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Norwegian Krone Exchange Rates Show Limits of Monetary Policy

By Frances Coppola

The economists’ “trilemma” says that it is not possible for a country to have free movement of capital, a fixed exchange rate, and an independent monetary policy all at the same time. In the 1990s, many central banks that had been struggling to control inflation under fixed exchange rate regimes allowed exchange rates to float. According to theory, moving to floating foreign currency exchange rates should restore monetary policy independence, giving central banks full control of inflation. But new research focused on Norway suggests that the krone’s floating currency exchange rate may not always guarantee monetary policy independence. 1

Norway is a small European country outside the European Union (EU). Although most of its trade is with other European countries, Norway is a long-standing trading partner and strategic ally of the United States. In 2016, 6.5 percent of Norway’s total imports came from the U.S., and 4.5 percent of its total exports went to the U.S. Hydrocarbons dominate Norway’s exports: in 2016, crude oil exports made up 21 percent of its total exports, and natural gas a further 19 percent.2Norway has significant influence on global energy markets and extensive bilateral ties with the U.S. energy sector.3


The new research finds that because the Norwegian krone’s foreign currency exchange rate (not to be confused with the Danish krone) tends to appreciate more than theory predicts, the principal channel through which monetary policy operates when exchange rates are floating may not work reliably in Norway.4


How Monetary Policy Works When Foreign Currency Exchange Rates Float


When exchange rates are floating, central bank monetary policy works through what is known as the “bank lending” channel. Central banks aim to influence the amount of lending in the economy by adjusting the funding costs of banks. When the central bank raises the interest rate at which it will lend to banks (in the U.S., this is known as the Federal Funds Rate), other lenders follow suit, thus raising the general cost of funding for the banking sector.


In Norway, the approach is slightly different, but the effect is the same. Norway’s central bank adjusts the interest rate that it will pay to banks for depositing funds (the “sight deposit rate”).5 This encourages other deposit-takers to adjust their rates too. Since a deposit from one bank is a loan to another, a higher deposit rate raises the cost of funds for banks.


Since banks’ primary source of profit is the spread between the interest rate at which they lend and their cost of funds, banks tend to raise interest rates on their own lending when their cost of funds rises. More expensive credit dampens consumer demand and hence tends to calm inflation.


Of course, a central bank can only set its domestic interest rates, not the interest rates prevailing on international markets. However, the theory of “uncovered interest rate parity” says that when foreign currency exchange rates are freely floating, the exchange rate will adjust to eliminate any difference between domestic and international funding costs.6 Thus, if Norges Bank (Norway’s central bank) raised interest rates above those prevailing on international markets, the Norwegian krone’s foreign exchange rate should rise to eliminate any possibility of banks obtaining cheaper funding by borrowing in dollars or euros and swapping into Norwegian krone.


But if “uncovered interest rate parity” does not reliably hold, then a bank that can obtain funding from international markets may be able to avoid the interest rate policy of its own central bank. In Norway, only the biggest banks can obtain funding directly from international markets, but many smaller banks can obtain funding from the big banks, so the impact of international foreign exchange funding could ripple out across the economy.


What Happens When Exchange Rates Don’t Fully Adjust to Interest Rate Changes?


The new research finds that uncovered interest rate parity does not fully hold for the Norwegian krone. There is a deviation between the actual krone/USD exchange rate and the exchange rate predicted by uncovered interest rate parity theory. This deviation has widened since the 1990s, mostly in a positive direction for the krone – i.e., the krone tends to appreciate more than theory predicts.7


The Norwegian krone’s tendency to appreciate may be because it is a petrocurrency, which means its foreign currency exchange rate tends to track the price of crude oil in U.S. dollars. However, research by Norges Bank shows that the relationship between the currency exchange rate and the oil price is not that strong, since Norway’s sovereign wealth fund tends to protect the economy from oil price changes.8“Safe haven” effects could also partly explain the krone’s tendency to appreciate.9


The researchers say that the fact that the Norwegian krone tends to appreciate more than theory predicts means that the bank lending channel for monetary policy is significantly influenced by global factors. The foreign currency exchange rate doesn’t fully adjust to changes in Norwegian interest rates, and so there can be persistent opportunities for banks to obtain cheaper funding in international markets than they can in domestic markets.10


This has significant implications for Norwegian monetary policy. The researchers find that banks actively choose whether to fund in domestic (krone) or international (USD or euro) markets, depending on the level of domestic interest rates. When domestic interest rates are higher than international rates, banks fund in the international foreign exchange markets; conversely, when domestic rates are lower than international rates, banks fund in domestic krone markets. The effect is that the bank lending channel of Norwegian monetary policy only works effectively if Norwegian interest rates are below international ones.11



Despite the Norwegian krone’s floating foreign currency exchange rate, Norwegian monetary policy is not fully independent. Because its banks can obtain funding in international markets, it is influenced by interest rate policies in its principal trading partners – the Eurozone, Sweden, and the U.K. And because its principal export, oil, is priced in dollars, it is also affected by Federal Reserve monetary policy. The good news for businesses is that this helps to moderate the cost of financing trade with Norway, while the tendency of the krone to appreciate can be a boon for U.S. businesses exporting to Norway.

Frances Coppola - The Author

The Author

Frances Coppola

With 17 years’ experience in the financial industry, Frances is a highly regarded writer and speaker on banking, finance and economics. She writes regularly for the Financial Times, Forbes and a range of financial industry publications. Her writing has featured in The Economist, the New York Times and the Wall Street Journal. She is a frequent commentator on TV, radio and online news media including the BBC and RT TV.


1.“Financial globalisation and bank lending: the limits of domestic monetary policy,” VoxEU;
2. “Norway,” The Observatory of Economic Complexity;
3. “Norway,” U.S. State Department; “Norway,” U.S. State Department; 4. “Financial globalisation and bank lending: the limits of domestic monetary policy,” VoxEU;
5. “Further information on key policy rate,” Norges Bank;
6. “Uncovered interest rate parity,” Investopedia;>
7. Financial globalisation and bank lending: the limits of domestic monetary policy, Norges Bank;
8. SWIFT gpi overview, May 2018,” SWIFT;
9. Financial globalisation and bank lending: the limits of domestic monetary policy, Norges Bank;
10. Ibid.
11. Ibid.

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