A stronger krone also dampens exports and reduces profitability in Norwegian business and industry. The effect on the exchange rate of a change in interest rates will vary as themes and sentiments shift in the foreign exchange market. The expectations channel: We believe that expectations play an important role when prices and wages are set. Expectations concerning future inflation and economic stability have considerable impact, not least in the foreign exchange market. Inflation expectations also influence wage demands and have an effect when companies adjust their prices. It is difficult to be precise about how expectations are formed. Confidence in the inflation target may provide an anchor. Past inflation rates may also influence what we think inflation will be in the future. There is thus an interaction between inflation expectations and inflation. If there is confidence in monetary policy, expected inflation in the medium term will be close to the inflation target. This contributes to stabilising inflation around the target. It is thus important for the central bank to ensure that households, companies, the social partners and financial market participants are confident that inflation will remain low and stable. Let me introduce the concepts of the “neutral rate” and the “long-term equilibrium rate”. Both should be seen as real rates, that is nominal interest rates adjusted for expected inflation. The neutral real interest rate is defined as the rate that does not in itself result in an increase or a reduction in price and cost inflation in the economy in the course of a business cycle.
The interest rate is also the price of money – the price we pay in order to have liquid holdings and the compensation we receive for storing our savings in less liquid forms. The interest rate is also used as an instrument in economic policy. Setting the interest rate to achieve a monetary policy objective, often price stability or low and stable inflation, is usually the responsibility of the central bank. This is also the case in Norway. Low and stable inflation provides the economy with a nominal anchor, and is the most important contribution monetary policy can make to sound economic developments in the long term. This contributes to increased predictability for those who take decisions about saving and investment today, although the result of those decisions also depends on how the economy develops in the future. In its conduct of monetary policy, Norges Bank operates a flexible inflation targeting regime, so that weight is given to both variability in inflation and variability in output and employment. Flexible inflation targeting builds a bridge between the long-term objective of monetary policy, which is to keep inflation on target and provide an anchor for inflation expectations, and the more short-term objective of stability in the real economy. Monetary policy influences the economy with long and variable lags. Norges Bank sets the interest rate with a view to stabilising inflation at the target within a reasonable time horizon, normally 1–3 years.