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Projections, uncertainty and choice of interest rate assumption in monetary policy.

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Introduction

Norges Banks' views on future interest rate developments have often attracted considerable attention. For a long period, our analyses were based on the assumption that the interest rate would move in line with market expectations, and the discussion was usually about whether the bank agreed with this interest rate outlook or had a different interest rate path in mind. In Inflation Report 3/05, projections were based on the Bank's own projected path for future interest rates for the first time. In other words, from using technical assumptions and others' assessments of our future interest rate setting, we have now in a sense "assumed ownership" of the interest rate path in our projections. This article provides an account of the background for this decision and the assessments underlying our forecasting.

When we make forecasts for variables such as output and inflation, we must at the same time have formed an opinion of the future interest rate path. Interest rate developments, in turn, must be considered in the context of other forecasts.

The choice of interest rate path in forecasting is important because monetary policy influences developments in the economy primarily through expectations. This is discussed in more detail in the following section. First I will focus on the role of the interest rate in Norges Bank's projections. I will then move on to describe the analytical tools used by the Bank to arrive at a projection for future interest rates. Finally, I will discuss the uncertainty inherent in the projections.

Choice of interest rate assumption in forecasting

Norges Bank seeks to achieve an interest rate path that provides a reasonable balance between the objective of stabilising inflation at target and the objective of stabilising developments in output and employment. This means we have to judge how these variables will develop in the period ahead and how they are affected by the interest rate. Hence, in order to make forecasts for inflation and output, we must also judge how interest rates will develop in the future.

The interest rate can be approached in various ways in forecasting. There might be arguments in favour of basing the interest rate assumption on external factors, as an exogenous assumption, either by assuming that the interest rate will remain constant through the projection period or that it will develop in line with market expectations. The projections that result from such technical interest rate assumptions do not necessarily provide a reasonable balance between the different objectives of monetary policy. In some cases, both the interest rate assumption and the projections may seem unreasonable. This may raise the question of the purpose of forecasting. However, it provides a starting-point for discussions about how the interest rate path might be adjusted to produce more acceptable results.

Alternatively, the interest rate can be treated in the same way as other variables forecast by the Bank. We would then have to try to make projections for inflation, output and the interest rate simultaneously, with the aim of arriving at an interest rate path that provides a reasonable balance between the different objectives of monetary policy. If the central bank has the intention of adhering to this interest rate path, this might be regarded as an interest rate forecast rather than a technical assumption.

Establishing such an interest rate path is not a straight-forward matter. Flexible inflation targeting, which is the system we use, means that the deviation from the inflation target and the output gap are both taken into account. There is considerable uncertainty surrounding the calculation of the output gap, and there is no simple relationship between developments in the output gap and developments in inflation. It cannot therefore be claimed with any great certainty that it is possible to identify one particular interest rate forecast that provides the indisputably "best" trade-off in monetary policy. More often than not, there will be a number of possible interest rate paths that might be said to provide a reasonable balance, in view of the uncertainty involved.

Norges Bank's treatment of the interest rate in forecasting has changed over time. In 1999 and 2000, forecasting was based on the assumption that the interest rate would develop in line with market expectations as indicated by forward interest rates. In 2001 and 2002, the Bank based its forecasting on the assumption that the interest rate would remain constant to the end of the projection period. The constant level of the interest rate was calculated on the basis of historical averages, although the historical period on which the calculations were based could vary from one period to the next. On some occasions, the interest rate assumption reflected the average for the interest rate over the previous three months, on other occasions, the average for the previous month. From mid-2003, the interest rate assumption was again linked to market expectations, and in autumn...

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