The interpretation of the policy mandate

The mandate for the monetary policy, as given by the Government on 29 March 2001, states that

Monetary policy shall be aimed at stability in the Norwegian krone’s national and international value, contributing to stable expectations concerning exchange rate developments. At the same time, monetary policy shall underpin fiscal policy by contributing to stable developments in output and employment.

Norges Bank is responsible for the implementation of monetary policy.

Norges Bank’s implementation of monetary policy shall, in accordance with the first paragraph, be oriented towards low and stable inflation. The operational target of monetary policy shall be annual consumer price inflation of

approximately 2.5 per cent over time. In general, the direct effects on consumer prices resulting from changes in interest rates, taxes, excise duties and

extraordinary temporary disturbances shall not be taken into account.

Norges Bank’s interpretation of its mandate in the introduction to the Inflation Report, reads as follows,

Objective

The operational target of monetary policy is low and stable inflation, with annual consumer price inflation of approximately 2.5 per cent over time. In general, direct effects on consumer prices resulting from changes in interest rates, taxes, excise duties and extraordinary temporary disturbances are not taken into account.

Implementation

Norges Bank operates a flexible inflation targeting regime, so that weight is given to both variability in inflation and variability in output and employment.

Monetary policy influences the economy with long and variable lags. Norges Bank sets the interest rate with a view to stabilising inflation at the target within a reasonable time horizon, normally 1–3 years.

The more precise horizon will depend on disturbances to which the economy is exposed and how they will affect the path for inflation and the real economy ahead.”

In its letter to the Ministry of Finance of 27 March 2001, in connection with the new mandate, Norges Bank describes the role of the exchange rate as follows

“The krone is floating, and the value of the krone fluctuates periodically, as do the exchange rates of other small and open economies. The best contribution

monetary policy can make to stabilising exchange rate expectations is to aim at the objective of low and stable inflation. Changes in the Norwegian interest rate level have a predictable effect on the krone exchange rate only when they also contribute to low and stable inflation.”

These statements indicate that there is a discrepancy between the mandate and the interpretation given by Norges Bank. The first sentence in the mandate specifies that monetary policy should aim at stability in the krone’s national and international value, contributing to stable expectations concerning exchange rate developments. However, exchange rate stability is not mentioned in Norges Bank’s interpretation. This

discrepancy has also been pointed out by previous Norges Bank Watch reports. The 2002 Report argues that the reference to exchange rate stability should be removed from the mandate, while the 2004 Report recommends that the interpretation should be clarified.

However, more recently, Norges Bank has changed its formulations on the motivation for exchange rate stability. The Annual Report of 2002 maintains the early and narrow focus on low inflation:

“Norges Bank no longer targets a specific level for the krone exchange rate.

Developments in the krone are nevertheless of considerable importance for Norges Bank's interest rate setting. [...] The value of Norwegian krone will vary, as will the value of other countries' currencies. Norges Bank's response to a change in the exchange rate will depend on how the change influences inflation.”

In contrast, the Annual Report of 2003 also mentions the effect of the exchange rate on output and employment:

“Norges Bank has no specific target for the level of the exchange rate. However, changes in the krone exchange rate are nonetheless of central importance in

interest-rate setting because they affect inflation and developments in activity.

The response to a change in the exchange rate will depend on its expected impact on inflation, output and employment.”

The role of the exchange rate in connection with the policy mandate is also discussed in speeches, e.g. in the one given by the Governor on 7 June 2004:

“The first paragraph of the mandate sets forth its intentions. The last paragraph specifies what Norges Bank is required to do.

The first sentence in the mandate refers to the value of the krone. Stability in the internal value of the krone implies that inflation must be low and stable. Low and stable inflation fosters economic growth and stability in financial and property markets.

The regulation also states that monetary policy shall be aimed at stability in the Norwegian krone’s external value, contributing to stable expectations concerning exchange rate developments.

With open trade with other countries and free capital movements, we do not have the instruments to fine-tune the krone exchange rate. The krone has appreciated when economic activity has been high and there have been expectations of a wide interest rate differential between Norway and other countries. The krone has depreciated when activity has declined and the interest rate differential has narrowed. There is also a strong tendency for the krone to revert to a level that stabilises the price level in Norway relative to our trading partners, measured in a common currency.

The task of monetary policy is to provide a nominal anchor. The inflation target is such an anchor. “

These latter formulations are closer to the discussion of the role of the exchange rate in policy documents from the Government, e.g. Kredittmeldinga 2003, where one among other things emphasizes the importance of the exchange rate for inflation and output.

The change in the Bank’s formulations is in harmony with our talks with the social partners, where we repeatedly heard that Norges Bank now was more concerned about the exchange rate than it was 2-3 years ago. However, it is still the case that the role of the exchange rate is neglected in the formulations in the introduction to the Inflation Report.

Given the specification in the mandate that inflation is the operational target, it is clear that Norges Bank should not sacrifice the inflation target in pursuing a specific target for the exchange rate. However, as we point out in chapter 3.2, under flexible inflation targeting, the interest rate is not pinned down exactly by the inflation target. In situations where the exchange rate is viewed as very weak or very strong, there might be room for the central bank to keep an eye on the effect on the exchange rate, as long as this is not inconsistent with the inflation target.

This view was adopted with the 2002 change of the monetary policy mandate in New Zealand, where it was specified that

“In pursuing its price stability objective, the Bank shall implement monetary policy in a sustainable, consistent and transparent manner, and shall seek to avoid unnecessary instability in output, real interest rates and the exchange rate.”

http://www.rbnz.govt.nz/monpol/statements/mar05.pdf.

In most situations, a clause on the exchange rate, or a possibility of interventions by the Bank (see discussion in Chapter 3.2), will not affect monetary policy nor the exchange rate. However, in a situation where the krone is very weak or very strong, the risk as seen from the market participants that the central bank will act to move the krone may be a risk that they do not want to take. If this is the way market participants reason, the central bank may contribute to exchange rate stability without compromising on its inflation target.

NBW’s view:

There are indications that Norges Bank interprets the policy mandate in a too narrow way, by downplaying the objective of monetary policy also to contribute to exchange rate stabilization. We find the existing policy mandate appropriate. In some situations, a clause about exchange rate stability in the mandate, and Norges Bank reminding the market about it, may affect market participants’ expectations, thus contributing to exchange rate stability. As a matter of principle, the statement of the objective for the monetary policy given in policy documents as the Inflation Report should be complete, not excluding the part about exchange rate stability.