1. The mandate for monetary policy

The task of monetary policy is to ensure low and stable inflation and to help keep employment as high as possible. The Monetary Policy Regulation states that the operational target shall be annual consumer price inflation of close to 2 percent over time. In addition, inflation targeting shall be forward-looking and flexible so that it can contribute to high and stable output and employment and to counteracting the build-up of financial imbalances.

Low and stable inflation is an overriding objective of monetary policy. Low and stable inflation over time is a precondition for a well-functioning economy. It also provides the best possible basis for high output and employment in the long term.

Norges Bank has monetary policy instruments to keep inflation close to 2 percent over time. Monetary policy also influences output and employment, but in the long term they are primarily affected by factors such as population composition, wage formation and broader economic policy. Hence, Norges Bank cannot have primary responsibility for maintaining high output and employment. But together with other policy areas, the Bank can contribute to high and stable output and employment.

In the long term, there is no conflict between low and stable inflation and high and stable output and employment. It is not possible to achieve permanently higher output and employment by accepting higher inflation. In the short term, however, a conflict may arise between the two considerations. In its conduct of monetary policy, the Monetary Policy and Financial Stability Committee then seeks to strike a balance between the objective of maintaining a stable inflation rate around target and high and stable employment, taking into account that a build-up of financial imbalances could threaten the stability of output and employment further ahead. Even though low and stable inflation is an overriding objective, weight will always be given to high and stable output and employment in the conduct of monetary policy. The Committee’s interpretation of its mandate is that considerable weight shall be given to employment – also at times when inflation deviates significantly from the target. See section 5 for a more detailed description of how the Committee manages the trade-offs.

2. Low and stable inflation

High inflation entails substantial costs for society. When inflation is high, it also tends to fluctuate considerably. High and variable inflation creates uncertainty about the future value of money and makes economic planning more demanding. Uncertainty may also mean that long-term investments will have to give way to investments with a shorter horizon. When prices rise rapidly, price signals are reduced as it becomes more difficult to distinguish between changes in relative prices and the general price level. Prices then lose much of their informational value. High inflation can also lead to undesirable changes in relative prices because some prices change less frequently than others. For example, rapid and unexpected price increases will often lead to changes in real wages because it normally takes time for nominal wages to be adjusted. This particularly affects low-income households.

However, some inflation may be beneficial to the economy. Among other things, this may facilitate wage adjustments by allowing real wages to be reduced without having to cut nominal wages.  In addition, some inflation also increases monetary policy space because there is a limit to how low policy rates can be set before there is a loss of transmission to banks’ lending rates. Because monetary policy has little influence on the equilibrium real interest rate[1], higher inflation over time will result in a higher nominal interest rate level and thereby a greater distance to the lower bound. Moreover, too low inflation increases the risk of amplifying a downturn through an increase in the real value of debt.

The aim is to stabilise the annual rise in the consumer price index (CPI) around the inflation target. However, the CPI is associated with considerable short-term fluctuations due to changes in individual prices. When setting the policy rate, the Committee largely chooses to see through the short-term fluctuations and will normally only respond with changes in the policy rate to the extent that changes in individual prices are expected to be passed on to other prices and wages and lead to a broad-based change in consumer price inflation.

Whether monetary policy should react to large changes in individual prices does not depend on whether it can influence the source of the changes. For example, monetary policy cannot influence the prices of imported goods in foreign currency. But by curbing or increasing the level of activity in the economy, it can help prevent changes in prices for some goods from spilling over to other prices and wages. And even though monetary policy cannot influence international prices in foreign currency, it can influence the exchange rate. An increase in the policy rate normally leads to an appreciation of the krone and thereby a slower rise in prices for imported goods. However, the monetary policy response to shocks depends on the underlying source of the shock because different types of shocks result in various degrees of conflict between the different monetary policy objectives. See further discussion in the box on the monetary policy response to various shocks.

The monetary policy assessments rely on a number of indicators of underlying inflation, which are adjusted for short-term changes in individual prices. In Norway, energy prices most often contribute to large short-term fluctuations in the CPI. The CPI adjusted for changes in tax changes and excluding energy products (CPI-ATE) is therefore an important indicator used to assess inflation.

It is not possible to fine-tune inflation, but in interest rate setting weight is given to avoiding large and persistent deviations from the inflation target. The goal is symmetrical in that, all else being equal, the aim is to bring inflation back to target just as quickly when inflation is above target as when it is below target.

The time horizon for bringing inflation back to target after a disturbance is not fixed but will depend on the extent to which inflation stabilisation comes at the expense of high and stable output and employment. If, for example, inflation has fallen below target when unemployment is high, the time horizon for bringing inflation back to target will be longer than when the labour market is better balanced. The Bank's Monetary Policy Report includes the current time horizon for when inflation is projected to return to target.

When assessing the time horizon for achieving the inflation target, the effect of the deviation from target on confidence in the inflation target is taken into account. Confidence cannot be measured precisely, but can be assessed using various indicators, such as the market’s expectations of future inflation and movements in financial markets.

When economic agents expect inflation to return to target after a deviation, disturbances affecting the economy will have less impact on inflation. The duration of a higher level of inflation will be shorter if firms and the social partners expect inflation to come down and take this into account when setting prices and wages. In addition, the exchange rate will normally appreciate when inflation rises unexpectedly because FX market participants expect the policy rate to be set higher in order to stabilise inflation. Similarly, the exchange rate will normally depreciate in the event of an unexpected decline in inflation. With confidence that the central bank will stabilise inflation, the exchange rate will therefore contribute to stabilising inflation when unexpected changes in inflation occur. If, on the other hand, there is a lack of confidence that monetary policy will stabilise inflation, the exchange rate may depreciate when inflation rises. The exchange rate will then amplify changes in inflation and may fuel wage and price spirals.

3. High and stable output and employment

Sustaining employment at the highest possible level is an overriding goal of economic policy and decisive for the welfare of society. Contributing to sustaining the level of economic activity so that as many people as possible can find work without having to search for too long is therefore an important consideration for monetary policy as well.

At the same time, monetary policy must take into account that if the level of activity in the economy becomes too high, prices and wages may accelerate and conflict with the objective of low and stable inflation. If monetary policy tightening is not implemented, a period of even tighter monetary policy and higher unemployment may be required at a later stage to restore price stability. In its conduct of monetary policy, the Committee therefore seeks to stabilise employment around its maximum sustainable level. This level is primarily determined by structural factors such as wage formation, the tax and social security system and population composition. The highest sustainable level cannot be directly observed, and it will vary over time.

As an indicator of our assessment of output and employment in relation to the maximum sustainable level, we estimate an output gap. When estimating the output gap, particular weight is given to labour market developments, while short-term fluctuations in labour productivity are normally disregarded. There is therefore no conflict between high and stable output and high and stable employment in the Committee’s operational interpretation of the mandate. When setting the policy rate, the estimation of the output gap is an important component of assessments.

Cyclical fluctuations are asymmetrical, with downturns often deepening and developing faster than upturns. In addition, the economic costs of cyclical fluctuations are in themselves asymmetrical. High unemployment entails substantial and direct costs both in the form of losses in aggregate income and output and in the form of welfare consequences for individuals who cannot find work. Strong pressures in the labour market may, in turn, entail costs for firms in the form of unfilled vacancies and recruitment costs. But these costs are probably considerably lower than the costs associated with high unemployment.

Possible hysteresis effects may also contribute to making the costs of cyclical fluctuations asymmetrical. Deep and prolonged downturns may cause unemployment to become entrenched at a high level, with many jobseekers eventually ending up outside the labour market. Wages and prices may then start to accelerate at a lower level of employment than prior to the downturn.

In its monetary policy reaction pattern, the Committee seeks to take account of the asymmetry of cyclical fluctuations and their costs. By preventing downturns from becoming deep and protracted, monetary policy can contribute to keeping the average level of employment over time as high as possible. If there are signs that hysteresis effects may have occurred following a downturn, it may be appropriate to accept that inflation will temporarily overshoot the target while labour market conditions normalise.

The policy rate affects different groups of households and different industries in different ways. Monetary policy is not a suitable tool for distribution policy or for influencing individual industries because the policy rate affects the economy broadly and cannot be targeted. Nevertheless, the effects of monetary policy on different groups of households and different industries must be taken into account, partly because of the implications for the aggregate impact of the policy rate on the level of activity.

4. Mitigating the build-up of financial imbalances

The build-up of financial imbalances increases the risk of a severe downturn further out. The consideration of mitigating financial imbalances is therefore largely derived from the consideration of high and stable output and employment over time.

Monetary policy cannot take primary responsibility for mitigating the build-up of financial imbalances. The regulation and supervision of financial institutions are the most important tools for cushioning shocks to the financial system.

A persistently low interest rate level can sow the seeds of increased risk-taking and rapid debt accumulation. High debt makes households and firms more vulnerable to income shortfalls, raising the risk of a severe downturn in the future. If there are signs that financial imbalances are building up, the consideration of longer-term stability may warrant maintaining a somewhat higher policy rate than the consideration of maintaining high and stable output and employment in the short term may suggest. The extent of monetary policy tightening depends in part on other regulations and their effect.

Tightening monetary policy to mitigate the build-up of financial imbalances may involve costs in the form of lower demand in the near term. The Committee’s monetary policy assessments weigh the consideration of reducing the risk of a severe downturn in the longer term against maintaining high and stable output and employment in the near term.

In many situations, the degree of conflict between the two considerations will be minimal. In an upturn, for example, property prices and credit will tend to rise sharply. A tighter monetary policy stance will then contribute to both greater stability in the short term and a lower risk of a severe downturn further out. In a situation where the risk of a severe downturn is acute, both the need to stabilise the real economy and maintain financial stability could suggest a rapid reduction of the policy rate as this could counteract a sharp decline in asset prices, which could have triggered or amplified a downturn.

In some situations, there may be a greater conflict between stability in the short and longer term. In a downturn, the policy rate will normally be reduced to curb the downturn. Even though a lower level of activity in the economy also curbs house price inflation and debt growth, a lower interest rate will, in isolation, stimulate the housing market. Such a stimulus will often be desirable and contribute to restraining the decline in economic activity, but in some cases the rise in house prices and debt may be so large that it may conflict with the aim of longer-term stability. There may then be grounds for lowering the policy rate somewhat less or starting to normalise the policy rate a little earlier than implied by the objective of sustaining activity in the short term.

In a situation where financial imbalances have already built up, there may also be a conflict between short- and long-term stability. In isolation, a lower policy rate will help reduce debt ratios and thereby mitigate vulnerabilities somewhat further ahead. However, this consideration must be weighed against the fact that many households and firms may be more vulnerable to interest rate increases and a loss of income in the short term.

Financial imbalances are difficult to measure. Different indicators based on developments in asset prices and credit are used to assess whether financial imbalances are building up.

5. Instruments, trade-offs and reaction pattern

Norges Bank’s key monetary policy instrument is the policy rate, which is the interest rate on banks’ deposits in Norges Bank up to a specified quota, and forward guidance, including the policy rate forecast. To ensure that the policy rate passes through to other market rates, Norges Bank sets the terms and conditions for banks’ loans and deposits in Norges Bank so that banks benefit from interbank at a rate close to the policy rate.[2]

The policy rate affects inflation and the real economy with a lag, and the effects are uncertain. The uncertainty surrounding the effects of the policy rate normally implies that monetary policy will respond less forcefully to shocks than would otherwise have been the case. Moreover, the policy rate will normally be changed gradually to enhance the predictability of monetary policy and reduce the risk of undesirable financial market volatility and unexpected reactions of households and firms.

In situations where the risk of particularly adverse outcomes is pronounced, it may be appropriate to react more forcefully than normal in interest rate setting. Examples of particularly unfavourable outcomes may be that inflation expectations become de-anchored, which may make it costly to bring inflation back to target, or that there is a sharp fall in employment that may persist through hysteresis effects.

When setting the policy rate, the Committee seeks to strike a balance between the aim of maintaining stable inflation around the target and the aim of maintaining a high and stable level of employment, taking into account that a build-up of financial imbalances may threaten stability in output and employment further ahead. The extent to which there is conflict between the various considerations depends on the type of shock and its magnitude and duration. Different types of shocks and the Committee’s normal reaction are discussed in more detail in the box "Monetary policy response to various shocks".

In assessing the level and path of the policy rate, the Committee gives weight to the forecasts of inflation and the real economy for the next few years. However, because it is demanding to capture all forms of forecast uncertainty, there is no mechanical relationship between the forecasts and the policy rate. The Committee seeks to set a policy rate that also provides acceptable goal attainment if realised outcomes differ from the forecasts or the forecasts are based on incorrect assumptions.

The economy may at times be exposed to such large negative shocks that the policy rate cannot be set as low as the shock might suggest because there is a limit to how low the policy rate can be set and still pass through to banks’ lending rates. It is uncertain where this level lies for Norges Bank’s policy rate, but based on the experience of other central banks, it is likely somewhat below zero. We will normally be very reluctant to set a negative policy rate, partly because this may lead to an undesirable and unintended impact on financial markets.

Other central banks use instruments such as government bond purchases to influence long-term rates. This is less relevant for Norges Bank as the share of fixed-rate loans is relatively low and Norway’s government bond market is much smaller than in many other countries. The costs of using such instruments will probably exceed the benefits. There is also a very high threshold for intervention in the foreign exchange market in the form of purchases or sales of kroner with a view to influencing the krone exchange rate. International experience indicates that the effects of interventions are small and short-lived at best, and the central bank may easily find itself in an undesirable game situation with market participants. However, interventions can have an effect when markets do not function, as was the case in March 2020 when the Bank intervened to stabilise the market.

In normal business cycles, monetary policy serves as the first line of defence in stabilisation policy. However, the experience of using both monetary and fiscal policy measures in addressing severe economic downturns has been positive. Monetary policy and fiscal policy have different characteristics and can be complementary in many situations. Policy rate decisions can be implemented quickly, and the policy rate has a broad effect on the economy. Fiscal policy measures, on the other hand, may be more targeted. The latter is particularly important when shocks affect different population groups very unevenly, as exemplified by the pandemic-related containment measures. However, the role of fiscal policy in economic stabilisation will be limited by other important fiscal policy objectives – primarily to ensure access to public services and welfare schemes.

Good information sharing between the central bank and the fiscal authorities is important to ensure that the combined effects of the two policy areas are well adapted to the economic situation. It is particularly beneficial that the monetary policy reaction pattern is well communicated so that the fiscal authorities can take this into account when making decisions.

In addition to fiscal policy, wage formation is important for monetary policy. A coordinated wage formation process, where the social partners give weight to high employment, dampens wage-price spirals and reduces the need to raise the policy rate. In conjunction with flexible inflation targeting, this contributes to stabilising inflation without resulting in wide fluctuations in the level of activity. At the same time, the nominal pay increases agreed in wage settlements will have a more predictable effect on the purchasing power of wages when monetary policy ensures low and stable inflation.

Boxes

Footnotes

[1] The equilibrium real interest rate, or the neutral real interest rate, denotes the interest rate that balances demand with production capacity.

[2] For a more detailed description of liquidity management, see Norges Bank Memo 3/2021.