When Does an Interest Rate Path “Look Good”? Criteria for an Appropriate Future Interest Rate Path – a Practician’s Approach

Abstract

When professor Lars E. O. Svensson (Princeton University) visited Norges Bank’s conference on monetary policy in 2004, he suggested we should “find an instrument-rate path such that projections of inflation and output gap ‘look good’.” We took on the challenge of how to translate the theoretical framework into some concrete criteria when evaluating interest rate paths in practice. The criteria should be viewed as necessary conditions for regarding the interest rate path as one that provides a reasonable balance between developments in inflation and the real economy. In other words, this paper discusses the grounds for the criteria we use when evaluating whether an interest rate path “looks good”. We have drawn up six criteria for an appropriate interest rate path. The criteria are also presented in a box in Norges Banks "Inflation Report" 1/2005. Even though it has proved difficult to satisfy all the criteria at the same time, I think they can function as a normative guideline for an interest rate path that provides a reasonable balance between the objective of stabilising inflation and the objective of stabilising output. This memo explains the grounds for the criteria. Although the criteria have already been presented in the March 2005 "Inflation Report", they can to some extent be considered as work in progress. The criteria will probably evolve over time, as new insights and new considerations emerge about how monetary policy should be conducted.