Do foreign interest rates matter in home central bank decisions?

Though John Taylor’s some ideas may not be acceptable to a few (including me), his blog is just wonderful. He comes with really interesting posts and articles.

In his recent post he looks at whether the impact of  foreign interest rates matter in central bank decisions. The focus is on this crisis but it could be applied generally as well. He points to examples of Norway and Sweden where foreign interest rates  matter greatly:

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.”

Now this is well-known that Norway,Sweden and New Zealand central banks publish forecasts of their policy rate. What I didn’t know is Norway also publishes something called “interest rate accounting”. This shows what factors will lead to movement of policy rate ! So the chart talks about following factors- demand, productivity, foreign interest rates etc. Fascinating stuff. Transparency at its best.


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