are published regularly. The Bank reports on the implementation of monetary policy in its annual report. If there are significant deviations between actual price inflation and the target, the Bank will provide a thorough assessment in its annual report. Particular emphasis will be placed on any deviations outside the interval +/- 1 percentage point.
The krone is floating, and the value of the krone fluctuates periodically, as do the exchange rates of other small and open economies. The best contribution monetary policy can make to stabilising exchange rate expectations is to aim at the objective of low and stable inflation. Changes in the Norwegian interest rate level have a predictable effect on the krone exchange rate only when they also contribute to low and stable inflation.
In its letter to Norges Bank, the Ministry of Finance states:
"In the Government's Long-Term Programme for 2002-2005, fiscal policy will be subject to the following guidelines:
- Considerable emphasis must continue to be placed on stabilising fluctuations in the economy in order to ensure appropriate capacity utilisation and low unemployment.
- Petroleum revenues will gradually be phased into the economy, approximately in step with the expected real return of the Petroleum Fund.
This implies a moderate increase in the phasing in of petroleum revenues in the years ahead.
Fiscal policy shall continue to have a main responsibility for stabilising developments in the Norwegian economy. At the same time, petroleum revenues shall be phased in gradually and in a sustainable manner in the Norwegian economy, with considerable emphasis on ensuring a continued strong internationally exposed sector, contributing to long-term balance in the economy.
In this situation, a clear, formal anchor is required to reinforce monetary policy's role in underpinning stable economic developments. "
Norges Bank concurs that there must be a sound interplay between fiscal policy and monetary policy to ensure stable economic developments. It would be advantageous if fiscal policy could be used to counter fluctuations in demand and output.
Norges Bank would assert that a gradual phasing in of petroleum revenues approximately in step with the expected real return of the Petroleum Fund will, ceteris paribus, contribute to deteriorating conditions for businesses exposed to international competition.
The Norwegian economy and government finances are influenced by large and varying revenues from petroleum activities. The basis for determining central government expenditure and taxes from one year to the next may then easily be impaired. If budget spending is allowed to vary in step with oil prices, the Norwegian economy may experience abrupt shifts and instability. Changes in oil prices could then quickly influence wage and price expectations, the exchange rate and long-term interest rates. In that case it would be very demanding to achieve nominal stability. Short-term interest rates would then have to be changed frequently and sharply and will generally reflect an increased risk premium on the Norwegian krone, which over time would result in a generally higher interest rate level. Norges Bank would therefore emphasise the importance of establishing broad consensus concerning a credible long-term anchor for fiscal policy which takes into account that oil prices may fluctuate from one year to the next.
Jan F. Qvigstad