1. 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

2. 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

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

4. 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)

5. 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

6. 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

7. 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

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

9. 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%

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

11. 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”

12. Previous practice of Norges Bank’s interest rate assumption
Why do we do it?
Previous practice of Norges Bank’s interest rate assumption
Constant interest rate
Markets’ interest rate expectations
…with comments
Our own interest rate forecast
The chart shows how Norges Bank has chosen different interest rate assumptions at different points in time

13. 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, )
” 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, )
An interest rate forecast is not necessarily a straitjacket
Could also be an advantage to create commitments
A forecast can create the desired commitments

14. How do we do it?
Criteria
Models

15. 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

16. 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

17. 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

18. 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

19. 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

20. 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).

21. 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

22. 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