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

"Valutaseminaret" - presentation (pdf)

[Chart: The krone celebrates its 150^th anniversary!]

This year, we celebrate the 150^th anniversary of the Norwegian krone. It was 150 years ago, in 1875, that Norway joined the Scandinavian Currency Union and the krone was established as a means of payment^[1]. The krone was pegged to gold which meant its value was tied to other currencies that were also pegged to gold. Norway therefore had to align its monetary policy with that of other countries. Today, we have monetary policy independence, enabling us to set monetary policy to achieve our own objectives. However, as seen in recent years, a floating krone can also result in large fluctuations in the krone exchange rate. These fluctuations have received considerable attention, and we monitor them closely. Today, I would like to focus on some key developments in the krone exchange rate over the past 25 years, a period that roughly coincides with the introduction of inflation targeting in 2001. I will cover three main points today. First, I will talk about the extent to which the krone has actually depreciated.  Second, I will discuss changes in expectations and potential implications for equity prices, interest rates and exchange rates. Finally, I will describe how we produce exchange rate forecasts.

[Chart: The krone exchange rate has varied against different currencies]

Here, we see the bilateral exchange rates between Norway and its main trading partners. Against the British pound and the Swedish krona, the exchange rate is now roughly the same as 25 years ago. However, the krone has depreciated against the euro and the US dollar. The krone appreciated in the 2000s, particularly against the US dollar and the British pound, while remaining relatively stable against the euro. 2012–2013 saw the beginning of a broad depreciation of the krone, particularly against the US dollar. The British pound, the euro and the US dollar have generally appreciated against many smaller currencies in recent years.

[Chart: The krone exchange rate has varied against different currencies + TP4]

At Norges Bank, we are concerned with the impact of exchange rates on the outlook for inflation and output. In our models, we therefore use a basket of our main trading partner currencies[2]. In the following, I will use a simplified aggregate consisting of the currencies of four of our largest trading partners[3], the British pound, the euro, the US dollar and the Swedish krona. In the 2000s, the krone appreciated against this aggregate, before depreciating from 2013.

[Chart: Nominal exchange rates alone provide little information]

The exchange rate tells us how much a unit in another currency costs in krone. This is not necessarily very useful in and of itself. It is more useful to find out what we can buy abroad for one krone, and then to look at what goods cost in Norway against other countries. There are a host of prices suitable for comparison. When going on holiday, it may be relevant to check how much a coffee costs abroad relative to Norway. When considering moving abroad, however, it may be more relevant to compare wages and the cost of living.

A basket usually consists of the prices of goods we consume. Here, we compare consumer prices in Norway against our trading partners, measured in a common currency. When comparing baskets, we also see that the krone has depreciated – compared with 25 years ago, prices for consumer goods are now higher among our trading partners. This mostly reflects a weaker nominal exchange rate, as we have had a level of inflation comparable to our trading partners and similar inflation targets. However, periods of somewhat higher inflation in Norway have made consumer goods not as “cheap” as nominal exchange rate developments alone would suggest. Other prices, however, have developed quite distinctly from consumer prices.

Here we see the gross output deflator, which is a broad price aggregate measuring the change in prices included in the calculation of GDP. It can be thought of as the value of output in Norway relative to other countries. The gross output deflator measured in a common currency is higher in Norway now than in 2000. Well into the 2000s, it increased more in Norway than among our main trading partners, partly reflecting a stronger krone, but mostly reflecting a much higher rise in prices for export goods and services in Norway. High export prices resulted in a favourable development in trade terms compared with other countries and enabled Norwegian firms to offer higher wages than trading partner firms. This trend reversed in the 2010s, even though we have since experienced periods of very high prices for export goods, for example in 2022 when oil prices rose substantially.

[Chart: Nominal exchange rates alone provide little information + relative equity prices]

This is a story well known to many. Now, let us compare international equity market developments expressed in a common currency. Here, the orange line shows the relative development in equity indexes[4]. We see that Norwegian equity indexes relative to foreign indexes are broadly in line with levels 25 years ago. During the 2000s, Norwegian equities outperformed foreign equities. However, this trend shifted around 2012, after which foreign equities have seen a significantly higher increase in value.

But what are the driving factors behind this development? Equity prices reflect discounted expected earnings. One possible explanation is that expected earnings in Norway first outpaced international expectations, followed by a weaker period. Many factors can lead to changes in expected earnings. In the following, I will examine two possible causes in more detail – oil prices and expected economic growth. First, let us look at oil prices.

[Chart: Expected oil prices have fallen since 2008]

This chart shows oil spot prices. During the 2000s, oil prices rose sharply, which may have pushed up expected earnings among many Norwegian firms. Bar a dip during the financial crisis, prices remained broadly elevated until 2014 and have mostly fluctuated around a lower level since then.

[Chart: Expected oil prices have fallen since 2008 + Equinor]

There is a strong correlation between the fluctuations in Equinor’s share price and oil prices. Developments on Oslo Børs have been greatly influenced by oil companies. The petroleum sector’s share of overall GDP has mostly been falling since 2014; even on a global level the value of oil production as a share of GDP has also fallen during the same period. The sectors dominating the equity markets and the economy will vary over time. In recent years, technology firms have become more dominant globally.

[Chart: Long-term economic growth expectations have fallen since 2013]

Expected earnings may also be affected by future growth expectations. This chart shows that, even relative to other countries, expected 10-year economic growth in Norway increased through the 2000s[5]. This potentially lifted expected earnings in Norway. The past decade has shown an opposite trend; expected growth has more than halved in Norway since its peak.

[Chart: Norway’s share of the “market portfolio” has fallen back …]

When looking at the total value of listed firms, we see the same trend as for equity values. Here, the equity values of individual firms are summed, and the total also includes the value of new firms. Norway’s share of the global market portfolio is currently around the same level as 25 years ago, as is the case for our four main trading partners. However, there have been major movements during the period. In the 2000s, Norway’s share of the investable market portfolio rose substantially, before falling after the financial crisis and the drop in oil prices. The overall share represented by our four trading partners has followed an almost opposite trend, where their share declined towards 2011-2012 and then picked up again.

[Chart: … and we see the same for foreign direct investment]

If we look at foreign direct investment, FDI, we see a similar picture. In this chart we see the stock of inward FDI in Norway and among our trading partners relative to global FDI stock. Norway’s share of inward FDI stock rose until 2012 and then fell back. Our trading partners saw their share of FDI stock fall in the first half of the 2000s before rising again.

Norway’s share of inward FDI stock may increase if investors invest more in Norway compared with the rest of the world or if an existing investment outperforms in Norway. The change in FDI stock may be partly explained by the change in equity values over the observed period.

[Chart: FDI inflows into Norway have declined]

New investment often constitutes a relatively small share of changes to FDI stock. This chart shows FDI inflows (transactions) relative to global FDI stock. FDI inflows also increased in the early 2000s, peaking between 2008 and 2012. They have since been consistently considerably lower, even negative at times.

[Chart: How do macroeconomic variables pass through to exchange rates?]

A recent study by Hilde Bjørnland and co-authors from Norges Bank[6] show that factors similar to those I highlighted as drivers of changes to expected earnings may also drive the krone exchange rate. We are not certain of exactly how macroeconomic variables pass through to exchange rates. The many foreign exchange market participants have differing motivations for their trades. Some studies point out that exchange rate changes may be a component of the changes to equity values in reaction to movements in expected earnings[7]. When expected earnings in a country decline, equity prices in foreign currency may decline partly through a weakening of the exchange rate. More research into Norwegian data in this area would be helpful in enabling me to draw more precise conclusions in the future.

I can, however, draw more precise conclusions regarding causal relationships between the krone exchange rate and expected earnings on another type of investment, namely money market investment.

[Chart: The policy rate can affect the exchange rate.]

As for equities, the exchange rate will, in theory, reflect the entirety of the information available to investors. It is only when the market reassesses or receives new information, for instance concerning policy rate changes, that we can expect exchange rates to change.

Here we see an example showing the euro exchange rate and policy rate expectations, measured using one-year rates[8], upon publication of the December 2023 rate decision. This illustrates what can happen when we take the market by surprise. The market expected the policy rate to remain unchanged, but the rate was raised by 0.25 percentage point. This had a clear impact on the Norwegian fixed income and foreign exchange markets.

[Chart: The relationship between changes in interest rate differentials and exchange rates]

We see a systematic correlation between the policy rate and the exchange rate around monetary policy decisions over an extended period. This chart shows how the euro to krone exchange rate is affected by changes in the one-year interest rate differential between Norway and the euro area on our publication dates^[9]. An increase in the interest rate differential of 10 basis points strengthens the exchange rate by somewhere between 0.5 and 1 percent. We take these calculated short-term interest rate effects into account when preparing exchange rate forecasts.

[Chart: We assume a relatively flat exchange rate going forward …]

Here we see the exchange rate projection published in December. At the time, we expected publication to have little impact on both Norwegian market rates and the krone exchange rate. The krone exchange rate projection was flat. As mentioned, there are many factors that can drive exchange rates. Beyond policy rate developments, we often have no further information than what the market has already priced into the exchange rate. Many studies show that the best exchange rate projection for the coming years is the current exchange rate[10]. This is also true for the Norwegian krone.

[Chart: … but the rate is expected to vary over time]

Despite the assumption that the krone exchange rate will remain relatively flat in the longer term, we nevertheless know the rate will vary over time. FX option pricing can give us an indication of the range of possible outcomes for the krone exchange rate at a specific point in the future. This chart shows expected volatility for some currency pairs based on implicit volatility over the next three months. If volatility is 3.5 percent, as in January, we should expect that the exchange rate against the euro may be 3.5 percent higher or lower in three months’ time. At the onset of the pandemic in March 2020, there was a marked increase in volatility for all currencies. The increase was particularly significant in Norway. The krone also remained somewhat more volatile than trading partner currencies for some time but has been more in line with the other currencies shown in the chart in recent months. High volatility increases the cost of currency hedging and reduces investors’ risk-adjusted return.

[Chart: The krone exchange rate and altered expectations]

Let me conclude. The krone has depreciated, but the degree of depreciation varies across different currencies. The depreciation of the krone after 2013 coincides with lower long-term growth prospects than among our trading partners. The Norwegian equity market has also been weaker and foreign direct investment inflows into Norway have declined. At the same time, looking back to gain some understanding of krone exchange rate drivers is of little help in making exchange rate projections.[11] Structural conditions and geopolitics will be in constant flow, impacting the economic outlook and monetary policy in Norway and beyond. We will generally make projections that differ little from the current exchange rate. Nevertheless, we are committed to improving our understanding of the drivers of the krone exchange rate, as well as the impact of monetary policy. I am looking forward to hearing more about this today.

Thank you for your attention!

Footnotes

[1] Norges Bank (2024) “Skandinavisk myntunion” [Scandinavian Currency Union] (in Norwegian only)

[2] The presentation shows an exchange rate aggregate of four trading partners. In Norges Bank’s monetary policy reports and its macro model, NEMO, a weighted exchange rate aggregate against our 44 main trading parts (I-44) is used, where the aggregate is based on import weights.

[3] The aggregate has the following constant weights: US 30%, euro area 50%, Sweden10%, UK 10%.

[4] Measured by MSCI.

[5] The chart shows monthly long-term estimates for real 10-year GDP growth. Estimates for Norway are for mainland Norway.

[6] Bjørnland, H.C., L. Brubakk and N. Maffei-Faccioli (2024) “Piecing the Puzzle: Real Exchange Rates and Long-Run Fundamentals”. Norges Bank Working Paper 21/2024.

[7]Djeutem, E. and G. R. Dunbar (2022) “Uncovered return parity: Equity returns and currency returns”, Journal of International Money and Finance, Vol 128, Nov 2022, Rey, H., V. Stavrakeva and J. Tang (2024) “Currency centrality in equity markets, exchange rates and global financial cycles”, NBER Working Paper 33003, September 2024 and Itskhoki, O. and D. Mukhim (2023) “What drives the exchange rate?”, NBER Working Paper 32008, December 2023. 

[8] 1-year swap rate against 6-month NIBOR.

[9] Daily figures for changes in EURNOK and differentials for one-year swap rates for EURIBOR and NIBOR on our publication dates from 2003 to 2024.

[10] Eichenbaum et al. (2021) provides a literature overview and finds that a “random walk” for exchange rates over the coming two years is hard to beat, see Eichenbaum, M.S., B.K. Johannsen and S.T. Rebelo (2021) “Monetary Policy and the Predictability of Nominal Exchange rates”, Review of Economic Studies (2021 88, 192-228..

[11] Engel, C. and S.P.Y. Wu (2024) “Exchange rate models are better than you think, and why they didn’t work in the old days”, Voxeu CEPR, 6 September 2024.