Monetary policy during 2003 was conducted against the following background: There had been an environment of gradually improving economic prospects since the summer. At the same time there were significant downside surprises on inflation, which appeared to warrant policy reaction. However, some of the drop in inflation reflects factors monetary policy in normal circumstances should not respond to.
Nevertheless, the Bank appeared to put more emphasis on its forecasts for inflation than output when setting interest rates, particularly after the summer. The result was that Norges Bank’s policy stance during 2003 moved from historically tight to historically loose, contributing to the Bank’s reputation as one of the most aggressive central banks.
When it comes to evaluating interest rate decisions made in 2003, we think that Norges Bank deserves credit for an easing of policy that has bolstered confidence in economic expansion and inflation approaching the target.
We nonetheless find reason to criticize the Bank for entering 2003 with monetary policy that was too tight, due to what we deem to be a policy error in the second half of 2002. This suggests it would have been appropriate for Norges Bank to implement a more rapid easing of policy in early 2003, a view that also gets some support from the Bank’s forecasts in March 2003.
The surprisingly weak development in core inflation during 2003 justified prompt central bank action. At the same time we think that the bank should be careful not to overreact to developments in CPI-ATE, and should consider various measures of underlying inflation like those discussed in chapter 5. This should render policy more robust and less prone to policy mistakes.
As recommendations for future policy, we would like to highlight:
• In cases where Norges Bank’s forecasts differ significantly from other independent forecasters, the Bank should conduct a closer scrutiny of the causes and construct alternative risk scenarios to render its monetary policy strategy more robust.
• Norges Bank should implement frequent, relevant and rigorous evaluations of its forecasts.
• Norges Bank should explore and pay attention to other indicators of underlying inflation.
• By implementing an optimal monetary policy strategy, Norges Bank could attain a lower volatility in interest rates.
Figure 4.11 Key economic and financial indicators
MCI weights: FX 3% = Deposit rate 1%
Business and consumer confidence Consumers' intentions on durable consumer goods purchases
Unemployment rate and wage costs
Core inflation, imported inflation and the NOK
Source: EcoWin
Jan May Sep Jan May Sep Jan May Sep Jan May Sep
01 02 03 04
Table 4.2 Norges Bank monetary policy meetings and interest rate decisions 2002
3 July 50 basis points rate hike to 7.0 per cent, continued ”tightening bias”
7 August Unchanged at 7.0 per cent, continued ”tightening bias”
18 September Unchanged at 7.0 per cent, change to ”neutral bias”
30 October* Unchanged at 7.0 per cent, continued ”neutral bias”
11 December 50 basis points rate cut to 6.5 per cent, change to ”easing bias”
2003
22 January 50 basis point rate cut to 6.0 per cent, continued "easing bias"
5 March* 50 basis points rate cut to 5.5 per cent, continued "easing bias"
30 April 50 basis points rate cut to 5.0 per cent, continued "easing bias"
25 June* 100 basis points rate cut to 4.0 per cent, continued "easing bias".
13 August 100 basis points rate cut to 3.0 per cent, continued "easing bias"
17 September 50 basis points rate cut to 2.5 per cent, change to "neutral bias"
29 October* Unchanged at 2.5 per cent, continued "neutral bias"
17 December 25 basis points rate cut to 2.25 per cent, change to "easing bias"
2004
28 January 25 basis points rate cut to 2.0 per cent, continued "easing bias"
11 March* 25 basis points rate cut to 1.75 per cent, continued "easing bias"
21 April Unchanged at 1.75 per cent, continued "easing bias"
*: with Inflation Report
5 The use of appropriate indicators
Underlying inflation and the output gap
At the centre of inflation targeting lie two widely used terms by the academic profession. The terms are underlying (also referred to as core) inflation and the output gap. Although generally understood and widely used by the economic profession, there are no theoretically established definition of these concepts, nor an agreed method of measuring them. Nevertheless, as they remain the central targets in a monetary objective function, they should be critically evaluated by any inflation targeting central bank.
The standard objective for monetary policy involves stabilizing inflation around an inflation target and stabilizing output around an output target equal to potential output. This can be formulated as an intertemporal loss function to be minimized
(1)
0
(1 )
t t
E τL τ
τ
∞ δ δ
= +
∑
−with the quadratic period loss function
(2) Lt =(π πt − )2+λ(yt−y*t)2
Et denotes expectations conditional on information available in period t, δ is the discount factor and fulfils 0 < δ < 1, πt is inflation, π is the inflation target, yt is output, yt* is potential output, and yt - yt* is the output gap. Finally, λ is a given weight on output-gap stabilization relative to inflation stabilization.
As discussed in Chapter 2, the monetary policy mandate in Norway is flexible, so that emphasis is not only given to inflation stabilization, but also to output stabilization (around trend), i.e. the output gap. Hence, the weight on the output gap (λ) in equation (2) above will be positive.
However, although the theoretical framework for monetary policy can be used to derive an optimal strategy (see Chapter 3), monetary policy in practice may be far from optimal. There are two main obstacles. First, the output gap is not directly observable and estimates have to be inferred from
data. In particular, estimates of the output gap are very sensitive to the measurement of the trend in the data, i.e. potential output. Second, in deciding on the inflation target, it is important that monetary policy focus on a measure of inflation that has the greatest relevance for the behaviour of economic agents. The selection of the consumer price index (CPI) rather than a producer price index as a target index for many central banks has usually been motivated by the fact that CPI inflation approximates increases in the cost of living. However, many central banks that have adopted inflation targeting also attempt to differentiate between persistent and temporary causes of price changes, to determine which variation of a price index should be the focus of policy. In particular, shocks that have only very short lasting effects on inflation should be ignored when setting interest rates, as monetary policy cannot mitigate these shocks. The permanent component of inflation (i.e. underlying inflation) is therefore often used to define an explicit target for inflation, rather than CPI itself.
Calculating underlying inflation and the output gap therefore relies on information on the long run properties in time series and proper care should be taken when constructing these two concepts. In the following discussion we give a brief evaluation of the way Norges Bank set out to measure these components and suggest some improvements.