They will again be put to the test when the terms-of-trade change is reversed and the gains either fully or partly dissipate. Monetary policy in Norway is oriented towards low and stable inflation. Low and stable inflation provides enterprises and households with an anchor for inflation expectations. Given that there is confidence in the nominal anchor, monetary policy shall also contribute to stable developments in the real economy. Norges Bank therefore operates a flexible inflation targeting regime. This means that weight is given both to variability in inflation and variability in output and employment in interest-rate setting. Monetary policy is facing particular challenges. Inflation has been considerably lower than the inflation target during the past three years. During the same three-year period, economic growth has been high, and higher than our estimate for long-term growth potential. The output gap has shifted from negative to positive. Unemployment is low and falling, and the increase in house prices, equity prices and credit has been high. Monetary policy has been and continues to be expansionary. Real interest rates have been low, and considerably lower than what is regarded as a neutral level. The expansionary monetary stance must be seen in the light of the fact that inflation has been very low and that there was idle capacity for a longer period. BIS Review 49/2006  1  The economy is periodically exposed to unexpected supply- and demand-side disturbances that affect both inflation and output.
They can also be seen through less direct linkages such as confidencerelated behaviors that are manifest in higher haircuts and margins or reluctance to do business with certain firms or types of firms, uncertainty about the true health of a firm, or the impact of fire sales on the valuation of a broad class of assets held by a broad range of investors. The fact that these costs are external to a given financial firm can lead to excess risk-taking. BIS central bankers’ speeches  3  The realization of these externalities during the financial crisis has had a profound impact on the Federal Reserve’s approach to supervision. Most specifically, they provided the practical experience to support the conceptual case for tightened prudential requirements for the largest, most systemically important institutions. This focus is seen in the mandate from the Dodd-Frank Act for the Federal Reserve to implement enhanced prudential standards, including higher capital standards, to mitigate the risks posed to financial stability by systemically important financial institutions. For example, both the Basel Committee for Banking Supervision and the Federal Reserve System have identified factors that contribute to a financial firm’s systemic importance through these types of externalities. These mechanisms are proxied for by observable metrics such as the size of the balance sheet, interconnectedness between firms, complexity of the business, cross-jurisdictional activity, short-term wholesale funding, and substitutability of certain activities.