The specific interest rate path cannot and must not be looked upon as a guarantee and a path to which we unconditionally have committed ourselves. Should economic developments deviate from the projected path, the interest rate path will also shift. Instead, it can be said that through our communication we commit ourselves to a pattern of behaviour, a response pattern. If interest rate expectations can be influenced, it will in many cases be useful for a central bank to commit itself to a predictable response pattern. This kind of commitment can, if it is perceived as credible, have a positive effect on the  2  BIS Review 10/2007  economy’s functioning and enhance the effectiveness of monetary policy. I will revert to this theme shortly. A relevant question is the extent to which our communication actually influences interest rate expectations. Forward interest rates derived from yields at various maturities will in the absence of term premia and other risk premia normally reflect the market’s short-term interest rate expectations.1 When Inflation Report 3/06 was published in the beginning of November last year, the forward interest rate was on a par with our forecast for the next six months, but considerably lower thereafter. It is now almost three months since the previous Inflation Report was published. Since that time forward rates have increased and approached Norges Bank’s interest rate path. Forward rates somewhat further out are still lower than our forecast.
BIS Review 10/2007  3  Long-term bond yields have been at historically low levels in recent years. From lying in a broad range around 10 per cent at the end of the 1980s, they have fallen to around 4 per cent in the past few years. Developments in nominal interest rates must be seen in the light of inflation developments. High and variable inflation pushed up nominal interest rates earlier, both directly and via an inflation risk premium. Future inflation uncertainty generates uncertainty as to the real value of investments and investors may require an extra compensation – a risk premium – for this. Low and stable inflation over the past 10-15 years has probably led to a decline in the normal interest rate level. Nevertheless, it would appear that long-term interest rates have been lower in recent years than one would believe to be a sustainable level, at least in the very long run. 4  BIS Review 10/2007  According to economic theory, in the long term the real interest rate is determined by structural fundamentals such as productivity and population growth and households’ long-term saving preferences.2 It seems reasonable that there is a long-term relationship between an economy’s potential growth and the real interest rate. If potential growth is higher than the real interest rate, the return on fixed investment will be higher than the cost of investing. This provides an incentive to increase fixed investment. Higher demand for fixed investment normally leads to higher real interest rates.