15  Financial Services Authority (2009): “Strengthening Liquidity Standards”, Policy Statement 09/16, UK October. BIS Review 131/2009  15  House prices in Norway have risen sharply and probably excessively. We must take account of developments in equity prices and property prices when projecting inflation and output. Norges Bank’s interest rate setting does not rely solely on one simple rule. Instead, we seek to take account of all factors that influence inflation and output in the medium term, and the key policy rate is set on the basis of an overall assessment. Asset prices such as house prices, the exchange rate and credit growth therefore have a bearing on Norges Bank’s interest rate setting. A written formulation of Norges Bank’s monetary policy reaction function would be fairly comprehensive and include all the variables that are considered. However, a reaction function must not be confused with the monetary policy target – our target function. The fact that we give weight to variables such as the exchange rate, house prices and credit growth in interest rate setting does not imply that there are specific target for these variables. The operational target for monetary policy is annual consumer price inflation of close to 2.5 per cent over time. Interest rate setting in a small, open economy can be particularly challenging in periods of strong credit growth and a wide interest rate differential against other countries.
2  Rygg, Nicolai (1950): Norges Bank i mellomkrigstiden (Norges Bank in the interwar years), Gyldendal Norske Forlag, p. 98. 3  Sejersted, Francis (1973): Ideal, teori og virkelighet. Nicolai Rygg og pengepolitikken i 1920-årene (Ideal, theory and reality. Nicolai Rygg and monetary policy in the 1920s) Cappelen, p. 51. BIS Review 131/2009  1  2  BIS Review 131/2009  Today we can see that the crisis was amplified by the surprise at how closely financial markets are interconnected. 4 Losses on high-risk US subprime mortgages triggered general distrust in the financial system. Financial institutions began to doubt their counterparties. They did not know whether counterparties held sufficient capital to cover any losses. Even worse, they were uncertain whether counterparties’ counterparties would be strong enough to withstand losses. So they stopped lending to each other. In the interwar period, as described by Rygg, depositors were responsible for the flight of funding. This time, that role was taken by banks’ lenders. Confidence had evaporated. Many banks worldwide had to take losses. The liquidity crisis turned into a solvency crisis. Banks in Norway have also noted that borrowers have experienced problems servicing their loans. However the increase in non-performing loans has been modest compared with the banking crisis at the beginning of the 1990s. 4  See for example Caballero, Ricardo J. and Pablo Kurlat (2009): “The ‘Surprising’ Origin and Nature of Financial Crises: A Macroeconomic Policy Proposal”. Paper presented at the Federal Reserve Bank of Kansas’ Jackson Hole Symposium.