Please note that the text below may differ from the actual presentation.

Thank you for inviting me to speak at this year’s Foreign Exchange Seminar. This year’s theme is “Stabilisation policy and challenges related to financial stability”. The role of monetary policy in stabilisation policy and the work to promote financial stability is being discussed here in Norway and in other countries. Norges Bank has emphasised that the responsibility given to the central bank must be commensurate with its scope for reaching the goals defined. And that is the theme of my remarks today: What scope does monetary policy have in a small open economy for pursuing domestic goals? To what extent can monetary policy dampen fluctuations in the real economy and financial markets in a world of free capital mobility? In other terms: Who decides the interest rate in Norway?   

One of the most famous economic theories is Nobel laureate Robert Mundell’s trilemma. A trilemma is a situation where a choice has to be made between three options, where each option has an unavoidable cost. The trilemma of international finance expresses that countries cannot achieve full capital mobility, a stable exchange rate and independent monetary policy simultaneously. According to Mundell, only two of the three options are possible: With full capital mobility, a country must choose between independent monetary policy and a stable exchange rate. If a country chooses a stable exchange rate, it then foregoes the option of setting the interest rate to accommodate domestic needs. With a floating exchange rate, monetary policy can play a greater role in stabilisation policy. This was also part of the reasoning behind the switch from an exchange rate target to an inflation target in Norway in 2001. In the period leading up to the move to inflation targeting, there was a growing conflict between the aim of maintaining a stable exchange rate and dampening fluctuations in the real economy. Monetary policy became procyclical. This was most recently witnessed in autumn 1998, when oil prices fell sharply and the key policy rate was raised by 3 percentage points. The introduction of an inflation target and the fiscal rule for government spending of petroleum revenues broadened Norges Bank’s responsibility for stabilising the real economy. Monetary policy was to be geared towards low and stable inflation while simultaneously contributing to dampening fluctuations in output and employment.

One might have expected a floating exchange rate to result in a wider and more variable interest rate differential between Norway and its trading partners. However, as the chart shows, there has been strong correlation between domestic and foreign money market rates also after the switch to inflation targeting. Does this mean that Norwegian interest rates are actually decided in Washington and Frankfurt? Is the choice between free capital mobility and an independent monetary policy? Or in other terms: Are the authorities in small open economies facing a dilemma and not a trilemma? The French economist Hélène Rey’s answer to this question is yes. At the Jackson Hole Symposium in 2013[1], Rey points to the close comovement between asset prices, capital flows and credit growth across countries. According to Rey, financial conditions in a small open economy are determined by financial conditions in the major international financial centres, regardless of the exchange rate regime.

There may be many reasons why interest rates, and more generally financial conditions, covary across countries. But a strong correlation does not mean that Mundell’s thesis is invalid or that monetary policy independence is illusory. The answer to the question of whether Norway has an independent monetary policy is an unequivocal yes. We can set a policy rate that differs from policy rates in other countries; the question is to what extent it is desirable to do so.

As a small open economy, Norway naturally is affected by external shocks and global developments. A study by economists at Norges Bank found that around 80 percent of fluctuations in mainland GDP in Norway can be ascribed to global conditions.[2] It is not unnatural then for interest rates in Norway to covary with trading partner interest rates. By and large, we react to the same shocks.

Over the past 30 years, there has been a trend decline in both nominal and real interest rates internationally. The decline in the real interest rate is related to long-term developments that have influenced global saving and investment. Large saving surpluses in emerging economies, particularly in China and oil-exporting countries, is likely one important factor. In many countries, saving has probably increased as a result of growing income disparity and pension saving among the large post-war cohorts. In addition, productivity growth has lagged, depressing the return on real capital. These structural factors have by and large been beyond the control of central banks and have contributed to the comovement of global interest rates, regardless of the monetary policy pursued. But there are still consequences for monetary policy as these factors influence the real interest rate level that is consistent with balanced developments in the economy, the so-called neutral interest rate. Economists at the Federal Reserve find that the neutral interest rate has declined markedly over the past 25 years in the US, euro area, UK and Canada.[3] They find a high degree of comovement between estimates of the neutral interest rate in the countries examined, and interpret this as a sign that common, global factors are important for understanding developments in neutral real rates.

International developments also influence monetary policy in the shorter term. Developments abroad influence the outlook for inflation and the real economy in Norway through multiple channels. Increased activity abroad boosts demand for Norwegian goods and services, which may in turn add to pressure in the labour market and push up wage and cost inflation at home. Higher wage and price inflation among our trading partners will normally result in higher prices for imported goods and services. This may also lead to higher prices for domestically produced goods that compete with imports. In isolation, both higher external demand and higher inflation abroad will pull in the direction of a higher interest rate among our trading partners and in Norway.

With a fixed exchange rate, changes in monetary policy abroad will normally have an almost one-to-one effect on interest rate setting at home. But also with a floating exchange rate, changes in monetary policy abroad will influence interest rate setting here in Norway. Some may interpret this as a lack of monetary policy independence. The fact that small open economies respond to foreign monetary policy is, however, fully compatible with optimal monetary policy under inflation targeting. All else equal, lower foreign interest rates will lead to a stronger Norwegian krone. A stronger krone will normally push down import price inflation and result in lower demand for domestically produce goods and services both abroad and at home. Under an inflation targeting regime, Norges Bank will lower the key policy rate to restrain the fall in inflation even though we do not have a defined exchange rate target. But, the interest rate change will typically be less than one-to-one. Unlike in the case of a fixed exchange rate regime, some of the adjustment will occur through the exchange rate.

Unconventional monetary policy may also have spillover effects on other countries. Purchases of government bonds by the major central banks put downward pressure on long-term interest rates. The decline in long-term interest rates may fuel currency appreciation pressures in other countries, which central banks may seek to ease, for domestic economic reasons, by lowering policy rates. Unconventional monetary policy may also have contagion effects that are not normally countered by exchange rate movements. In response to lower government bond yields, investors may turn to other markets offering higher returns. Willingness to accept lower compensation for risk pushes up asset prices and depresses risk premiums in the bond market, also in countries that are not pursuing a more expansionary monetary policy. Several studies find that term premiums have over time become more closely correlated across countries and strongly correlated with US term premiums.[4] This illustrates a more general point, namely that changes in financial conditions, in terms of ease of access to funding, can spread through many channels regardless of the monetary policy framework.

In its April 2017 Global Financial Stability Report, the IMF raised the question:[5] How can countries manage domestic financial conditions amid global financial integration?” In line with the results of Rey and her co-authors, the IMF finds that global factors account for a large share of the variability in domestic financial conditions in the countries examined. Global factors are particularly important for emerging economies. The common global component moves in tandem with US financial conditions and measures of global risk, such as the VIX index. However, it is the IMF’s view that a high degree of comovement across countries does not mean that countries have lost control of domestic financial conditions. The IMF’s conclusion is that countries retain considerable influence over their domestic financial conditions through the use of monetary policy. Interestingly, the IMF also finds that the importance of global financial cycles has not increased over time.

Norges Bank takes account of developments in financial conditions in the conduct of monetary policy. In the Bank’s Monetary Policy Report, we follow developments in risk premiums, lending spreads and banks’ credit standards. Changes in these conditions, which in some cases may be driven by global conditions, influence interest rate setting. In autumn 2016, for example, uncertainty regarding the effects of the US money market reform pushed up US money market rates. This fed through to premiums in Norwegian money market. Norges Bank can dampen the impact of higher premiums on the Norwegian economy by reducing the key policy rate. A floating exchange rate and the freedom to set our own interest rate provides greater scope to cushion the effects on the Norwegian economy stemming from global capital market shocks than would have been possible with an exchange rate target.

Let me summarise what I have said so far: In a closely integrated global economy, countries will be affected by many of the same disturbances, and developments in large countries will be of considerable importance for developments in other countries. The more similar and closely integrated economies are, the stronger the covariation will be among interest rates, even if monetary policy is oriented towards stabilising the economy in each country. Thus, a high degree of correlation between interest rates or financial conditions across countries is not necessarily a sign of a lack of monetary policy independence. With a floating exchange rate, we can set an interest rate that differs from foreign rates and use monetary policy to stabilise the economy.

Of course, it is possible that considerable contagion effects between countries may reflect a “fear of floating” and a desire to dampen exchange rate volatility, even if these countries officially operate a floating exchange rate regime. The exchange rate can also prove to be a source of shocks and for some countries, it may be appropriate to forego some degree of monetary policy independence to achieve a more stable exchange rate. In emerging economies, where it has been common to borrow foreign currency, exchange rate movements and sudden shifts in capital flows may have wealth effects with potentially substantial spillovers to the real economy and the financial sector. On the whole, the foreign exchange risk of Norwegian households, banks and firms is limited. In Norway’s experience, the exchange rate has, in the period of inflation targeting, acted as a shock absorber and cushioned the effects of shocks to the Norwegian economy. Even though the interest rate level in Norway is to a large extent influenced by foreign rates, this does not mean that a fixed exchange rate could have been an equally good option. A floating exchange rate has been particularly important in terms of dampening the impact of considerable oil price volatility.

However, the fact that Norway has a floating exchange rate and the freedom to set an interest rate that diverges from foreign rates does not mean that monetary policy is able to resolve all stabilisation policy challenges. With several objectives and only one instrument, the central bank will often face a trade-off between different considerations. The extent to which a conflict between objectives arises will depend on the shock and how interest rate changes affect the economy. This applies to both closed and open economies. In a small open economy, monetary policy must take greater account of global conditions, and the exchange rate channel will be more important.

A lesson learned is that in a small open economy, a large number of shocks will leave the central bank faced with a trade-off between bringing inflation quickly back to target and avoiding wide fluctuations in the real economy. A domestic cost-push shock, for example unexpectedly high wage growth, is a classic example of a shock that involves such a trade-off. But in an open economy, other shocks, such as unexpected changes in domestic demand or in foreign interest rates, may also result in a trade-off between inflation and stability in the real economy.[6] This can be explained within a simple model framework: An increase in the foreign interest rate leads to a weaker exchange rate unless the domestic interest rate increases to the same extent. If the domestic interest rate is increased to the same extent as the foreign interest rate, which would be the case with an exchange rate target, output and employment, and hence inflation, would fall. If the real economy is to be fully sheltered, the interest rate must be increased, but not to the same extent as the foreign interest rate, so that the effect of a slightly higher interest rate and the effect of a slightly weaker exchange rate cancel each other out. But inflation will then move above target because the activity level is unchanged while the exchange rate is weaker. The central bank must therefore consider a trade-off between inflation stability and stability in the real economy.

Because all types of shocks involve trade-offs between different monetary policy considerations in an open economy, it is essential that inflation targeting is practised flexibly. Under a strict inflation targeting regime, monetary policy may therefore easily become procyclical. In addition, short-term stability considerations may come into conflict with longer-term considerations. For example, credit and asset price cycles are typically longer than business cycles. A strict inflation targeting regime may amplify the build-up of financial imbalances that may pose a threat to economic stability further out.

A relevant question in this connection is whether increasing financial globalisation has made monetary policy trade-offs more demanding. The answer is not obvious, and a thorough response would require a more extensive analysis, but let me venture to answer, “Yes, perhaps”.

IMF chief economist Maurice Obstfeld has pointed out that if long-term interest rates are largely determined by global conditions relating to international investors’ risk aversion and risk perceptions, changes in central bank policy rates may have less of an effect on the economy. Obstfeld also points out that financial globalisation may weaken the effectiveness of national regulatory and macroprudential measures. In that case, monetary policy may have to assume a greater responsibility for financial stability. However, this will make it more difficult to achieve other monetary policy objectives. Giving weight to financial stability will typically entail greater short- and medium-term variability in inflation and the real economy.

It is also possible that in a world of very low interest rates and a widespread search for yield, even small differences in interest rate levels across countries are likely to result in substantial capital movements. In countries with a floating exchange rate, this will primarily affect the exchange rate. A study by the BIS finds that exchange rates have over time become more sensitive to changes in monetary policy.[7] The relationships in the foreign exchange market are rarely stable, and the results must be interpreted with caution. Nevertheless, the question then arises: If the exchange rate is more sensitive to changes in monetary policy, what are the implications for monetary policy in terms of its role in stabilising the economy?

In attempting to answer that question, we have used Norges Bank’s macro model NEMO to estimate Taylor curves where we measure variability in inflation along one axis and variability in the output gap along the other. The farther out in the diagram the Taylor curve is, the greater the conflict in the short term between the aims of stable inflation and stability in output and employment. The curves will depend on the nature of the shock. Here we have assumed an unexpected change in the policy rate among our trading partners. The curves in the chart are based on two different assumptions regarding the effect of interest rate changes on the exchange rate. In this model-based analysis, monetary policy trade-offs will become more demanding if the exchange rate becomes more sensitive to changes in interest rates. It is still possible to stabilise either inflation or the output gap perfectly, at least in the model, but the conflict between objectives in the short term increases.

Also in the event of unexpected changes in domestic demand, greater exchange rate sensitivity will result in an increased conflict between objectives in the short term. In this chart, we show the trade-off resulting from an unexpected change in house prices. House price movements affect domestic demand, and can also influence the risk of financial instability. When the exchange rate is more sensitive to changes in interest rates, it will be more “costly” to use the interest rate to counteract the change in house prices, so that the conflict between inflation stability and stability in the real economy in the short term increases.

These model analyses indicate in isolation that if there is greater exchange rate sensitivity to changes in the interest rate differential, it may become more difficult for monetary policy to stabilise the economy.

However, it is important to underscore that this conclusion depends on the nature of the shock. For example, if, in the model, a domestic cost-push shock occurs, greater exchange rate sensitivity means that the central bank will be able to stabilise the economy with small changes in the policy rate and with small effects on the real economy. This results in a reduced conflict between objectives. Moreover, monetary policy will be more effective in counteracting shocks to the exchange rate, such as a shift in the risk premium on the krone. This is illustrated in this chart, where greater exchange rate sensitivity results in an inward shift of the Taylor curve. With greater exchange rate sensitivity to changes in interest rates, a change in the risk premium will require a smaller change in the interest rate so that the impact on domestic demand will be smaller. It is therefore not necessarily the case that greater exchanger rate sensitivity will in general make it more difficult to stabilise the economy.

Let me conclude. Mundell’s trilemma is still valid. A floating exchange rate enables monetary policy in Norway to pursue domestic objectives. Room for manoeuvre in monetary policy is particularly important when the economy is affected by shocks. However, we are naturally affected by developments in the outside world. Globalisation has increased the importance of global conditions for the Norwegian economy and more closely integrated financial markets may increase the conflict between monetary policy considerations. Flexible inflation targeting is a good framework for managing trade-offs between considerations. Often, but not always, a reasonable trade-off will imply that we will not have to deviate that much from foreign interest rates. Therefore, monetary policy has limited scope for restraining the build-up of financial imbalances at no cost to other stabilisation policy objectives. However, restricting capital mobility is not a viable option. Global capital markets make it possible to share risk across countries and to decouple domestic saving and investment, something Norway benefited from when it built up its oil sector in the 1970s and is now spreading oil revenue over several generations. Instead, we must ensure that the Norwegian economy is as resilient to shocks as possible. Fiscal space and a resilient financial sector will be even more important. Monetary policy can then do its job.

 Footnotes:

1. Rey, H. (2013) “Dilemma not Trilemma: The global financial cycle and monetary independence”,
2. See Bergholt, D., V. H. Larsen and M. Seneca (2017), “Business cycles in an oil economy”. Journal of International Money and Finance. (Forthcoming)
3. Holston, K., T. Laubach and J. C. Williams (2017), “Measuring the natural rate of interest: International trends and determinants”. Journal of International Economics, vol. 108, issue S1, pp 59-75.
4. See eg Dahlquist, M. and H. Hasseltoft (2012), “International Bond Risk Premia”. Journal of International Economics 90 (1), pp 17-32.
5. See Chapter 3 of Global Financial Stability Report, April 2017.
6. See Røisland, Ø. and T. Sveen (2005), “Pengepolitikk under et inflasjonsmål”[Monetary policy under inflation targeting]. Norsk Økonomisk Tidsskrift 119 (2005), pp 16-38 (Norwegian only).
7. See Ferrari, M., J. Kearns and A. Schrimpf (2017), “Monetary policy’s rising FX impact in the era of ultra-low rates”. BIS Working Papers No 626, April 2017.