The Exchange Rate Regulation of 6 May 1994 states that monetary policy in Norway should be aimed at maintaining a stable exchange rate in relation to European currencies over time. Norges Bank has defined “European currencies” as the euro. What we mean by a “stable exchange rate…. over time” needs to be made more precise. The krone exchange rate has fluctuated in recent years, in spite of Norges Bank’s active use of instruments, indicating that Norges Bank cannot fine-tune movements in the krone exchange rate. Thus, in its use of the interest rate Norges Bank focuses on the fundamental preconditions for stability of the krone exchange rate over time. Empirical work on the Norwegian economy suggests that there is mean reversion in the real exchange rate. This implies that higher inflation in Norway than among its trading partners tends to be followed by a nominal exchange rate depreciation. Thus, in order to stabilise the nominal exchange rate against the euro, monetary policy instruments must be oriented towards bringing inflation down to the level aimed at by the Eurosystem. However, we cannot exclude the possibility that a shock that leads to a change in the equilibrium real exchange rate occurs. Examples of such shocks are a large permanent shock to the oil price or a permanent increase in the government expenditure. If such shocks occur, Norges Bank must prevent monetary policy from contributing to higher inflation or a deflationary recession, since that would undermine the confidence in the krone.
Aiming at a price level target may in some situations require a monetary policy that leads to a deflationary recession, which may be hard to turn due to the zero limit on nominal interest rates. In other situations it may require inflating the economy. A monetary policy leading to inflation or a deflationary recession will undermine confidence in the krone, thereby generating exchange rate instability. We also note that the present exchange rate range has more or less prevailed for more than 10 years, indicating that base drift may not represent a substantial problem in practical policymaking. How does Norges Bank operate? Forecasts of inflation and general macroeconomic development play a large role in the conduct of Norwegian monetary policy. Projections are presented in the Bank’s quarterly Inflation Reports. If the inflation forecast does not approach the level aimed at by the euro countries in 2 to 3 years for a given interest rate path, Norges Bank will consider adjusting the interest rate. In this narrow sense, one could say that the conduct of monetary policy in Norway has some similarities with “inflation forecast targeting”, in Lars Svensson’s terminology. In addition to economic forecasts, we aim to develop tools that can supplement the use of our large macroeconometric model. At the moment we are working on the construction of simple calibrated models that will be presented at this workshop. The calibrated models can be employed, for instance, to test the performance of simple indicator rules. How does the Norwegian system differ from inflation targeting?