An increase in the policy rate normally leads to a stronger krone. This pushes down imported goods inflation. The krone exchange rate fluctuates, and the relationship between interest rates and the exchange rate is uncertain. Nevertheless, the exchange rate channel is an important channel for the transmission of monetary policy in a small open economy like Norway. The current high level of inflation is, as you know, not unique to Norway. Policy rates are on the rise in many countries. Had we raised the policy rate substantially less than other central banks, this could have led to a weaker krone and higher imported inflation. Chart: Should the central bank stabilise domestic or total inflation? A question that has been raised is whether the central bank should have disregarded imported inflation when setting its policy rate. [5] It could be argued that domestic inflation covaries more closely with the level of economic activity. [6] If this were the case, and the central bank stabilised domestic inflation, it would also stabilise output and employment. This chart shows underlying inflation, or total CPI-ATE inflation, and the rise in prices for domestically produced goods and services. The output gap is an indicator of the activity level. As shown in the chart, the difference in covariance with activity between the two indices is not very large.
That is why in its monetary policy strategy, the Committee has interpreted “high employment” to mean the highest level of employment consistent with price stability over time. This level may vary over time and is primarily determined by structural conditions, such as labour force composition, the tax and social security system and wage formation. If we had attempted to use monetary policy to keep employment over that level permanently, inflation could have accelerated rapidly. An even higher policy rate may then have been required at a later stage, which may in turn have increased the risk of an economic downturn. In the Norwegian wage formation model, the social partners put weight on employment and firms’ profitability in wage negotiations, which is also an assumption underlying our economic projections. Over time, the system of coordinated wage determination has likely contributed to greater real wage flexibility and to keeping unemployment low by international standards. Experience nevertheless shows that there is a clear tendency for wage growth to increase when the labour market is tight and competition for labour intensifies. Similarly, wage growth tends to edge lower when the unemployment-to-vacancy ratio is high. Monetary policy trade-offs in the event of a cost shock Let me now turn to how we are seeking, in the current high-inflation environment, to strike a balance between the aim of low and stable inflation and the aim of high and stable employment. Over the past year, the policy rate has been raised from a very low level.