There are, however, some institutional responses that will take place if the Bank is not able to return the exchange rate back to its initial range, as defined by the mandate, without contributing to inflation or a deflationary recession. I will come back to this issue later in my speech. 1  BIS Review 101/2000  The base drift problem If the inflation rate in Norway deviates from the inflation rate in the euro countries, the nominal exchange rate will need to adjust over time. However, some of you may object that stabilising the Norwegian inflation rate at the level aimed at by the euro countries may not be sufficient to stabilise the nominal exchange rate. The reason is that inflation in both Norway and the euro countries will be subject to stochastic shocks. This means that even if the expected inflation rates in Norway and the euro countries were the same, the actual inflation rates would deviate. Technically speaking, the relative price levels will be subject to base drift, and so will the nominal exchange rate. Professor Larry Ball has discussed this in a paper on Norwegian monetary policy. Keeping the relative price level constant would require that we target the price level and not the inflation rate. However, in the 1920s Norway experienced that a policy aimed at achieving a specific level for the purchasing power of money led to substantial macroeconomic instability.
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?