The Challenges of Globalisation for Small open Economies with Independent Currencies Reykjavik, 31 May and 1 June 2007 Session 1: Challenges of globalisation to monetary policy in small open economies Audun Grønn: Optimal monetary policy in a small open economy – the Norwegian experience

Motivation for presentation Globalisation is a driving force for greater openness / transparency Experience has led Norges Bank to adopt a monetary policy regime marked by a high degree of transparency Secrecy and surprises tried earlier – with mixed experience In 2005, introduction of endogenous interest rate path – the central bank taking ownership of the interest rate forecast High degree of transparency viewed as ”optimal” Review of the monetary policy framework in Norway

Monetary policy framework in Norway What do we do? Why do we do it? How do we do it?

Monetary policy in Norway What do we do? 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)

Three main ingredients of Norges Bank communication What do we do? Three main ingredients of Norges Bank communication The forecasts (baseline scenario) The uncertainty analysis (uncertainty surrounding the projections – alternative scenarios) The decomposition of changes in the interest rate forecast

The forecasts: Baseline scenario in MPR 1/07 Key interest rate Output gap 30% 50% 70% 90% CPI CPI adjusted for taxes and energy Oppdatert 1/3

Uncertainty analysis: Alternative scenarios in MPR 1/07 CPI-ATE Output gap Higher capacity utilisation Lower inflation Higher capacity utilisation Lower inflation Key interest rate Higher capacity utilisation Oppdatert 1/3 Lower inflation

Decomposition of changes in the interest rate path IR 3/06 MPR 1/07 IR 1/06 IR 2/06

Isolated effect on the interest rate of lower inflation (red line). Decomposition of changes in the interest rate path Isolated effect on the interest rate of lower inflation (red line). Isolated effect on the interest rate of higher output gap and weaker exchange rate (red line). 30% 50% 70% 90%

Why do we do it? Why interest rate forecasts? Previous practice of Norges Bank interest rate assumptions Talking about the future – expectations

Why interest rate forecasts? Why do we do it? Why interest rate forecasts? A key rationale for introducing interest rate forcasts as forward guidance has been to improve the projections in the IR/PPR and simplify Norges Bank’s communication of its monetary policy The backdrop to this is the evolution of the thinking of Norges Bank, which has become based on the recognition that an essential part of monetary policy is ”management of expectations”

Previous practice of Norges Bank’s interest rate assumption Why do we do it? Previous practice of 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 The chart shows how Norges Bank has chosen different interest rate assumptions at different points in time

Talking about the future… Why do we do it? 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) An interest rate forecast is not necessarily a straitjacket Could also be an advantage to create commitments A forecast can create the desired commitments

How do we do it? Criteria Models

Criteria for choosing a good interest rate path How do we do it? 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

Forward-looking core model How do we do it? Forward-looking core model Currently 1A – ”pedagogical device” Gap model determining interest rate, inflation, output, exchange rate Implementing NEMO

Modelling monetary policy: two approaches How do we do it? Modelling monetary policy: two approaches Simple interest rate rule rt = art-1 + (1-a)[b1(Etpt+k -p*)+b2yt +b3Dyt] Optimal policy Minimizing a loss function L = (π - π*)2 + λy2 + δ(r - r-1)2

Inflation and output gaps in the baseline scenario How do we do it? Inflation and output gaps in the baseline scenario Output gap Inflation gap

Discretion vs commitment How do we do it? Discretion vs commitment Discretion Re-optimize each period Take expectations as given Commitment Commit oneself to a specific reaction pattern Seek to affect private expectations Types of commitment 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 The interest rate path in MPR 1/07 only consistent with commitment

Experience Effects on three-months forward interest rates1) Change from the previous day to the day of publication of IR/PPR 1)Average of absolute value of changes in htree-month implicit forward interest rates. Chang eof iterest rate on publication day and two years ahead (overall change for 9 three-month rates).

Experience Market participants Communication Internal organisation Well understood Communication More precise than verbal deliberations alone Internal organisation Close link between analysis and policy makers Competence New analytical challenges

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