One of the features of the forecasts presented in the Inflation Reports from the start of inflation targeting in 2001 and throughout 2003 is that Norges Bank’s two-year ahead inflation forecast is on target. We interpret this simple inflation forecast-targeting procedure as the key element of the monetary-policy strategy of the Bank. Indeed, Governor Svein Gjedrem has stated several times that this principle guides Norges Bank’s interest-rate setting. The following quote from Gjedrem (2002) is representative:
“If it appears that inflation will be higher than 2½ per cent with unchanged interest rates, the interest rate will be increased. If it appears that inflation will be lower than 2½ per cent with unchanged interest rates, the interest rate will be reduced.”
In addition, Gjedrem (2003) stated at a hearing before the Standing Committee on Finance and Economic Affairs of the Storting, that
“Norges Bank sets the interest rate with a view to achieving inflation of 2½ per cent at the two-year horizon.”
Simple forecast-targeting is convenient from a practical point of view when making decisions about the interest rate. By either the use of market expectations about interest rates or a constant-interest-rate assumption, the policymaker need only decide what the current interest rate should be in order to keep Norges Bank’s two-year ahead inflation forecast on target.
However, if we take the objectives of Norges Bank seriously and aim to stabilize inflation and output in the most efficient manner, the simple inflation-forecast targeting strategy is normally dominated by other strategies. The simple forecast targeting using constant-interest-rate assumption (an assumption made for the inflation forecasts in most of 2003) is, however, only efficient in stabilizing the policy objectives under the following two conditions: (i) the central bank only cares about stabilizing inflation and not about stabilizing output fluctuations, and (ii) the central bank policy has no effect on inflation before the end of the two-year horizon (see Leitemo, 2004). From our experience with Norges Bank, it seems that neither of these conditions is satisfied. Norges Bank is indeed concerned about stabilizing both output and inflation fluctuations. Moreover, the interest rate is widely regarded as having some effect on inflation in less than two years, in particular, through its effect on the exchange rate and the prices of imported goods.
There are therefore benefits in changing the strategy in the direction described below.
In both the first and second Inflation Report of 2003, inflation forecasts were based on the assumption of a constant interest rate. In the Inflation Report of October 2003, Norges Bank switched to using “market” interest rate expectations, derived from the market for interest rate futures. We believe that this switch to using “market expectations” is an improvement to the monetary-policy strategy. The reason is that the Bank’s projections are more accurate since market expectations regarding interest rate development will be closer to the actual interest rate setting. We believe, however, that it is important for the Bank to announce and make explicit comments on any changes it makes to the implementation of its monetary-policy strategy. The Bank should have made the motivation and the reasons behind the change in October 2003 more explicit. If Norges Bank chooses to continue using the simple forecast-targeting procedure, we recommend that Norges Bank either maintains the market interest rate assumption or, even better, bases its forecasts on its own expectations about the future path of the interest rate. In any case, we recommend against switching back to the constant-interest-rate assumption. The Bank has previously switched back and forth between interest-rate assumptions without making the motivation for this clear. Such unpredictable changes decrease predictability and hence the credibility of the strategy, making policy less effective in its use of the expectations channels of monetary policy, leading potentially to a worsening of the policy outcome.
Time inconsistency
Norges Bank has argued that the forecast-targeting approach is suitable for gaining credibility for the inflation target. Its reasoning is arguably that the policy procedure ensures that private-sector expectations of inflation two years ahead and beyond are equal to the target level. However, although the forecast of inflation presented by the Bank shows that inflation will be back on target after two years, these forecasts do not take into account the fact that consecutive interest-rate setting contributes to postponing the return of inflation to target as the two-year horizon moves across time. Measures taken in 2004 by Norges Bank to bring inflation back to target by 2006 may be undermined by efforts in 2005 to bring inflation back to target by 2007. In the same manner, measures taken in 2004 may undermine those taken in 2003. In the economics literature this problem is denoted as time inconsistency. The plan for policy for 2004 and 2005 that was suitable from the perspective of policymaking in 2003 may no longer be suitable from the perspective of policymaking in 2004. Therefore, inflation forecasts presented by Norges Bank showing that inflation will be back on target after two years, can be highly misleading. It will in general take (possibly much) longer time before inflation is brought back to target. See the illustration in Box 3.1.
Currently, the inflation rate is well below the inflation target, yet Norges Bank’s forecasts show that inflation is expected to be back on target in 2006. We believe that the forecast will be steadily pushed forward in time, implying that the return to the inflation target could be expected to take longer than the stated 2 years. Time inconsistency can only be avoided if the Bank deviates from its projected interest-rate path in response to new information in the future. For instance, the Reserve Bank of New Zealand publishes such interest-rate projections.
Box 3.1. Illustration of the time inconsistency of simple inflation-forecast targeting.
2.5%
Interest Inflation Projection
IP04 IP03
2003 2004 2005 2006 Year
Year 2006
2005 2004
2003
i03 i04 rate i
The figures above provide an illustration of the time inconsistency of simple inflation forecast targeting for a central bank with an inflation target of 2.5 per cent and a target horizon of two years. Suppose that the inflation projection made in 2003 based on the constant interest rate i03 follows the path IP03 above. From the perspective of 2003, the interest rate i03 is the desired rate for 2003 and 2004 because it takes the inflation projection back to the inflation target in two years time. The interest rate should then be increased in 2005 to keep inflation equal to the target. The desired interest rate path and inflation path from the perspective of 2003 are indicated by the bold solid lines in the figures above.
However, in 2004, the central bank reconsiders its interest rate. It checks out the inflation projection two years ahead (2006) and notices that it is above target. Following a simple inflation forecast targeting strategy, it decides to increase the interest rate to i04
because at a constant rate of i04 the inflation projection IP04 (indicated by the dash-dotted line) is equal to the inflation target in 2006. So, the interest rate path that was desired in 2003 is no longer followed in 2004. In subsequent years, the central bank further increases its
interest rate gradually, leading to the interest rate path and inflation path indicated by the dash-triple-dotted profiles.
It is clear that the central bank suffers from time inconsistency; it deviates from the interest rate path desired in 2003, even though no new information has arrived. The result of time inconsistency is that inflation reaches the inflation target too slowly. This problem could be avoided by following (in the absence of new information) the interest rate path constructed in 2003.
It is noteworthy that Statistics Norway throughout 2003 has not expected inflation to be back on target by 2005/2006, which is fully consistent with the problem of time inconsistency inherent to Norges Bank’s strategy.
Due to time inconsistency, the argument that forecast-targeting contributes to increased credibility about the inflation target is weak. Indeed, it can be argued that due to the time inconsistency involved, the strategy does not work as intended. Credibility of the inflation target depends on the Bank’s ability to keep inflation close to target over time, and not only at some (moving) point of time in the future. If agents cannot fully rely on the inflation forecasts presented by the Bank in forming efficient inflation expectations about the future, Norges Bank may lose one valuable channel to influence private-sector expectations, as agents find it more advantageous to base their inflation expectations on other sources of information. Time inconsistency is the most important reason behind our recommendation that the Bank should leave the simple inflation-forecast targeting strategy in favour of a more optimal strategy that includes publishing the Bank’s projection for the interest rate path.
The fixed two-year targeting horizon
The economy is constantly hit by shocks that change the state of the economy. Some of these shocks require strong responses by Norges Bank to achieve stable inflation and output over time, whereas other shocks incur a worse trade-off between inflation and output stabilizing objectives and require only mild responses.
Accordingly, the optimal aggressiveness of the Bank to bring inflation quickly back to target depends on the degree to which such aggressiveness has adverse effects on output. Thus the expected time it will take for inflation to be back on target should depend on the particular shock and state of the economy. Always responding so that the two-year inflation forecast is on target is a restriction on policymaking that is likely to increase inflation and output gap fluctuations, which is not in accordance with the monetary-policy objectives. Although Norges Bank seems to acknowledge this problem, the forecast-targeting horizon has remained fixed at two years since the adoption of inflation targeting in 2001, despite a variety of shocks to the economy, both in kind and magnitude. In Chapter 4 we argue that policy at the start of 2003 provides a case where a change in the forecast-targeting horizon clearly was needed in order to achieve an interest rate setting in line with the ex ante optimal stabilization of policy objectives.
By focusing on two-year ahead forecasts, Norges Bank runs the risk of not responding to all shocks in a desirable way. For instance, it may not adjust interest rates appropriately in response to a shock whose effects on inflation and output are pronounced and can be mitigated by policy, but disappears within two years. Exchange rate shocks were considered to be mainly short-lasting. However, recent evidence suggests that they may have a more persistent effect on inflation than previously believed (see Inflation Report 1/2004). Still, it is an example of a shock that affects inflation mainly in the shorter term, but occurs frequently and with great magnitude in the Norwegian economy.
Since the exchange rate has such a profound influence on the objectives of monetary policy, the lack of understanding of the exchange rate channel should remind us that the control of inflation and output cannot be achieved with any high precision in an economy like the Norwegian.