The Transparent Effect of Foreign Interest Rates on Central Bank Decisions

Last June the central bank of Norway hosted a fascinating conference in Oslo on the use of monetary policy rules in small open economies. The Norges Bank is a remarkably transparent central bank. As with the Swedish Riksbank, it announces not only its most recent interest rate decision, but also the likely path for its interest rate decisions in the future. While some have criticized publishing future interest rate forecasts, the experiences in Norway and Sweden show that there are advantages of such increased transparency. For example, consider the debate at the Risksbank earlier this month about the path of interest rates in the next two years. The Riksbank minutes (which provide much more detail than FOMC minutes) reveal a substantive debate between some, such as Deputy Governor Lars Svensson, who preferred an interest rate path in which rates were held low for a long time and others who wanted to increase rates more rapidly.

As explained in the minutes, the debate was in part over forecasts of monetary policy rate decisions abroad: “Given statements made by the Federal Reserve and the ECB, …low policy-rate expectations must be regarded as very realistic. The differential between Swedish and foreign interest rates is currently moderate. If the repo-rate was to become credible and policy-rate expectations for Sweden were to shift up to the repo-rate path, the expected differential in relation to other countries would be considerable. This would trigger substantial capital flows and lead to a dramatic appreciation of the krona. Both higher market rates and a stronger krona would entail a drastic tightening of actual monetary policy.”

More light is shed on the effect of lower interest rates abroad on policy by the experience of the Norges Bank; the effects can be illustrated using charts from their Monetary Policy Reports. Consider the decision to lower the path of interest rates in Norway earlier this year. The lower path is shown by the red line in this picture:

The Norges Bank explained this change with their useful (and very transparent) “interest rate accounting” bar chart. Observe that a big reason for the rate cut was that foreign interest rates were expected to be lower.

Further evidence is shown in the Norges Bank efforts to use monetary policy rules in their decision-making. As shown in the third graph, their interest rate path is lower than a Taylor Rule without the foreign interest rate and about the same as a policy rule in which the foreign interest rate is added to a Taylor Rule. Whether such adjustments are good or bad was the subject of my keynote address at the conference, but whatever the answer, we should be grateful for their high level of transparency which helps us research the question.

About John B. Taylor 117 Articles

Affiliation: Stanford University

John B. Taylor is the Mary and Robert Raymond Professor of Economics at Stanford University and the Bowen H. and Janice Arthur McCoy Senior Fellow at the Hoover Institution. He formerly served as the director of the Stanford Institute for Economic Policy Research, where he is now a senior fellow, and he was founding director of Stanford's Introductory Economics Center.

Taylor’s academic fields of expertise are macroeconomics, monetary economics, and international economics. He is known for his research on the foundations of modern monetary theory and policy, which has been applied by central banks and financial market analysts around the world. He has an active interest in public policy. Taylor is currently a member of the California Governor's Council of Economic Advisors, where he also previously served from 1996 to 1998. In the past, he served as senior economist on the President's Council of Economic Advisers from 1976 to 1977, as a member of the President's Council of Economic Advisers from 1989 to 1991. He was also a member of the Congressional Budget Office's Panel of Economic Advisers from 1995 to 2001.

For four years from 2001 to 2005, Taylor served as Under Secretary of Treasury for International Affairs where he was responsible for U.S. policies in international finance, which includes currency markets, trade in financial services, foreign investment, international debt and development, and oversight of the International Monetary Fund and the World Bank. He was also responsible for coordinating financial policy with the G-7 countries, was chair of the working party on international macroeconomics at the OECD, and was a member of the Board of the Overseas Private Investment Corporation. His book Global Financial Warriors: The Untold Story of International Finance in the Post-9/11 World chronicles his years as head of the international division at Treasury.

Taylor was awarded the Alexander Hamilton Award for his overall leadership in international finance at the U.S. Treasury. He was also awarded the Treasury Distinguished Service Award for designing and implementing the currency reforms in Iraq, and the Medal of the Republic of Uruguay for his work in resolving the 2002 financial crisis. In 2005, he was awarded the George P. Shultz Distinguished Public Service Award. Taylor has also won many teaching awards; he was awarded the Hoagland Prize for excellence in undergraduate teaching and the Rhodes Prize for his high teaching ratings in Stanford's introductory economics course. He also received a Guggenheim Fellowship for his research, and he is a fellow of the American Academy of Arts and Sciences and the Econometric Society; he formerly served as vice president of the American Economic Association.

Before joining the Stanford faculty in 1984, Taylor held positions as professor of economics at Princeton University and Columbia University. Taylor received a B.A. in economics summa cum laude from Princeton University in 1968 and a Ph.D. in economics from Stanford University in 1973.

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