13-02-2023 12:09

Optimising inflation, employment or both?

Should a central bank single-mindedly focus on keeping the consumer price index (CPI) right on target at all times, or weigh in other key factors for the economy in its monetary policy choices? Find out more in this conversation between Nordea expert Johan Trocmé and Ole Christian Bech-Moen from Norges Bank.
Oslo Opera House

In the latest Nordea On Your Mind report, Johan Trocmé (JT) interviews Ole Christian Bech-Moen (OCBM), Director of Monetary Policy at Norges Bank. Bech-Moen explains the Norwegian flexible inflation-targeting policy, where the pace of driving inflation to target levels can be varied to give room for securing stable and high employment. In the long run, there is no conflict between these two policy objectives; on the contrary.

JT: We have had an extraordinary decade with ultra-low interest rates and loose monetary policy including quantitative easing by central banks. Do you think the sudden and sharp revival of inflation will require central banks to reconsider their current inflation targets? Is a "new normal" something other than a current typical 2%?

OCBM: Monetary policy target is set by political authorities, and we have a clear and sound mandate for monetary policy in Norway. Especially in periods of structural change and considerable uncertainty, it is even more important that monetary policy contributes to price stability and stability in the economy.

There is an international debate about what an inflation target should be. There is no consensus on what an optimal inflation target is. In general, there will be a cost to changing the inflation target, partly because it may affect the central banks' credibility and trust. This cost can be particularly high when inflation deviates a lot from the target.

JT: Is there such a thing as an ideal measure of inflation? Is it better for a central bank to have a target for a broad-based CPI, or an adjusted CPI? Should other metrics such as PPI or wage inflation be weighed in?

OCBM: The CPI seeks to measure the rise in prices facing households. The index is widely used and well known. Virtually all inflation-targeting countries have chosen to stabilise CPI inflation.

Monetary policy is forward-looking, and as the CPI is associated with considerable short-term volatility, indicators of underlying inflation are better predictors of the CPI than the CPI itself. In practice, we use different underlying inflation indicators; for example, the CPI adjusted for tax changes and excluding energy products (CPI-ATE).

Under a flexible inflation-targeting regime, as in Norway, the differences between stabilising CPI inflation and stabilising the rise in another price index are very small in practice.

There is no consensus on what an optimal inflation target is.

Ole Christian Bech-Moen, Director of Monetary Policy at Norges Bank.

JT: Norges Bank has a monetary policy mission to reach "annual consumer price inflation of close to 2% over time", but the policy also stipulates that "…inflationtargeting shall be forward-looking and flexible so that it can contribute to high and stable output and employment and to counteracting the buildup of financial imbalances". How would you describe Norges Bank's thinking and approach to balancing reaching the CPI target with maintaining stability and robust economic activity?

OCBM: In the long run, there is no conflict between low and stable inflation and high and stable employment – on the contrary. The best contribution monetary policy can make to high and stable employment over time is to keep inflation low and stable.

In the short run, however, a conflict may arise between how quickly one should seek to return inflation to target and the aim of high and stable employment. In the day-to-day conduct of monetary policy, Norges Bank’s Monetary Policy and Financial Stability Committee must therefore weigh these two considerations against each other.

The greater the weight the central bank puts on high and stable employment, the longer it will normally take to bring inflation back to the target after a deviation. In its deliberations, the Committee is concerned with balancing the risk of tightening too much against the risk of tightening too little. If it does not tighten monetary policy enough, there is a risk that inflation will be entrenched, and that it will be necessary to raise the policy rate even higher at a later stage to reduce inflation. On the other hand, the Committee wants to avoid a situation where the economy contracts more than what is necessary to bring down inflation. According to our latest forecast, published in December, inflation will fall and approach the target further out. If the Committee’s sole concern had been to rapidly return inflation to the target, it would have set the policy rate higher.

JT: Very generally, how is Norges Bank’s approach to monetary policy (or indeed the overall mandate for the central bank) different from those of the other Nordic central banks? Are there significant differences to the approach of the ECB or the Fed?

OCBM: There are some differences in how the mandates are formulated. We have an inflation target and are also mandated to help keep employment as high as possible and to counter the buildup of financial imbalances. Norges Bank practises flexible inflation-targeting, and the time horizon for seeking to bring inflation back to the target after a deviation is flexible, depending on the shocks to which the economy is exposed.

Comparing monetary policy in Norway with those of central banks such as the Fed, with a dual mandate there is hardly any basis for claiming that Norges Bank places less emphasis on high and stable employment than these central banks do.

Approaches may also differ among central banks according to differences in the transmission of monetary policy into the economy. For instance, in Norway households are highly indebted, which means that interest rate hikes have a large and direct effect. At the same time, almost all mortgages have adjustable-rate mortgages, which means that changes in the policy rate affect mortgage rates with only a few weeks' lag. This makes the policy rate an effective instrument.

JT: Inflation is markedly higher than the target and expectations have increased. How do you assess the risk of a wage-price spiral?

OCBM: We do not believe that there is an imminent danger of a wage-price spiral in Norway. We have a solid tradition whereby the social partners take into consideration firms’ profitability and employment developments in wage negotiations. There may therefore be a reduced need to tighten monetary policy in response to a cost shock than would otherwise have been the case. Last year, prices rose much faster than wages, but we do not assume that this will be compensated for in this year’s wage settlement.

At the same time, in today’s situation we must guard against a rise in inflation expectations with the risk of inflation being entrenched at a high level. That would make it more demanding to bring it down.

Nordea On Your Mind is the flagship publication of Nordea Investment Banking’s Thematics team, which produces research for large corporate and institutional clients. The research does not contain investment advice and typically covers topics of a strategic and long-term nature, which can affect corporate financial performance.

Top decision makers at Nordea’s large clients across the Nordic region receive Nordea On Your Mind around eight times per year. The publication’s themes vary widely, and many are selected from suggestions by clients. Examples of covered topics include artificial intelligence, wage inflation, M&A, e-commerce, income inequality, ESG, cybersecurity and corporate leverage.

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