MNI INTERVIEW: Norges Bank Needs Scenarios For Krone Weakness

Norges Bank should publish economic scenarios illustrating how alternative assumptions can affect its main policy projections, one of the authors of an annual report into monetary policy commissioned by the Norwegian central bank told MNI, pointing in particular to repeated failures to anticipate a weaker currency and the associated uplift in inflation.

While Norges Bank should continue to produce its quarterly economic forecasts on the assumption that the krone will oscillate around a constant level on the I-44 import-weighted index, it would be useful to provide accompanying alternative scenarios, said Leif Anders Thorsrud, a Professor at the BI Norwegian Business School, who worked on Norges Bank Watch 2024.

They should not “necessarily depart from a random walk forecast for the exchange rate. I think that would go against a lot of academic literature," Thorsrud said in an interview.

“You could easily just say, Okay, let's assume that the exchange rate gets much weaker than what we expect. How much inflation kick can we get from that?" he said, adding that that risk would be spelled out in a scenario.

BERNANKE REPORT

Former Federal Reserve chair Ben Bernanke recently recommended that the Bank of England move towards scenario forecasting, and the Riksbank in neighbouring Sweden sets out detailed alternative scenarios. Analysis from Norges Bank and Governor Ida Wolden Bache has already highlighted inflationary risk from currency weakness, though June's Monetary Policy Report may be too early for a switch in approach. (See MNI INTERVIEW:Tough For BOE To Agree Scenarios-NIESR's Millard)

Thorsrud’s research suggests that the green transition may be a structural factor weighing on the currency of oil-rich Norway, and one which will persist far longer than Norges Bank’s three-year forecast horizon.

“That steady state is changing, or it will be a persistent change, and then it doesn't really matter what your forecasting horizon is, because you're forecasting around the wrong steady state,” Thorsrud said. (See MNI INTERVIEW: Commodity Currencies Hit By Climate Risk)

While academic literature has tended to show currency forecasters struggle to consistently beat the so-called “random walk” of exchange rates, the Norges Bank Watch authors found that they could better predict last year’s depreciation by factoring in weaker long-term demand for oil.

“What we basically found then was that it wasn't impossible to predict that the exchange rate would depreciate as much as it did,” Thorsrud said, though he cautioned that it was possible their model did well as a result of luck.

RESILIENT GROWTH

Another focus of the Norges Bank Watch was the surprising resilience of growth in the post-pandemic economy, and Thorsrud noted that Norges Bank’s models had been better predictors in this regard than the Bank’s policymakers.

“Most economists in Norway … and probably the Bank as well, have been quite surprised how well the real economy has been performing despite, everything that's been happening,” Thorsrud said. “I think the Bank was much more afraid of downside risk on growth than what their formal models told us sometimes to be … I think there was a disconnect there. But in this, in this, this particular time period, I guess maybe the models were maybe more right.”

A mix of strong fiscal support from the Norwegian state, high levels of public sector employment and the spending of involuntary Covid savings all combined to prevent growth from cratering despite high nominal interest rates, he said.

“The real interest rate … hasn't been really high ... So so that's most important to keep in mind when you think about the (fact that) the real economy doesn't really seem to have tanked," Thorsrud said.