Norges Bank Watch 2002
An Independent Review of
Monetary Policy and Institutions in Norway
Lars E.O. Svensson (chair), Princeton University
Kjetil Houg, Alfred Berg
Haakon O.Aa. Solheim, Norwegian School of Management BI
Erling Steigum, Norwegian School of Management BI
September 19, 2002
The Centre for Monetary Economics (CME) at the Norwegian School of Management BI has for the third time invited a committee of economists for Norges Bank Watch, with the objective to evaluate the monetary-policy regime in Norway and Norges Bank’s conduct of monetary policy. The committee for Norges Bank Watch 2002 consists of Professor Lars E.O. Svensson (chair), Princeton University, Chief Economist Kjetil Houg, Alfred Berg, Doctorate Student Haakon O.Aa. Solheim, Norwegian School of Management BI, and Professor Erling Steigum, Norwegian School of Management BI. The committee met in Oslo in June 2002, had discussions with key officials at Norges Bank and the Ministry of Finance, and has worked on its report until September 2002.
A realistic view of monetary policy
In order to evaluate the conduct of monetary policy, it is important to have a realistic view of what monetary policy can and cannot achieve. People typically ask too much of monetary policy—no less in Norway than elsewhere. In the long term, monetary policy can only control nominal variables such as inflation and the nominal exchange rate. It is beyond the capacity of any central bank to increase the average level or the growth rate of real variables such as GDP and employment, or to affect the average level of the real exchange rate. At best, monetary policy can reduce the variability of real variables somewhat. An attempt to increase the average level or growth rate of GDP, or to maintain a real undervaluation of the currency, would trigger every-rising inflation, at increasing cost to the economy in terms of less efficient resource allocation and arbitrary and inequitable redistributions of income and wealth. For these reasons, an increasing number of countries have specified low and stable inflation, “price stability,” as the primary goal for monetary policy.
In the short and medium term, monetary policy has effects on both nominal and real variables. However, the complex transmission mechanism of monetary policy, varying lags and strength of the effects through different channels, unpredictable shocks and inherent uncertainty combine to prevent fine-tuning.
Best-practice inflation targeting
There is considerable agreement among policy makers, academics and researchers in the monetary-policy area that so-called flexible inflation targeting is the best monetary-policy setup. Then inflation is stabilized around a low inflation target in the medium term rather than at the shortest possible horizon, and a gradual and measured policy response avoids creating unnecessary variability in the real economy. Any required real exchange-rate adjustments are achieved through a floating exchange rate. Because of shocks, uncertainty and imperfect control, considerable variability may remain in the real economy, especially for small, open and less diversified economies like Norway. Best-practice central banks that have adopted flexible inflation targeting include the Reserve Bank of New Zealand, the Bank of England and Sveriges Riksbank. We believe these banks provide a relevant standard of comparison for the conduct of monetary policy in Norway.
Fiscal policy and real appreciation
Of special importance to Norway is the fact that a permanent future fiscal expansion, which is implied by the new guidelines for fiscal policy and the phase-in of the oil revenues, is likely to lead to a permanent real appreciation of the krone, a current increase in the neutral real interest rate and an even larger real appreciation of the currency in the short and medium term. This real appreciation is an equilibrium response of the economy to the new fiscal-policy situation and the related increased relative demand for output and resources of the sector producing nontradable goods and services (the sector sheltered from international competition). It will imply reduced competitiveness of the tradable-goods sector in Norway (the export and import-competing sectors exposed to international competition) and will most likely lead to reduced output, employment and profits in the tradable-goods sector. Attempts to delay such an equilibrium adjustment of the real exchange rate by stabilizing the nominal exchange is likely to be quite costly and result in more variable inflation and output gap, without in the end preventing the real appreciation of the currency.
The institutional framework
With regard to the institutional framework for monetary policy, there is considerable agreement among central bankers, academics and researchers in the areas of political economy and monetary policy that the institutional framework that is best designed to achieve the short- and long-term goals for monetary policy in a democratic society is one with (1) a legislated mandate of price stability, (2) operational independence for the central bank in fulfilling the mandate, and (3) accountability structures that make the central bank accountable to the government or the parliament for fulfilling the mandate. During the 1990s, central-bank legislation in many countries has been reformed to meet these requirements.
With regard to the institutional framework for monetary policy in Norway, we find that it has considerable weaknesses. There is no legislated mandate for price stability. Although Norges Bank in practice has considerable operational independence, this independence is insufficiently safeguarded in the central-bank act. There is no explicit accountability structure according to which Norges Bank can be held accountable for its policy. In a well-known international comparison of central-bank legislation, Norges Bank is ranked as the least independent central bank among the developed economies. With regard to the institutional framework, we have the following recommendation:
- A full-fledged institutional reform should be undertaken, similar to those that have been accomplished in the U.K. or Sweden. The reform should specify a mandate for price stability, operational independence, and accountability for Norges Bank.
Within the existing legislative framework, however, there are several potential improvements that we recommend:
- In order to resolve the inherent inconsistency between exchange-rate stability and low and stable inflation for Norway, the references to exchange-rate stability in the monetary-policy guidelines should be deleted. (More precisely, the first sentence should be deleted and the second sentence moved to after the fifth sentence.)
- The appointments to the Executive Board should be of experts on monetary policy and related areas, for instance, macroeconomics and financial markets, so that the members can independently contribute to the achievement of the announced objectives for monetary policy.
- The custom to invite political parties to nominate members to the Executive Board should be discontinued, in order to avoid the risk of sectoral, political or special-interest representation and related risks of deadlocks or policy directed to special interests rather than the country as a whole.
- Nonattributed minutes and attributed voting records from the Executive Board should be published, in order to strengthen the accountability and further improve transparency. These minutes should note without attribution to individual members which issues were discussed and what arguments were presented, as well as how individual members have voted.
- The essential material on monetary policy submitted to or formulated by the Executive Board, for instance, the Strateginotat (Notes on Strategy) outlining policy for the next four months, should be published, in order to strengthen accountability and further improve transparency.
- Several additional improvements to strengthen the accountability of Norges Bank should be undertaken: (1) An evaluation by the Ministry of Finance of how Norges Bank has conducted monetary policy and achieved the stated objectives for monetary policy should be included in the Kredittmelding (the report by the Ministry of Finance to the Storting). (2) Regular hearings on monetary policy should be held in the Storting with the governor and other officials of Norges Bank, with the assistance of experts appointed by the Storting. (3) An annual or biannual conference on monetary policy in Norway should be held, financed by Norges Bank but organized independently, for instance, by an academic institution, and open to the general public and media. At such a conference, papers evaluating monetary policy by the Bank could be presented by national and international experts followed by comments by Bank officials and public discussion.
The conduct of monetary policy
When it comes to the conduct of monetary policy, we believe Norwegian monetary policy is in very good hands. The Bank has a very competent and highly trained top management and staff. The top management and many in the staff has long experience of economic policy, both monetary and fiscal policy. The Bank has a long tradition of academic research and analysis. Although the Bank has a short experience of inflation targeting, for several years before inflation targeting was introduced, it organized conferences and meetings on monetary policy, including inflation targeting, with academic researchers and central-bank officials from many countries. In this way the Bank built up an understanding of, and a competence in inflation targeting. We believe the Bank’s Inflation Reports, the speeches by Bank officials and published articles and working papers by the Bank clearly demonstrate the high quality of the Bank’s analysis and understanding. The Bank gives the impression of being a very competent and enthusiastic newcomer to the inflation-targeting camp, and it is our firm view that it masters the insights required for successful inflation targeting.
Overall, we believe Norges Bank is conducting monetary policy in line with the best international practice, like that demonstrated by the Reserve Bank of New Zealand, the Bank of England and the Riksbank. Nevertheless, we would like to recommend a number of improvements to the conduct of monetary policy, which if undertaken would in several cases push the frontier of best-international-practice inflation targeting further out:
- Inflation projections should generally be done conditional on the Bank’s preferred instrument-rate path; that is, conditional on its best forecast of its future interest-rate settings. This would normally be a time-varying instrument-rate path. The assumed exchange-rate path should also normally be the Bank’s best forecast of the future exchange rate, also normally a time-variable path. This would avoid some problems and inconsistencies associated with the current standard assumption of constant interest and exchange rates. It may also make monetary policy more predictable and improve the Bank’s communication with the market.
- The central projections should be the mean projections (the probability-weighted average outcome) rather than mode projections (the most likely outcome). This is in line with established economic theory, which says that it is the mean forecast rather than the mode forecast that is relevant for decisions. This would normally make the somewhat cumbersome adjustment of the mode projection to the balance of risk unnecessary, and the fan charts for the projections would mainly be used to illustrate the uncertainty of the projections.
- The Bank should construct and publish projections of potential output, actual output and hence the output gap, conditional on time-variable instrument-rate paths. In this way the Bank can better reach the most desirable compromise between inflation variability and output-gap variability and the resulting compromise will be more open to external scrutiny.
- The emphasis on the precise two-year horizon of inflation projections on target should be reduced. Instead, the Bank should find the projections of inflation, the output gap and the corresponding instrument-rate path that the Bank thinks would achieve the best compromise between inflation stability and output-gap stability. These projections should be published in the Inflation Report and the Bank should set its instrument rate accordingly. These projections will then be the Bank’s best unconditional forecast of future inflation, output gap and instrument rate. Publishing them will maximize the impact on private-sector expectations and thereby implement monetary policy more effectively. Publishing them also opens the Bank’s projections for more precise external scrutiny. The fan charts around the projections should be constructed and interpreted as the Bank’s best unconditional estimate of the uncertainty in the projections, thus conditional on its own future policy response.
- The Bank’s analysis and explanations might benefit from further use of the concepts of potential output, output gap and neutral real interest rate.
- The Bank could be more explicit about the weight it puts on output-gap stability relative to inflation stability.
The debate on monetary policy and currency appreciation
The krone has appreciated strongly in both nominal and real terms. We find the real appreciation of the krone a logical outcome of the new guidelines for fiscal policy, which imply a permanent future fiscal expansion. This is likely to be accompanied by not only a permanent real appreciation of the krone but an even stronger current real appreciation and a higher neutral real interest rate. These adjustments are equilibrium adjustments of the real economy to the new fiscal policy. Thus, they occur independently of monetary policy, and cannot be prevented by monetary policy. Monetary policy might delay the real appreciation somewhat by focusing on stabilizing the nominal exchange rate instead of inflation and the output gap. Perhaps such monetary policy could delay the real appreciation a few quarters or perhaps a year or so. Such a monetary policy, by being in the short run more expansionary than current policy by Norges Bank, would in the present situation most likely lead to increasing inflation and an overheated economy. The real appreciation induced by fiscal policy would then arise through an increase in the price level. As discussed in the text of the report, historically such policies, because of the inherent inertia in inflation once it has taken off, have lead to an over-appreciation and hence overvaluation of the currency, and the boom has quickly turned to bust.
As far as we can see, in the current situation with a zero or positive output gap and considerable inflationary pressure, Norges Bank is conducting inflation targeting according to best international practice. This requires a relatively high real interest rate, but this is not surprising since the neutral real interest rate is likely to be higher, because of the future fiscal expansion and related current growth in consumption and aggregate demand.
The current public debate about the real appreciation and monetary policy seems quite confused. Several recent debaters do not seem to understand the relation between the real appreciation and fiscal policy and the limitations of monetary policy. Arguably, the Bank’s motivation for the de facto inflation target from 1999 may have contributed to the confusion. There, inflation equal to that in Europe was motivated as a way to achieve long-run stability in the exchange rate. This argument relies on long-term purchasing-power parity, that is, the long-term real exchange rate is stable. However, in an oil economy where oil revenues sooner or later will be phased in, long-term purchasing power is unlikely to apply. Indeed, as argued above, a permanent fiscal expansion may trigger a permanent real appreciation of the currency. Although this is well known by the Bank, arguably the Bank could explain the current situation with even more clarity. Thus, we recommend:
- The Bank should more clearly explain the limits of monetary policy in relation to the real adjustment of the Norwegian economy that is likely to take place due to the new guidelines of fiscal policy and, in particular, explain that monetary policy cannot be expected to prevent the associated real appreciation of the krone.
Research at the Bank
Norges Bank has a strong research tradition. Its Research Department plays a leading role in Norwegian macroeconomic research. The department is also very strong in time-series econometrics and the economics of banking.
The Bank is somewhat unusual among inflation-targeting central banks in that the main economic model used for projections and simulations, RIMINI, is largely an empirical so-called reduced-form model that generalizes the empirical properties of Norwegian data. Most other inflation-targeting central banks instead to a large extent use structural models that are closer to macroeconomic theory and have equations that have structural interpretations. An inflation-targeting central bank needs to make projections conditional on alternative instrument-rate settings, for instance, instrument-rate paths. Doing this in a reduced-form model is associated with inherent problems, especially whether the reduced-form model is invariant to the alternative instrument-rate paths. A mostly empirical model is also very sensitive to the problem of being estimated on data from a different monetary-policy regime, in the Norwegian case from periods of exchange-rate targeting and interest-rate regulation.
Although the Bank and individual researchers there have already produced impressive research on the theory and practice of inflation targeting, we believe even more resources should be shifted to such activities. Active research in these areas is of considerable importance to the Bank. The Bank must have its own competence and capacity for such research for several reasons: Such competence and capacity is necessary in order to rightly assess the quality and practicality of research related to monetary policy and inflation targeting conducted at other central banks and academic institutions, which is a prerequisite for taking advantage of and applying such research to Norwegian problems and issues of concern for Norges Bank. Furthermore, such competence and capacity is necessary to do research specifically directed to specific Norwegian problems and issues of concern for Norges Bank. Finally, such competence and capacity at the Bank will allow the Bank to contribute to the world-wide development of monetary policy and inflation targeting. Regarding the research at Norges Bank, we recommend:
- Less emphasis on the Bank’s large reduced-form model RIMINI and more emphasis on the development of alternative structural models.
- An even stronger commitment to research at an academic level on issues related to monetary policy in general and inflation targeting in particular.
- A high proportion of the working papers should be of such quality that they are accepted for publication in international scientific journals.
Copies of the report and an executive summary are available on CME’s website at http://www.bi.no/ and Professor Svensson’s personal website www.larseosvensson.net. The first page of the report lists the committee members email addresses where they can be contacted.