Introduction^[1]

Good afternoon. Let me start by thanking the Peterson Institute for the invitation and for giving me the opportunity to address this distinguished audience. It’s a pleasure to be here.

[Chart: The tightening was synchronised across countries]

The tightening of monetary policy by central banks over the past few years has been unprecedented in several respects. By some measuresthis has been the most globally synchronised of all tightening episodes in the past half century. [2]

In Norwayas in many other countriesglobal supply chain disruptions contributed to a rise in prices for a broad range of goods during the pandemic. When pandemic restrictions were liftedeconomic activity quickly rebounded. The high level of household saving gave an additional impetus to demand. When Russia invaded Ukraine in February 2022energy and commodity prices soared. Since Norway is a major exporter of oil and gasthose price increases constituted a positive terms-of-trade shockand they generated large inflows into the Norwegian government’s sovereign wealth fundthe Government Pension Fund Global. But at the same timethe increases in energy prices contributed to pushing up domestic business costs and spilled over into consumer prices.

[Chart: Policy rate at 4.5% to end of yearaccording to forecast]

Norges Bank started a gradual normalisation of interest rates in September 2021and our key policy rate now stands at 4.5 percent. The policy rate forecast in our latest Monetary Policy Report in September implies that the policy rate will remain at 4.5 percent to the end of this yearbefore being gradually reduced from first quarter 2025.

The trade-offs we face as policymakers when setting interest rates depend not only on the shocks that occurbut also on the relative strength of the different transmission channels of monetary policy. The transmission channels can vary both across countries and over time depending onamong other thingsinstitutional features of labor and housing markets as well as the balance sheets of households.[3]

My remarks today will focus on one particular aspect of the monetary policy transmission mechanism in Norwaynamely the strong direct effect of monetary policy on household spending operating through net interest expenses.[4]  As I will return tothe strong cash-flow channel combined with an unexpectedly large currency depreciation has created some particular trade-offs for monetary policy over the past few years.

A strong cash-flow channel

[Chart: Large differences in pass-through of monetary policy to disposable income]

The cash-flow channel is likely to be stronger when households are more indebted and when interest rates on outstanding debt are tightly linked to short-term rates. Along both of these dimensionsthere is a lot of variation across countries.[5]

Norway has over many years benefitted from revenues from our petroleum sector. With more than 1.7 trillion dollars invested abroad through its sovereign wealth fundthe Norwegian government is a large net lender. But Norwegian households are among the most indebted in the worldwith an average debt-to-income ratio of close to 250 percent. Since the interest rate on 95 percent of home loans moves in tandem with short-term money market ratesthere is a fast and strong pass-through of policy rate hikes to household disposable income.[6]

In the USwhere fixed-rate mortgages account for more than 90 percent of home loansmost of them with an initial 30-year fixation periodand the average household is less indebted than in Norwaythe pass-through of higher policy rates to borrowing costs can be expected to be much smaller in the short run. In factwhile the policy rate has increased by more in the US than in Norway during the current tightening cycleinterest payments as a fraction of income has increased by much more in Norway.

[Chart: More indebted households respond more strongly to interest rate changes]

To gain more insight into the cash-flow channelwe have recently assembled a new and unique dataset that combines rich information on household balance sheets and income from tax returns with directly measured consumption expenditures from individual electronic transactions for all residents of Norway. Using this datasetmy colleagues have estimated how much the responsiveness of consumption to interest rates varies with household indebtedness.[7] In the chart you can see the change in consumption following a one percentage point unexpected increase in the policy rate and how that varies with a household’s gross debt-to-income ratio. As we can seethe consumption response to a policy tightening increases with indebtedness.[8] These effects set in a couple of months after the interest rate hike and increase over the course of the first year. If we compare a household with a debt-to-income ratio of three to a household with no debtthe indebted household will cut spending by around 1.5 percentage points more after one year.[9]

[Chart: Households around the world have become more indebted]

We can use these results to understand how the monetary policy transmission mechanism has changed over time. Households’ debt-to-income ratios have increased markedly in many countries over the past quarter century.[10] In Norwayhousehold debt increased from around 120 percent of disposable income in 1995 to almost 250 percent in 2021. A back-of-the-envelope calculation based on our microdata estimates suggests thatdue to this increased indebtedness aloneaggregate consumption will fall by around 50 basis points more in reaction to a one percentage point contractionary monetary policy shock now than in the 1990s.[11] That amounts to as much as a two-thirds increase in the interest rate effect on household spending.[12]

Trade-offs in monetary policy

Now let me explain how a strong cash-flow channel can give rise to a particular monetary policy trade-off in a small open economy that is hit by a cost-push shock or an exchange rate shock that increases inflation. According to the textbook theorythe central bank should respond to either shock by increasing the interest rate to bring inflation gradually back to target. A higher interest rate dampens aggregate demand directlybut also contributes to appreciating the currency. If the aggregate demand channel is strong compared with the exchange rate channelfor instance because cash-flow effects on consumption are importanta larger reduction in output – and a larger increase in unemployment – are needed to achieve a given disinflation. That is because more of the disinflation will come through lower output and employment and less through lower imported inflation. Hencewhen the aggregate demand channel is strongthe so-called sacrifice ratio of stabilising inflation is high – lowering inflation sufficiently comes at the cost of a larger increase in unemployment.[13] In smallopen economies where the effects of monetary policy on aggregate demand are weakerthe central bank gets more help from the exchange rate in bringing inflation downand inflation can be stabilised at lower employment costs.

A weaker krone exchange rate

[Chart: The Norwegian krone has depreciated]

Against this backdroplet me share some perspectives on the krone exchange rate. Over the past three yearsthe Norwegian krone has depreciated by 10 percent against an import-weighted basket of currencies. Against the dollarthe value of the krone is 23 percent lower than it was three years ago.[14]

The newspaper The Economist has referred to the weakening of the krone since the pandemic as “a mystery”.[15]  While it is challenging to explain all movements in exchange rateswe believe we do know something about the factors that have affected the value of the krone over time.

Firstover the longer termrealstructural factors matter. For exampleresearch suggests that the build-up of the Norwegian petroleum sector drove a stronger real exchange rate from the beginning of the 1970s up until the beginning of the 2000sand that the subsequent decline in the importance of the petroleum sector has pulled in the direction of a gradual exchange rate depreciation.[16]

Secondin recent years the pandemicwar and high inflation have led to heightened geopolitical and economic uncertaintyand market volatility has increased. This may have led to a flight by investors away from less liquid and more volatile currencies. Rebalancing of Norwegian asset managers’ hedging positions in response to declines in international asset prices may also have contributed to the weakening of the krone.[17]

[Chart: Trading partners’ policy rates increased faster in 2022 and 2023]

Thirdexchange rates react to monetary policy decisions. We have seen over time that a tightening of monetary policy that is unexpected by the market normally leads to an immediate krone appreciation.[18] And what central banks in other countries do is also important. Through the spring of 2023the interest rate differential against Norway’s main trading partners felland more than the market had expected. The differential gradually turned negative. The decline in the interest rate differential coincided with the krone depreciation.

[Chart: Inflation has fallen more slowly in Norway]

The depreciation of our currency in the last few years has slowed the disinflation process. While CPI inflation rose less in Norway than among our main trading partners throughout 2022inflation has since fallen at a slower pace in Norway. A weaker currency directly pushes up imported inflation.[19] It also raises inflation for domestically produced goods and services through the effect of the exchange rate on the prices of imported intermediate inputs and on wage growth. In Norway we have a system of coordinated wage determination in which the profitability of the manufacturing sectorwhich has a high export sharehas a strong bearing on wage settlements in the rest of the economy. We believe that this system of wage determination in general contributes to counteracting wage-price spirals. Howevera weaker krone exchange rate normally results in higher export sector profitability. This could lead to higher wage growthwhich in turn may result in higher inflation.

Conclusion

Let me conclude. The cash-flow channel from interest rates to households’ disposable incomes is strong in Norway relative to many other countries. Combined with the depreciation of the krone exchange ratethis has created some particular trade-offs for monetary policy in Norway over the past few years. These trade-offs have had a bearing on interest rate setting and the speed at which we aim to bring inflation back to target.

[Chart: Inflation will slow and unemployment edge up]

At the time of our latest monetary policy meetingour assessment was that the policy rate needed to be kept at today’s level for a period ahead. At the same timewe are approaching the time to lower the interest rate. With the September policy rate pathinflation is projected to move down further and approach 2 percent towards the end of 2027. Unemployment will likely edge upto about the level prevailing before the pandemic.

Looking further aheadthe job of ensuring price stability may become more demanding. The consequences of climate change are becoming increasingly visibleand a global transition to a low-carbon economy is imperative. Geopolitical tensions and the desire to safeguard national supply lines are affecting trade and cross-border cooperation. At the same timetechnological innovations and artificial intelligence may lead to upheavals in the labour market.

These developments will pose a challenge to all aspects of economic policyincluding monetary policy. Large changes in relative prices may be necessary. With a flexible inflation targeting regimewe can look through temporary changes in inflation. Stillthe most important contribution monetary policy can make to support necessary structural change and high employment is to ensure low and stable inflation.

Thank you.

Sources

AhnSeHyounSigurd Galaasenand Mathis Mæhlum (2024) “The Cash-Flow Channel of Monetary Policy - Evidence from Billions of Transactions”. Forthcoming Working Paper.

AlstadheimR.K. B. NordalO. SyrstadS. T. Ellenand M. W. Wassas (2021) “Bond market fire sales and turbulence in the Norwegian FX market in March 2020”. Staff Memo 2/2021. Norges Bank.

BacheIda Wolden (2023) Speech at the Centre for Monetary Economics (CME)BI Norwegian Business School: Monetary Policy and the krone exchange rate. Norges Bank9 November.

BallLaurence (1994) “What determines the sacrifice ratio?” The University of Chicago Pressvolume: Monetary policyJanuary, pages 155–193.

BjørnlandHildeLeif BrubakkNicolò Maffei-Faccioliand Ørjan Robstad (2024) “Piecing the puzzle: Real exchange rates and long-run fundamentals”. Forthcoming Working Paper.

CeruttiEugenioJihad Dagherand Giovanni Dell'Ariccia (2017) ”Housing finance and real-estate booms: A cross-country perspective”. Journal of Housing Economics38Decemberpages 1–13.

CloyneJamesClodomiro Ferreiraand Paolo Surico (2020) “Monetary policy when households have debt: new evidence on the transmission mechanism.” Review of Economic Studies87 (1)Januarypages 102–129.

FlodénMartinMatilda KilströmJósef Sigurdssonand Roine Vestman (2020) “Household Debt and Monetary Policy: Revealing the Cash-Flow Channel”. Economic Journal, 131 (636)Maypages 1742–1771.

ForbesKristinJongrim Haand M. Ayhan Kose (2024) “Rate cycles”. The World Bank Development Economics ProspectsWorking Paper.

Carriere-SwallowYanM. FirstD. Furceriand D. Jimenez (2023) ”State-Dependent Exchange Rate Pass-Through2. International Monetary Fund Working Paper No. 2023/086.

International Monetary Fund (2024) World Economic Outlook – Steady but Slow: Resilience amid Divergence. IMFApril 16.

RanaldoA. and P. Söderlind (2010) “Safe haven currencies”. Review of Finance14 (2)pp 385-407.

RomerDavid (1993) “Openness and inflation: theory and evidence”. The quarterly journal of economics108 (4)Novemberpages 869–903.

Footnotes

[1] These remarks are based on Governor Ida Wolden Bache’s remarks at the Jackson Hole Economic Policy Symposium 2023 and on Norges Bank’s Monetary Policy Report 3/2024.

[2] ForbesHa and Kose (2024).

[3] IMF (2024).

[4] Flodén et al. (2021) and International Monetary Fund (2024) use similar definitions of the cash-flow channel.

[5] Debt net of deposits more accurately captures how much a given change in policy rates affect disposable incomeat least when both lending rates and deposit rates closely follow short-term rates. Chart 3 shows gross debt due to a lack of extensive cross-country data on deposits.

[6] This does not take into account cross-country variation in the tax system and the particular structure of adjustable-rate and fixed-rate mortgage contractsboth of which can affect pass-through. Firstlong-term mortgages (e.g. 30 years) are more common than shorter-term (e.g. 2-5 years) in some countries than in others. Secondin some countrieshouseholds are allowed to deduct mortgage interest payments from taxable income. How much this deduction amounts to varies substantially across countries (CeruttiDagher and Dell’Ariccia2017). A high tax deduction reduces pass-through of the policy rate to disposable income.  Thirdunder the terms of annuity loans – such as the ones common in Norway – principal payments are automatically reduced in the short run when the lending rate increases. This might also lower the pass-through to consumption.

[7] See AhnGalaasen and Mæhlum (2024). Confidence intervals as well as estimates for other horizons are included in the paper. CloyneFerreira and Surico (2020) and Flodén et al. (2020) also estimate how the effect of monetary policy varies along this dimension.

[8] AhnGalaasen and Mæhlum (2024) also provide estimates of the consumption response along the dimension of (debt-deposits)/income.

[9] The estimated marginal propensity to consume out of interest expenses is around 30 percentwhich is within the range of MPC estimates out of other types of income shocks.

[10] In the dataset of advanced and emerging economies shown in Chart 5the median country – when ordering countries by the percentage increase in household debt-to-income over the period – doubled its household sector debt-to-disposable-income ratio between 1995 and 2021.

[11] This number is derived from the equation (% change in consumption due to cash-flow effect) = MPC x (change in lending rate) x (debt/income)/(consumption/income). We assume an MPC of 30% out of interest payments (AhnGalaasen and Mæhlum2024)close to full pass-through of policy rates to lending ratesan average consumption/income ratio of 0.7 and an increase in debt/income of 120 percentage points. This assumes that other parts of the transmission mechanismas well as the MPCstay the same.

[12] Estimates based on Norwegian data from the mid-1990s until the early 2020s or late 2010s indicate that the consumption response to a one percentage point monetary policy shock peaks at around one percent after 1-2 years (see Norges Bank’s Monetary Policy Report 2/2022p. 40and 4/2023p. 52). Assuming that the increase in debt-to-income has increased this response by 0.5 percentage points over the same sample periodthe total response of consumption would have been around 0.75 percent in 1995.

[13] See Romer (1993) and Ball (1994).

[14] The numbers refer to the krone depreciation between September 2021 and September 2024 for the krone against the I-44 index and against the US dollar.

[15] “Norway’s weak currency presents a mystery.” The Economist14 September2024.

[16] Bjørnland et al. (2024).

[17] Alstadheim et al. (2021) find that rebalancing of hedging positions contributed to the suddenlarge weakening of the krone in March 2020. Research on the later time period is work-in-progress.

[18] See the evidence cited in BacheIda Wolden (2023).

[19] The estimated pass-through of exchange rate shocks to inflation is slightly higher in Norway than for an average of other advanced economies. See “A weaker krone exchange rate pushes up inflation – but by how much?” in Norges Bank’s Monetary Policy Report 3/24 and Carriere-Swallow et al. (2023).