Norway: Selected Issues
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International Monetary Fund
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Publication Date:
14 Jun 2005
eISBN:
9781451829778
Language:
English
Keywords:
ISCR; CR; import price; headline CPI inflation; reaction function; baseline inflation measure; core inflation; financial market; Exchange rates
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This Selected Issues paper analyzes inflation in Norway with a view to shedding light on this surprising development and the possible near-term course of inflation, using statistical and econometric analyses. The paper reviews recent developments of monetary policy and inflation in Norway, applies statistical and econometric tools to identify factors influencing inflation, and describes the implications of the analysis for policymaking. Using data for six advanced small open economies explicitly targeting inflation, the paper examines empirically whether deviations of the exchange rate from their equilibrium levels systematically affect the conduct of monetary policy.

Abstract

This Selected Issues paper analyzes inflation in Norway with a view to shedding light on this surprising development and the possible near-term course of inflation, using statistical and econometric analyses. The paper reviews recent developments of monetary policy and inflation in Norway, applies statistical and econometric tools to identify factors influencing inflation, and describes the implications of the analysis for policymaking. Using data for six advanced small open economies explicitly targeting inflation, the paper examines empirically whether deviations of the exchange rate from their equilibrium levels systematically affect the conduct of monetary policy.

II. Implicit and Explicit Targets in Small Open Economies14

A. Motivation and Overview

1. In Norway—like in other industrialized open economies—the inflation targeting regime has been instrumental in taming inflation and stabilizing the economy, and appears to have gained considerable credibility over time.15 Since March 2001, Norges Bank has operated a flexible inflation targeting regime, taking into consideration both variability in output and employment, and variability in inflation. The operational target of monetary policy is annual consumer price inflation—adjusted for tax changes and excluding energy products—of “approximately 2½ percent” over a “reasonable” time horizon, lately redefined as 1–3 years. According to survey evidence, Norway’s medium-term inflationary expectations remain anchored at 2½ percent. Recent measures have further improved the transparency and the flexibility of the Norwegian monetary policy framework, while enhancing guidance to the markets.16

2. An unsettled issue in inflation-targeting open economies such as Norway remains whether deviations of the real exchange rate from equilibrium should be taken into account in formulating monetary policy. Under a flexible inflation targeting regime, should policymakers focus solely on domestic variables and avoid any reaction to movements in the foreign exchange market? Or is it correct to claim that “a substantial appreciation of the real exchange rate [...] furnishes a prima facie case for relaxing monetary policy,” as argued by Obsteld and Rogoff (1995)? The primacy of inflation targeting entails that, as soon as macroeconomic indicators suggest that inflationary pressures are beginning to surface, the monetary authority should start a gradual policy tightening. Indeed, delays in rising interest rates might undermine the credibility of the inflation targeting framework itself. In practice, however, the room for maneuvering of small open economies’ (SOEs) policymakers is likely to be constrained by the need to avoid an exchange rate appreciation that would damage the traded goods sector. Should this prospect make a case against an immediate policy tightening?

3. Using data for six advanced small open economies explicitly targeting inflation, this chapter examines empirically whether deviations of the exchange rate from their equilibrium levels systematically affect the conduct of monetary policy. The basic test is to see if such deviations enter the monetary policy reaction function, modeled as a forward-looking interest rate rule, and thus whether they enter as a separate argument in the interest rate rule.

4. This chapter finds that most of the inflation targeters examined do not respond to output deviations and, if they target core inflation, not to the exchange rate. In three out of six cases (Canada, Australia, and New Zealand) where the available measure of core inflation closely resembles headline CPI inflation, the real exchange rate does appear to enter the monetary policy reaction function independently. Estimates from rolling regressions also indicate that monetary policy responses in inflation-targeting open economies have varied significantly over time. As the institutional framework for the conduct of monetary policy has evolved over recent years, the parameterization of interest rate reaction functions has changed accordingly. Interestingly, rolling regressions imply that confidence in inflation targeting has increased over time in all six economies.

5. Norway, in particular, now appears to be targeting the inflation rate, but not, independently, output or the exchange rate. The use of an explicit target for core inflation, and a greater use of the expectation channel of monetary policy appear to be key features behind this result. In this respect, time-varying estimates of the monetary policy responses suggest that the credibility of the framework has increased over time and is now well established. At the same time, putting private sector perceptions about the stability of monetary policies at center stage highlights the importance of central bank communication.

6. The chapter is organized as follows. Section B briefly reviews the standard framework of analysis of forward-looking monetary reaction functions. The model is generalized to an interest rate rule explicitly allowing for real exchange rates to act both as information variables and as monetary policy targets. Inter alia, alternative targets for inflation and a range of proxies for the output gap are here examined. Section C reports the main empirical results from estimating standard forward-looking rules as well as augmented forward-looking Taylor rules, which allow for possible exchange rate targeting. For each country, the actual and the implied value of the policy interest rate under the standard and the augmented monetary reaction function are shown. Finally, changes in central banks’ behavior over time are analyzed by presenting results from rolling regressions, in which parameter estimates are reported over successive forty-quarter windows. The results are open to several interpretations, which are discussed in the concluding section.

B. Theoretical Background

7. Extensive academic work on monetary policy tends to characterize conduct in terms of interest rate rules and consequences in stylized models embedding these rules.17 According to this framework, short-term money market rates are set to stabilize domestic variables—such as price inflation and real output—around their equilibrium path. Several contributions within the so-called New Keynesian synthesis have shown that—under quite general conditions—a simple, inward-looking, interest rate rule can be regarded as an optimal policy response for a closed economy.18 Less attention has been paid to the choice of monetary policy objectives in a small open economy context, given that an open economy is isomorphic to a closed economy whenever the exchange rate pass-through to import prices is complete.19 In other words, under complete exchange rate flexibility, SOE’s policymakers should also focus solely on domestic targets. Unfortunately, there is extensive evidence that—in reality—departures from the law of one price for traded goods prices are large and pervasive. Under these circumstances, policy choices are hardly independent of exchange rate dynamics and monetary conduct is liable to focus on more than just domestic stabilization.20 Indeed, recent empirical studies provide evidence that exchange rates are statistically significant in interest rate rules depicting the reaction function of major economies.21

8. Following a widespread approach in the literature of flexible inflation targeting, this chapter assumes that central banks face a quadratic loss function over inflation and output.22 Under standard conditions, this implies that in each period the monetary authority has a target for the nominal money market interest rate i*t, which is a function of the gaps between expected inflation and output from their respective targets:

i t * = i * + β [ E ( π t + k π |   Ω t ) − π * ] + γ [ E ( Y t + k y | Ω t ) ] , ( 1 )

where i* is the desired nominal rate of interest when both inflation and output are at their target levels; E(πt+kπ|Ωt) denotes the expectations of inflation at time t+kπ; and E(yt+ky|Ωt) denotes corresponding expectations of the output gap at time t+ky⁢.⁢π* is the level of inflation implicitly or explicitly targeted by the central bank, whereas the output gap, y, is defined as the difference between the level of real output and its trend. The coefficients β and γ measure the strength of policy responses to deviations from the target variables. A parameter γ=0 implies monetary policy is uniquely concerned about price stability and does not aim at stabilizing business cycle fluctuations. If β <1, policy is attempting to accommodate inflationary shocks, which—over the long run—will lead to instability as real rates respond perversely to inflationary disturbances.23

9. However, central banks are likely to react gradually to expected deviations from targets, by smoothing their policy rate adjustments over several periods.24 To account for this behavior, the interest rate rule is modified by allowing for a second-order partial adjustment to the target rate, namely:

i t = ρ ⁢ ( L ) ⁢ i t − s + [ 1 − ρ ⁢ ( L ) ] ⁢ i t * + v t , ( 2 )

where ρ(L) is a second-order polinomial, L is the lag operator, it* is the target rate whose behavior is described by equation, and vt is a zero-mean interest rate shock. Combining equations (1) and (2) yields an expression for the standard forward-looking Taylor rule, e.g.,

i t = ρ ( L ) i t − s + [ 1 − ρ ( L ) ] { α + β [ E ( π t + k π | Ω t ) ] + γ [ E ( y t + k y | Ω t ) ] } + v t , ( 3 )

which, in turn, allows direct inference of the policy responses, β and γ, and derivation of the implied (ex-ante) equilibrium real interest rate, r*=α−(1−β)⁢π*, if the inflation target is known. So far, the only innovation in this policy rule specification regards the inclusion of two lagged terms (rather than one) in the interest rate. This more flexible dynamic structure provides a better description of some of the changes in monetary responses over time.

10. It is under debate whether and how exchange rates (and asset prices, in general) should be taken into account in formulating monetary policy.25 While it is unanimously recognized that exchange rates are useful indicators of inflationary pressures in the economy (because changes in the exchange rate feed through into domestic prices and affect aggregate demand), central bankers have often been explicit that exchange-rate stabilization is not a direct target of policy. To assess whether this is really how they act, the interest rate rule (3) is further generalized to allow for policymakers’ responses to exchange rate disequilibria:

i t = ρ ( L ) i t − s + [ 1 − ρ ( L ) ] { α ˜ + β ˜ [ E ( π t + k π | Ω t ) ] + γ ˜ [ E ( y t + k y | Ω t ) ] + δ [ E ( e t + k e | Ω t ) ] } + ε t , ( 4 )

where et+ke denotes the forward-looking real exchange rate. In line with recent empirical literature, purchasing power parity (PPP) is assumed to hold in the long run, so that the real exchange rate follows a persistent, albeit stationary, process. The equilibrium real exchange rate can thus be captured by a constant included in the intercept term α of the “augmented interest rate rule” (4), implying that central banks attempt to correct expected misalignments from PPP. If the real exchange rate is expressed as the domestic price of foreign currency, the resulting monetary rule will stabilize it if δ> 0, as an appreciation of the real exchange rate will require a cut in the short-term interest rate. Under the augmented specification, the implied (ex-ante) equilibrium real interest rate will hence be identified only if both the inflation target and the equilibrium real exchange rate are known: r*=α˜−(1−β˜)⁢π*+δ⁢e*⁢.

11. Under rational expectations, central banks form their forecasts of future inflation, output gap, and real exchange rate using all relevant information available at the time the interest rate is set. Let zt denote the vector of indicators comprising the central bank’s information set at that time (i.e., zt ɛ Ωt). If the monetary authority adjusts the interest rate according to the augmented interest rate rule (4), while forming expectations of future variables in a fully rational manner, then there must exist a set of parameters {ρ1˜^,ρ2˜^,α˜^,β˜^,γ˜^,δ^} such that the residuals obtained from the estimation of equations (4) are orthogonal to the information set available, zt. Formally, E[ϵt|zt]=0. This set of orthogonality conditions forms the basis of the estimates, using the Generalized Method of Moments (GMM). In addition, the validity of the set of instruments used can be tested by means of over identifying restrictions, provided the number of instruments in zt is greater than the number of parameters to be estimated.

12. The dataset comprises quarterly data from January 1984 to June 2004 for six inflation targeting countries: Norway, Sweden, United Kingdom, Canada, Australia, and New Zealand. The baseline inflation measure is the annual core inflation rate (πCORE), as reported by national monetary authorities. Because this measure is generally available only over recent periods, the series were extended backwards using the fourth differences in the log of CPI, as reported by the IFS database. Results are, however, also described using fourth differences in the log of CPI series (πCPI) throughout the sample. Figure II-1 plots the instrument interest rate (that is, the rate used by the central bank as a policy instrument) for each of the six countries against measures of underlying and headline inflation. As for the output gap, the preferred indicator is the growth gap (yDGAP), given recent findings on the optimal policy response to potential output uncertainty (Orphanides and van Norden, 2002). Results are also reported for two alternative measures of the output gap: the Hodrick-Prescott filter for the level of real output (yHP), and the real unit labor cost after adjusting for wage markup (yARMC), constructed as documented in Galí, Gertler, and López-Salido (2001).

Figure II-1:
Figure II-1:

Interest Rate, Core, and Headline Inflation

Citation: IMF Staff Country Reports 2005, 197; 10.5089/9781451829778.002.A002

Figure II-2 seems to confirm that the three output gap series are positively correlated but not identical.26 Finally, for all countries, misalignments from PPP are proxied by the logs of demeaned real effective exchange rates based on CPI, given that real effective exchange rates series based on unit labor costs were not available for all countries.

Figure II-2:
Figure II-2:

Output Gap Measures

Citation: IMF Staff Country Reports 2005, 197; 10.5089/9781451829778.002.A002

C. Empirical Results

13. Table II-1 reports GMM estimates of the parameters {ρ1^,ρ2^,β^,γ^} in the standard forward-looking Taylor rule (3), where only expected inflation and expected output gap are considered as explanatory variables. The target horizon is assumed to be one quarter for both inflation and the output gap (i.e. kπ=ky=1), although results are qualitatively unaffected by this choice (not reported). The instrument set, zt, includes a constant, a world commodity price index, and four lags of the policy rate, inflation, and the output gap. In estimating the model for Norway and Sweden, the 1993Q1 and the 1992Q4 interest rate observations, respectively, are dummied out as extreme and unsystematic monetary tightening episodes dealing with the ERM crisis.

Table II-1:

Forward-Looking Taylor Rule

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14. Estimation results yield parameter values broadly consistent with previous findings reported by the literature for inflation targeting countries. In particular, for Norway, for each of the specifications considered the estimate of β is always correctly signed, strongly significant, and greater than unity, while the estimate of λ is not statistically different from zero at conventional significance levels. This implies that Norges Bank has responded only to deviations of the expected inflation from target, not to the expected output gap. The same conclusion can be drawn for Sweden, United Kingdom, and New Zealand, whose parameter estimates look very much alike in size and statistical significance.27 As for Australia, the estimate of β is strongly significant and greater than unity, but there is also some evidence that monetary policy stabilizes expected business cycle fluctuations. The evident outlier is Canada, for which monetary policy responses to both inflation and output gap are much stronger than in other countries, though the parameters are estimated with far less precision. For all specifications and for each country, the over-identifying restrictions cannot be rejected, with the Hansen test supports the validity of the instrument set used. Standard deviations of the countries’ policy rates are estimated in the order of 1 percent, with the exception of New Zealand, where the volatility is slightly higher (around 1.3 percent).

15. Next, the parameters {ρ1˜^,ρ2˜^,β˜^,λ˜^,δ^} for the six countries are estimated using an augmented interest rate rule (4). The target horizon for the three forward-looking variables—inflation, output gap, and real exchange rate—is still assumed to be one (i.e. kπ=ky=ke=1). The results of the GMM estimation are reported in Table II-2, using alternative measures of inflation and output gap. In all countries except the United Kingdom, there is some evidence that—over the sample—real exchange rate movements have direct explanatory power in characterizing interest rate changes. In Norway and in Sweden, this is true only if the monetary authority is assumed to target headline rather than core inflation (recall that Norway targets core inflation). In three out of six cases (Canada, Australia, and New Zealand)—where, ex post, the available measure of core inflation closely resembles headline CPI inflation—the real exchange rate yields significant (and correctly signed) parameter estimates, even when the central bank is assumed to target core inflation.

Table II-2:

Augmented Forward-Looking Taylor Rule

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16. Overall, the inclusion of exchange rate disequilibria does not seem to affect appreciably the model’s interest rate predictions. To aid interpretation of the results, Figure II-3 juxtaposes, for each country, the actual interest rate to the estimated interest rate implied (i) by the baseline standard forward-looking Taylor rule (Table II-1), and (ii) by the augmented interest rule allowing for exchange rate responses (Table II-2). The interest rates implied by the estimated rules characterize well the behavior of the actual rates. Indeed, both specifications of the reaction function satisfactorily trace the dynamics of the interest rates. The simple visual inspection of the models’ predictions suggests that the contribution of real exchange rate disequilibria is not sufficient to distinguish between the two models. Even for Australia and New Zealand—where deviations from PPP play a slightly greater role in explaining interest rate movement, given our preferences for measuring inflation and output gap—the standard Taylor rule that provides a better fit over the latest quarters of the sample.

Figure II-3:
Figure II-3:

Interest Rate: Actual versus Implied

Citation: IMF Staff Country Reports 2005, 197; 10.5089/9781451829778.002.A002

17. A more flexible approach to inflation targeting implies that central banks can decide to apply a somewhat longer period for bringing inflation back to target. The horizon for achieving the inflation target implicitly provides some indication of how much weight the central bank gives to stability in the real economy. Considerable emphasis on stability in the real economy—at the expense of somewhat greater and more persistent deviations from the inflation target—implies a relatively long horizon.

18. A precondition for a longer monetary policy horizon is that financial market participants are confident that inflation will be low and stable over time. Financial market confidence in the inflation target provides central banks with greater scope for promoting stability in the real economy. This scope tends to increase as the inflation target is incorporated as an anchor for the formation of inflation expectations, in general, and wage formation, in particular. This creates a role for regular central bank communication to help financial markets filter macroeconomic news. However, in situations where there is a risk that confidence in monetary policy is in jeopardy, a rapid and pronounced change in the interest rate may be needed.

19. The results confirm the view that central banks tend to smooth the adjustment of interest rates over several quarters, thereby increasing the predictability of monetary policy conduct. However, the extent to which central banks rely on smoothing appears to differ across countries and over time. In particular, for Sweden, Australia, and New Zealand, the coefficient on the first lag appears to be close to one, while the second lag displays a significant corrective behavior, signaling more elongated and predictable interest rate movements in response to changes in the macroeconomic environment and, hence, a greater use of the expectation channel of monetary policy. Previous work in this area indicates that the strength of the expectation channel relates to the degree of forward-looking behavior in the rest of the economy, which—in turn—can be seen as the policymakers’ reward for ensuring monetary stability (Bayoumi and Sgherri, 2004a, 2004b). Figure II-4—plotting parameter estimates from rolling regressions over successive forty-quarter windows—shows that, in this respect, Norges Bank (and, to a lesser extent, the Swedish Riksbank) has enjoyed the greatest confidence gains over recent times, possibly in connection with its latest switch to a longer adjustment horizon. At the other end of the spectrum is Canada (and, to a lesser extent, the United Kingdom), which respond the quickest to macroeconomic misalignments.

Figure II-4:
Figure II-4:

Interest Rate Smoothing1

Citation: IMF Staff Country Reports 2005, 197; 10.5089/9781451829778.002.A002

1 Rolling GMM estimates over successive forty-quarter periods. Dates displayed on the horizontal axes indicate the initial period of the 10-year window.

20. Central banks’ response to real exchange rate misalignments have varied over time. Rolling-window estimates of the exchange rate responses (Figure II-5) suggest that, even if the level of the implied instrument rate is very similar to the one implied by the standard forward-looking Taylor rule, central banks in each of the six countries have effectively targeted exchange rates at some point over the sample. Norway (and Sweden) appear to have been concerned about exchange rate misalignments until the first half of the 1990s. Over the past decade, however, the interest rate response to deviations of exchange rates from target has become statistically insignificant.

Figure II-5:
Figure II-5:

Long-term Response to the Real Exchange Rate1

Citation: IMF Staff Country Reports 2005, 197; 10.5089/9781451829778.002.A002

1 Rolling GMM estimates over successive forty-quarter periods. Dates displayed on the horizontal axes indicate the initial period of the 10-year window.

D. Discussion

21. Inflation targeting is now a well established framework for the conduct of monetary policy. Norway’s experience, like that of other countries, has been that the period of inflation targeting has delivered favorable economic outcomes. According to surveys, medium-term inflationary expectations in the country remain anchored at 2.5 percent, thus contributing to stabilizing inflation around the target and amplifying the effects of monetary policy itself. Expectations concerning inflation and economic stability are indeed of crucial importance for both wage-price formation and the stability of the foreign exchange market.

22. Inflation targeting has evolved over time across a number of dimensions, notably the degree of flexibility and the approach to communication. The chapter’s results show that in Norway the regime has recently become much more flexible, allowing greater scope for inflation to vary around the target and, as a result, for broader macroeconomic goals to be taken into account. As the central bank has started to smooth the adjustment of interest rates over a longer horizon, the predictability of monetary policy conduct has also increased. In addition, the monetary authority has recently become more transparent, improving the scope of its communication and delivering it in more varied forms.

23. Although with some significant differences across countries exchange rates are generally not key for systematic monetary responses in inflation targeting small open economies. More precisely, if a country attempts to target core (rather than headline) inflation, the exchange rate does not seem to enter as a separate argument in the interest rate rule. At the same time, however, exchange rates are found to be valuable inputs into the monetary policy decision-making process, as information variables. Nonetheless, this finding may be consistent with the view that, while committed to a flexible inflation targeting regime, central banks may act in response to exchange rates on occasions when there is a need to smooth out high volatility in foreign exchange markets that could destabilize domestic inflation.28 Indeed, to detect unsystematic interest rate responses to abrupt corrections in asset prices, a non-linear framework of analysis could be more helpful than a standard linear framework like the one used in this chapter.

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14

Prepared by Silvia Sgherri.

15

Over the 1990’s, New Zealand, Canada, the United Kingdom, Sweden, and Australia all changed the institutional framework under which monetary policy was conducted, by shifting to an inflation targeting regime. Norway and Iceland followed suit in 2001. The literature on the institutional aspects of inflation targeting in industrial countries is vast. For a recent review, see Bernanke and Woodford (2005) and references therein.

16

On recently introduced measures enhancing the transparency of Norway’s monetary framework and related discussion, see the staff report.

17

See, among others, Clarida, Galí, and Gertler (1999), Taylor (1993, 2000), and Woodford (2001).

18

See, for example, Taylor (1999) and references therein.

19

On this point, see Galí and Monacelli (2002).

20

Corsetti and Pesenti (2002) and Monacelli (2003) show that, with incomplete pass-through, optimal monetary policy is not purely inward looking.

21

See, for example, Clarida, Galí, and Gertler (1998) and Chadha, Sarno, and Valente (2004).

23

Christiano and Gust (2000) emphasize that a high inflation expectations trap may arise if policy accommodates inflation.

24

Sack and Wieland (2000) provide an in depth discussion of interest rate smoothing. On the issue of gradualism as optimal response to uncertainty, see Brainard (1967) as canonical reference on the theory side, Woodford (1999) for a recent application, and Walsh (2003) for an exhaustive review.

26

In the case of Norway, all pairwise correlations between the three output gap measures are statistically significant, ranging between 0.24 (between yHP and yARMC) and 0.58 (between yHP and yDGAP. For all countries, the adjusted real unit labor cost exhibits the least synchronized behavior.

27

For the United Kingdom, this holds true in five out of six specifications, while the estimate of λ becomes significant when the output gap is proxied by the HP filter and price changes are measured by core inflation. The same exception remains valid in Table II-2, when deviations from PPP are also allowed for.

28

The debate on the significance of monetary responses to changes in asset prices remains open. While some authors claim that including asset prices in the central bank’s policy rule may be optimal (Cecchetti and others, 2000; Bordo and Jeanne, 2002) and that central banks react significantly to stock market movements by changing the short-term interest rate (Rigobon and Sack, 2003), other studies argue that central banks should not respond directly to asset prices (Bernanke and Gertler, 2001). Allowing for nonlinearity in the monetary reaction function could help to shed some light on this empirical issue.

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Cover IMF Staff Country Reports
Norway: Selected Issues
Author:
International Monetary Fund
Volume/Issue:
Volume 2005: Issue 197
Publisher:
International Monetary Fund
ISBN:
9781451829778
ISSN:
1934-7685
Pages:
56
DOI:
https://doi.org/10.5089/9781451829778.002
Figure II-1:

Interest Rate, Core, and Headline Inflation
Figure II-2:

Output Gap Measures
Figure II-3:

Interest Rate: Actual versus Implied
Figure II-4:

Interest Rate Smoothing1
Figure II-5:

Long-term Response to the Real Exchange Rate1