Projections, Uncertainty and Choice of Interest Rate Assumption in Monetary Policy

Abstract

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.