A supply side perspective on the historical short term co-movement of output and prices in Norway : empirical evidence and implications for monetary policy

Abstract

This thesis explains how inflation targeting as an objective for monetary policy, to some extent, relies upon the inflation rate reflecting output cycles in the short-term. It also explains how this assumption does not hold in response to supply shocks, and can lead to pro-cyclical monetary policies and financial instability. In order to determine if this assumption holds in Norway, the historical co-movement between output and prices 1830-2017 is investigated. Looking at the contemporanous correlations between these two variables, they are always strongly negative or close to zero. In fact, post-WWII they are all strongly negative. In opposition to the underlying assumption of current monetary policy, the evidence suggests that the inflation rate has historically not reflected output cycles. Even worse, post-WWII output and prices have clearly tended to move in opposite directions. Although these results do not reveal causality, they might indicate that short-term movements and shocks from the supply side have been, and are more influential to output and price cycles than often assumed. This hypothesis is explored by looking at the co-movement between inflation and variables representing key supply side factors: capital (incl. natural resources), labour and productivity. In all sub-periods since 1900, productivity has a clearly negative relationship with inflation, helping to explain the lack of historical co-movement between output and inflation. Negative correlations between labour supply and inflation is also found pre-WWI and especially post-WWII. Lastly, the correlation between import prices and inflation is strongly positive across all sub-periods. Reflecting that import prices strongly influences inflation. However, the correlation between import prices and output shifts from positive to negative post-WWII. This may suggest that strong imported supply shocks have moved inflation oppositely of output. Therefore, the results might indicate that short-term movements on the supply side can provide important information to understand the lack of any significant co-movement, and even negative relationship, between output and inflation. These findings implies that inflation targeting can be fundamentally pro-cyclical and lead to financial instability. Thus, it is important that central banks considers output gaps and financial stability in monetary policy.