The Centre
for Monetary Economics (CME) at the BI Norwegian School of
Management has for
the fifth time invited a committee of economists for Norges
Bank Watch with the objective of
evaluating monetary policy in Norway. The committee for Norges
Bank Watch 2004 consists of
Hilde C. Bjørnland (University of Oslo), Thomas Ekeli
(Pareto Securities), Petra M. Geraats
(University of Cambridge) and Kai Leitemo (BI Norwegian School
of Management). Norges
Bank Watch 2004 is funded by the Ministry of Finance. However,
Norges Bank Watch 2004 is
fully independent and the views and recommendations in this
report may not correspond to those
of the Ministry of Finance.
The main task of the committee has been to evaluate how well
Norges Bank has fulfilled
its monetary policy mandate given by the Norwegian Government
on 29 March 2001. In
particular, the committee has reviewed Norges Banks
interpretation of the mandate and finds that
its interpretation is insufficiently flexible. In addition,
the committee has assessed Norges Banks
monetary policy strategy and decision making process and considers
them suboptimal and
inefficient. Furthermore, the committee has evaluated Norges
Banks forecasts and interest rate
decisions in 2003 and has detected persistent forecast errors
as well as policy mistakes that kept
monetary policy too tight at the end of 2002 and early in
2003 and perhaps too loose at the end of
2003. The committee has also assessed Norges Banks use
of indicators for underlying inflation
and the output gap, and concludes that its measures are poor
and need improvement. Finally, the
committee has evaluated Norges Banks public communication
and transparency and finds that
despite increased public communication, there is still a notable
lack of transparency.
MONETARY
POLICY IN 2003
Difficult
economic environment
The
economic environment in recent years has been challenging
for monetary policymakers
worldwide. The bursting in 2000 of an historic investment
and equity market bubble has driven
cyclical developments. In addition, inflationary pressures
have been dampened by globalisation,
illustrated by the profound consequences of Chinas increased
involvement in the global economy
and intense competitive pressures. There has also been heightened
geo-political uncertainty,
clouding the outlook for the world economy and the oil price.
Furthermore, Norwegian policymakers have had to cope with unusually high wage growth
and large exchange rate fluctuations.
Massive
forecast failures
In the forward-looking framework of flexible inflation targeting
that Norges Bank subscribes to,
economic forecasts are the cornerstone for designing monetary
policy because they indicate the
need to adjust policy in light of economic developments. The
experiences of the past two years
are in this respect disturbing. Norges Banks forecasts
in the autumn of 2002 painted a picture of
robust economic growth and inflation near its 2.5 per cent
target, apparently justifying a high
interest rate of 7 per cent. However, the national accounts
today show that the mainland economy
was then sliding into recession. In addition, annual core
inflation plunged far below its expected
path, ending up at only 1.1 per cent in 2003, using Norges
Banks preferred measure of the CPI
adjusted for taxes and energy prices (CPI-ATE). This is far
outside the 90 per cent confidence
intervals for the Banks forecasts as well as the +/-
1 percentage-point range around the inflation
target stipulated by the government. It is also disconcerting
that the forecast errors during the past
18 months appear to be persistent.
These forecast
failures raise important questions with regard to the robustness
of the
Banks policy decisions. Since the central bank forecasts
are crucial in setting the optimal interest
rate, it is essential to conduct a timely and thorough search
for the sources of forecast failures in
order to improve future forecasts and reduce the chance of
policy errors. In that respect, we find
that Norges Banks efforts should be strengthened by
implementing more frequent, relevant and
rigorous evaluations of its forecasts.
Monetary
policy too tight in early 2003
With the benefit of hindsight, one may easily draw the conclusion
that monetary policy in late
2002 and early 2003 ought to have been less restrictive. But
to conclude whether Norges Banks
interest rate decisions were appropriate, the assessment of
the conduct of monetary policy should
primarily be based on the information available to the central
bank at the time (i.e. an ex-ante
rather than an ex-post perspective).
This committee
shares the assessment of Norges Bank Watch 2003 that by not
correcting
the policy errors made in the second half of 2002 quickly,
monetary policy at the start of 2003
ended up being too tight. We also find evidence that the Bank
ignored the signals provided by its
own forecasts and paid insufficient attention to other forecasters.
In cases where Norges Banks
projections differ significantly from other independent forecasts
(e.g. by Statistics Norway), the
Bank should conduct a closer scrutiny of the causes and construct
alternative risk scenarios to
render its monetary policy strategy more robust.
Dramatic
easing as economy is recovering
2003 was an effervescent year for Norges Bank, starting off
with the sight deposit rate at 6.5 per
cent, an economy in recession and inflation sliding far below
the target. An historic easing of
policy took the key rate to 2.25 per cent by the end of the
year (and down to 1.75 per cent in
March 2004).
In an effort
to correct the forecast and policy errors made in the second
half of 2002,
Norges Bank found itself in the unusual situation of lowering
interest rates by a 100 basis points
both in June and August 2003, and another 50 basis points
to 2.5 per cent in September, at the
same time as the economy was recovering. Norges Bank deserves
credit for an easing of policy in
2003 that has bolstered confidence in an economic expansion
and a return of inflation towards its
target. However, the decisions in the spring and summer of
2003 highlight what we see as
structural weaknesses in the Banks forecasting and decision
making procedure.
The substantial interest rate reductions in August and September
2003 were based on a
strategy discussion that took place in early June, which in
turn was based on preliminary forecasts
for the June Inflation Report (probably conducted in the second
half of May). Norges Banks
tradition of only publishing three Inflation Reports a year
meant that the forecasts in the June
Inflation Report were based on GDP-data published in March
2003, covering the end of 2002
only. Thus, these big interest rate cuts were not based on
up-to-date forecasts, using the most
recent quarterly data. Instead, the Executive Board should
discuss strategy and forecasts closer to
the implementation of policy, and the monetary policy decisions
and publications of the Inflation
Reports should be better synchronized with releases of new
and updated national accounts
figures. In addition, the Inflation Report should be issued
four times a year and include a
quarterly estimate of the output gap, for which the Bank should
employ more sophisticated
methods to get a better grip on where the economy is in the
cycle.
Insufficient
flexibility
Norges Banks
interest rate setting in the second half of 2003 and early
2004 was increasingly
responding to large, persistent downward surprises in current
(CPI-ATE) inflation instead of
relying on its forecasts. The risk of deflation needs to be
taken seriously by a central bank and a
declining trend in core inflation below the target justifies
prompt central bank action. However,
we are concerned that the Banks focus on CPI-ATE may
have resulted in an overreaction in
policy.
Although
underlying inflation has clearly decelerated, there are a
number of factors that
suggest that the CPI-ATE measure exaggerates this development.
In our investigation of other
measures of underlying inflation, we find support for the
argument that underlying price pressures
are probably not as weak as suggested by CPI-ATE. Alternative
statistical measures indicate that
inflation has fallen to a lesser extent. While the annual
average for CPI-ATE inflation was 1.1 per
cent in 2003, the other measures we considered actually range
from 1.9 to 2.8 per cent.
In addition, one should not exaggerate fears of a deflationary
spiral in the Norwegian
economy, considering the fact that the real economy has continued
to improve, income growth for
households and the corporate sector has been robust, and housing
and equity prices have risen
briskly. We therefore think that with the continued lowering
of interest rates at the end of 2003
and early 2004, Norges Bank runs the risk of making monetary
policy too loose.
We also find that Norges Bank is not availing itself of the
flexibility provided for in the
monetary policy mandate. By exploring alternative measures
of underlying inflation and by
implementing an optimal monetary policy strategy with a flexible
horizon, the interest rate setting
would be more robust and less prone to policy mistakes. Norges
Bank could then also attain a
lower volatility in interest rates, softening the impression
that the Bank ranks among the most
aggressive central banks.
MANDATE,
STRATEGY AND TRANSPARENCY
Flexibility
of mandate
The flexibility of inflation targeting depends on a number
of factors, namely the target range, the
target horizon, the presence of escape clauses and the extent
to which other objectives (like output
and exchange rate stabilisation) are emphasised explicitly
in the mandate.
Norges Bank has decided to adopt a horizon of two years in
which the inflation target
shall be reached. The motivation for a target horizon of two
years (in contrast to a shorter
horizon) is that by returning inflation more slowly to its
target, the variability of output is
reduced. However, new analysis from Norges Bank suggests that
the full effect of monetary
policy actions on inflation takes longer than the two to three
years previously anticipated. When
the full effect of a monetary policy action exceeds the target
horizon, interest rates need to be
adjusted excessively, creating interest rate volatility. The
two-year horizon therefore works as an
unnecessary constraint on monetary policy, producing more
volatility in macroeconomic
variables.
The monetary
policy mandate states that Norges Bank should ignore the direct
effects on
consumer prices resulting from changes in interest rates,
taxes, excise duties and extraordinary
temporary circumstances when setting interest rates. However,
in its interpretation of the
mandate, Norges Bank has decided that it shall target a core
measure of inflation called CPI-ATE,
which only disregards the direct effect of changes in energy
prices and taxes. In that sense,
Norges Bank is not fully utilising the flexibility provided
by the escape clauses in the mandate.
Given the limitations of measures of core inflation, Norges
Bank should also pay attention to
other measures than CPI-ATE when deciding on its monetary
policy stance.
The mandate of Norges Bank states that in addition to the
operational target for inflation,
monetary policy should contribute to stable expectations concerning
exchange rate developments.
Norges Bank has interpreted this as referring to the long
run only. Generally, exchange rate and
inflation stability are not compatible in the medium term,
so a clarification of the mandate is
desirable in this respect to ensure that it is in accordance
with the governments intentions.
Suboptimal
monetary policy strategy
Norges Bank
has a monetary policy strategy of inflation forecast targeting
that involves adjusting
the interest rate so that the two-year ahead forecast for
inflation equals the inflation target. There
are three problems with this strategy.
First, the
inflation forecast targeting strategy induces so-called time
inconsistency in the
sense that the desired interest rate path adjusts as the end
point of the two-year target horizon
changes over time. As a result, inflation reaches the target
too slowly, which could be prevented
by focusing on a projected interest rate path and only updating
it in response to new information.
Second, the strategy ignores that a fixed two-year horizon
is not optimal in response to all
shocks. Some shocks may be easily stabilized without inducing
output volatility, whereas others
may be more pernicious. So, it would be desirable to adopt
a flexible target horizon.
Third, the monetary policy strategy only focuses on the end
of the target horizon, thereby
ignoring potentially large fluctuations in inflation and output
over the horizon. Instead, Norges
Bank should set interest rates that stabilize the path of
inflation and output continuously over
time, not just at the end of the target horizon.
In line with
Norges Bank Watch 2002 and 2003, we recommend that Norges
Bank
abandons its current strategy and publishes the optimal interest-rate
path that is projected to
produce the greatest stabilization of inflation and output
over time. The Bank should also
systematically address the role of uncertainty in monetary
policymaking.
Lack of transparency
Norges Bank
significantly increased its public communication in 2003.
Although the Bank is
releasing more and more material, it has not yet succeeded
in making monetary policy in Norway
fully transparent.
First of
all, there is some murkiness about the institutional framework
for monetary
policy. In particular, it would be desirable to strengthen
the formal independence of Norges Bank
in interest rate setting and its accountability. Moreover,
the current practice that the Governor has
to submit the anticipated interest rate decision to the Ministry
of Finance the day before the
monetary policy meeting of the Executive Board should be discontinued.
Instead, Norges Bank
should only inform the Ministry of Finance immediately after
the Executive Board has made the
interest rate decision, before the public announcement and
implementation of the decision.
There is also a notable lack of transparency about the economic
information relevant for
monetary policy decisions. We recommend that Norges Bank issues
its Inflation Report at
quarterly frequency and incorporates the current Strategy
Document as well as some additional
data, projections and evaluations. Furthermore, it should
be endorsed by the Executive Board,
describe its view at the monetary policy meeting, and be published
within a week of the interest
rate decision.
There is
even less detailed information about the Executive Board's
discussion and
assessments on which the monetary policy decision is based.
To remedy this, Norges Bank should
release attributed voting records at the policy announcement,
and publish non-verbatim,
unattributed minutes of the monetary policy meetings of the
Executive Board within three weeks
of the interest rate decision.
To provide
clarity about its policy stance, Norges Bank should release
an explicit policy
inclination together with the interest rate decision, preferably
in the form of a projected path for
the policy rate over several quarters.
Implementation
of these recommendations would improve both the efficiency
of external
communication and the quality of the internal decision process
at Norges Bank.
OVERALL
ASSESSMENT
The monetary policy mandate in Norway specifies an inflation
target of 2.5 per cent annual
inflation, with a tolerance margin of +/- 1 percentage point.
Using the inflation measure that the
Bank has decided to focus on, Norges Bank failed to meet its
objectives as the annual rate of CPIATE
inflation was 1.1 per cent in 2003.
However,
our analysis shows that other measures of underlying inflation,
which might
even be closer to the specifications provided by the Banks
mandate, ranged from 1.9 to 2.8 per
cent in 2003. Although this is consistent with the inflation
target, our evaluation shows that there
is much scope for improvements to monetary policy making in
Norway.
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