Norges Bank 1 Monetary policy framework in Norway Øistein Røisland Norges Bank

Norges Bank 2 Agenda What do we do? Why do we do it? How do we do it?

Norges Bank 3 What do we do?

Norges Bank 4 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)

Norges Bank 5 30%50%70%90% Key interest rate Output gap CPICPI adjusted for taxes and energy Baseline scenario in Monetary Policy Report 1/07

Norges Bank 6 Alternative scenarios in Monetary Policy Report 1/07 Lower inflation Higher capacity utilisation Lower inflation Higher capacity utilisation Lower inflation Higher capacity utilisation Key interest rate Output gap CPI-ATE

Norges Bank 7 Decomposing changes in the interest rate path IR 1/06 IR 2/06 IR 3/06 MPR 1/07

Norges Bank 8 Isolated effect on the interest rate of lower inflation (red line). 30%50%70%90% Isolated effect on the interest rate of higher output gap and weaker exchange rate (red line). Decomposing changes in the interest rate path

Norges Bank 9 Why interest rate forecasts?

Norges Bank 10 Changes in Norges Bank’s interest rate assumption Constant interest rate Markets’ interest rate expectations …with comments 2005 Our own interest rate forecast

Norges Bank 11 Talking about the future… –“In these circumstances, the Committee believes that policy accommodation can be maintained for a considerable period" (FED, ) –” 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, )

Norges Bank 12 Experiences Communication –More precise than verbal deliberations alone Market participants –Well understood Internal organisation –Close link between analysis and policy makers Competence –New analytical challenges

13 a. March 2006 b. July 2006 Implied forward rates before report (shaded) Implied forward rates day after report (black) NB forecast (red) Implied forward rates before report (shaded) Implied forward rates day after report (black) NB forecast (red) Market reactions after publication of Monetary Policy Reports

14 a. March 2006 b. July 2006 c. November 2006 Implied forward rates before report (shaded) Implied forward rates day after report (black) NB forecast (red) Implied forward rates before report (shaded) Implied forward rates day after report (black) NB forecast (red) Implied forward rates before report (shaded) Implied forward rates day after report (black) NB forecast (red) Implied forward rates month after report (green) Implied forward rates before report (shaded) Implied forward rates day after report (black) NB forecast (red) d. March 2007 Market reactions after publication of Monetary Policy Reports

Norges Bank 15 How do we do it?

Norges Bank 16 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

Norges Bank 17 Core model Currently –Simple 4 equation ”new-keynesian” model Implementing –NEMO, a modern DSGE model –Down-scaled version of GEM

Norges Bank 18 Modelling monetary policy: two approaches Simple interest rate rule r t =  r t-1 + (1-  )[  1 (E t  t+k  -  * )+  2 y t +  3  y t ] Optimal policy –Minimizing a loss function L = (π - π * ) 2 + λy 2 + δ(r - r -1 ) 2

Norges Bank 19 Simple rule r t =  r t-1 + (1-  )[  1 (E t  t+k  -  * )+  2 y t +  3  y t ] Iterate towards optimal policy through choices of coefficients No unambiguous relationship between coefficients and preferences (loss function)

Norges Bank 20 Inflation and output gaps in the baseline scenario Output gap Inflation gap

Norges Bank 21 ”Lambda”-consistency Preferences should be consistent over different strategy rounds Used to apply an indirect method to estimate ”lambda” –”Revealed preferences” –Compare loss with higher and lower interest rate than reference path –Gives an interval for ”lambda” in Norges Bank’s loss function –However: This method is only valid under a discretionary policy!

Norges Bank 22 Inflation and output gaps in the baseline scenario Output gap Inflation gap

Norges Bank 23 Inflation and output gaps in the baseline scenario Output gap Inflation gap

Norges Bank 24 Inflation and output gaps in the baseline scenario Output gap Inflation gap

Norges Bank 25 Inflation and output gaps in the baseline scenario Output gap Inflation gap 2011

Norges Bank 26 Inflation and output gaps in the baseline scenario Output gap Inflation gap

Norges Bank 27 Discretion, Commitment and Timeless Perspective

Norges Bank 28 Discretion –Re-optimize each period –Take expectations as given Commitment –Commit oneself to a specific reaction pattern –Seek to affect private expectations –Not time-consistent (incentive-consistent) Discretion vs commitment

Norges Bank 29 Commitment Two main types: 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

Norges Bank 30 The interest rate path in MPR 1/07 only consistent with commitment

Norges Bank 31 Inflation and output gaps in the baseline scenario Output gap Inflation gap 2011

Norges Bank 32 Ramsey and Timeless (baseline scenario) Sources: Statistics Norway and Norges Bank Ramsey Timeless Ramsey Timeless and Ramsey: - λ= Weight change in interest rate=0.2 Output gap Key policy rate Timeless CPI-ATE

Norges Bank 33 Sources: Statistics Norway and Norges Bank Timeless and Ramsey: - λ= Weight change in interest rate=0.2 CPI-ATEOutput gap Key policy rate Timeless with different λ’s λ=0.20 Baseline scenario λ=0.40

Norges Bank 34 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 However, not obvious –what the loss function looks like –what to assume about the degree of commitment.