In these past 15 years, the Norwegian economy has been exposed to different types of shocks. The supply side has been influenced by increased labour immigration following EU enlargement in 2004. The legacies from the financial crisis have posed challenges that monetary policy has had to address. And not least, the Norwegian economy has had to contend with wide fluctuations in the terms of trade. Chart: Performance Inflation targeting has performed well over the past 15 years taken as a whole. When inflation targeting was introduced, inflation had already come down after years at an elevated level and has since been low and relatively stable. At the same time, monetary policy has helped to moderate fluctuations in the real economy. Flexible inflation targeting has functioned well. The monetary policy framework has provided sufficient flexibility to address the shocks that have hit the economy. LONG-TERM INTEREST RATES HAVE FALLEN Chart: International interest rates In recent years, monetary policy has faced a new challenge in many countries. The interest rate level that is consistent with balanced developments in the economy has fallen. This is reflected in the low level of global interest rates. The decline in real interest rates has been particularly marked over the past 15–20 years. In 2001, when inflation targeting in Norway was adopted, real long-term interest rates were around 3 percent. Now, the same interest rates are around zero. Chart: Forces driving the fall in the global real interest rate The causes of the decline in interest rates are complex.
It may also be difficult to predict financial market reactions to very low and negative real interest rates. As early as 1967, US economist William Brainard discussed how central banks should respond to economic shocks when there is uncertainty about the impact of the policy rate on the economy. He concluded that the policy rate should be used with greater caution when uncertainty about its effect increases (Brainard (1967)). This involves a trade-off that can be illustrated graphically. Chart: Monetary policy and uncertainty This chart describes a situation where the policy rate is used to counteract the effect of a negative shock to the real economy. Two different interest rate paths are shown. The uncertainty is illustrated using bands around the expected paths for the policy rate, inflation and the output gap. In the scenario denoted by the blue line, the central bank does not take the uncertainty associated with the interest rate into consideration. In contrast, the yellow line represents a scenario based on a more cautious monetary policy response to the perceived uncertainty involved. The expected real economic costs of a more cautious response – as measured by the output gap – are somewhat higher, and inflation moves further from the target. In that respect, this is a less appropriate path for the policy rate. But there is also a benefit: uncertainty about the future path is substantially reduced. As you can see in the chart, the uncertainty bands around inflation and output have narrowed.