Mr Gjedrem considers challenges to economic policy in Norway  (Central Bank Articles and Speeches, 28 Jan 99)
Central bank: norges | Type: speech | Date: 1999-01-28

## Mr Gjedrem considers challenges to economic policy in NorwayAddress by the Governor of the Central Bank of Norway, Mr Svein Gjedrem, at Gausdal 28/1/99.

## 1) Economic policy in NorwayIn Norway, fiscal policy has been an important economic policy component for stabilis demand

for goods and services.

Since 1994, monetary and exchange rate policy have oriented towards maintaining a stable exchange rate against European currencies.

The partners are responsible for negotiating wages and thereby have a substantial infl employment.From 1986 to December 1992, Norway operated a fixed exchange rate regime.

The fix exchange rate policy introduced in the summer of 1986 served as a nominal anchor for ec policy, and inflation was gradually brought under control.

This process was associa considerable real economic costs in the form of idle production capacity in the period However, the cost of stabilising the economy was hardly greater in Norway than in co experiencing a comparable situation.

On the contrary, Norway avoided the sustained inc structural unemployment and the persistent deterioration in government finances experie many European countries in the 1980s and 1990s, and which they are carrying with them i next decade.

Norway's policy laid the foundation for balanced and broad-based economic in the years after 1992.Following the decision to allow the krone to float on 10 December 1992, the guideli monetary policy were revised.

Monetary policy was subsequently oriented towards exchang stability, but without stipulating a central rate with fluctuation margins.

This was guidelines set out in the Exchange Rate Regulation laid down by Royal Decree of 6 May 19If stabilisation policy is to have the intended effect, all components of policy mu effectively.

This has not been the case in the last three years.Sources: The and BankMinistry of Finance Norges1) Change from previous year.

Per cent of mainland GDP.For several years, average annual growth rates and employment growth have been mark higher in Norway than the average for the rest of Europe.

In part fuelled by the sharpin petroleum investment, pressures built up in the economy, accompanied by growing l shortages.Following the currency crisis in autumn 1992, Norwegian interest rates rapidly fell to levels.

The interest rate level in Europe fell after the turmoil early in the 1990 gradually picked up in Norway, the economy was stabilised by tightening fiscal policy. to stabilise the krone exchange rate, Norges Bank reduced its key rates at the beginni after the krone had appreciated markedly over a period.Fiscal policy is an important instrument for smoothing fluctuations in the economy.

Ho has proved difficult to prevent fiscal policy from being influenced by mood shifts when the economy approaches a peak and memories of earlier recessions fade.

Monetary p shall provide a nominal anchor for economic developments.

With exchange rate stability anchor, monetary policy may be pro-cyclical in periods.

This may give rise to cons challenges in terms of the Government's and the Storting's (Norwegian parliament) abil will to maintain a firm fiscal stance.

Under a system designed to maintain exchange rat it is important that the authorities actually manage to implement fiscal policy in suc pronounced and undesirable cyclical fluctuations do not occur.During the last cyclical upturn, fiscal policy has been relatively tight, but the tigh became weaker as growth gained momentum.

Fiscal policy should have been tighter in 1 1997 and 1998.

Another lesson from this period is that investment in the petroleum sect be managed better in order to avoid fluctuations in the mainland economy.

One cannot ex central government budget to be able to counter the shocks to the mainland economy orig from the wide fluctuations in demand from oil companies.

## 2) Internal instabilityFiscal policy has not had a sufficient stabilising effect on the economy in recent yea given rise to a dilemma for the social partners involved in the income settlements.Labour market -changes in annual wages and vacanciesSources: Directorate of Labour and Norges BankModerate wage settlements made a substantial contribution to achieving broademployment growth from 1992.

In the period 1993-1998, employment rose by more than 2 000, while unemployment fell from about 6.5 per cent to below 3 per cent, the lowerecorded for 10 years.

Whereas 20 unemployed were competing for each vacancy at employment offices in 1993, the ratio was reduced to a little more than 2 in 1998.An increasingly tight labour market has led to rising wage growth.

Last year's wage se resulted in nominal wage growth of 6 per cent in 1998.

Evidence suggests that wages in rose by more than 71/2 per cent between the fourth quarter of 1997 and the fourth q 1998.

In the local government sector, wage growth is set to top 9 per cent at the end As pay increases became effective late in the year, the wage carry-over into 1999 (3 cent) will be substantial.

Assuming normal wage drift - roughly 1-11/2 per cent - and negotiated pay increases, wage growth may easily near 6 per cent this year.

Even if no pay increases are awarded, wage growth is not likely to be lower than 41/2-5 per cent i a result of the substantial wage carry-over.

The wide wage growth differential agai countries will continue.

Wage growth in the euro area was about 1.7 per cent last year, growth is expected to be about 21/2 per cent this year.

A wage settlement with no in wages in Norway will, however, contribute to curbing annualised wage growth by a subst margin in the course of the year.With sizeable labour shortages, a short-term interest of both employers and employees wage increases, with high wage growth as a result.

However, the economy has bui stabilisers.

High wage growth will reduce employment and thereby the risk of persisten wage growth.

## 3) Wider inflation differential against trading partnersThe Asian crisis has resulted in reduced international consumer price inflation.General pressures in the economy have had only a marginal impact on price inflation in Consumer price inflation hovered around 2.5 per cent throughout 1998, which was well the

level anticipated by most observers.

The fall in import prices has been the m restraining the rise in prices.

The Asian crisis has probably had a dampening im international price inflation.

The direct effect of the crisis has been a fall in the produced in Asian countries and the indirect effect has been a slowdown in global dem intensified price competition across countries.

As a result, commodity and producer pr also fallen.

The widening of the inflation differential projected by Norges Bank has o result of reduced inflation in other countries.12-month rise in consumer pricesNorgesWide sectoral differences in price developmentsAlthough inflation has remained stable in Norway, there are wide differences in developments among various sectors.

Services prices have shown the sharpest rise, movinas much as 7 per cent in 1998.

The main explanatory factor is that the high level of wa has a greater impact on this sector as labour costs account for a substantial share o The rise in the consumer price index is being restrained by subdued or zero impo inflation.

## 4) The Norwegian economy at a turning pointThe

Norwegian economy continued to expand at a relatively strong pace in 1998, a somewhat more moderately than in previous years.

In Norges Bank's December Inflation Re the central bank projected a period of slower growth.

Several years of robust grow contributed to high capacity utilisation.

Labour shortages and high wage growth wil dampening impact on growth in the years ahead.Sources: Statistics Norway and Norges BankForecasting is a challenging enterprise at a stage when the economy is nearing a turnar difficult to pinpoint the timing and the amplitude of the turnaround.

However, evide suggests that Norway is entering a period of slightly weaker growth.

The inter environment has led to slower growth in demand and lower prices on the world market.

T weakening profitability in the export sector in Norway.

In addition, the wage settlem increased business costs, which will increase the need for enhancing the efficiency of Reduced earnings and higher interest rates will have a dampening effect on business inv The extraordinarily high level of oil investment recorded in recent years has been expe for some time.

The drop in oil prices may lead to more pronounced cyclical fluct Restructuring, streamlining and cost cuts in the oil industry will also affect employmeThe local government sector, where employment has increased sharply during this cy upturn, placed itself in a very difficult situation during the last income settlement. consolidate its financial position and employment growth in this sector is expected marked slowdown.There are already signs of a turnaround in the labour market.

Unemployment is no longer and is expected to rise in the period ahead.

The labour market is still tight, and projects weak growth in employment in 1999.

The labour market will be just as tight du year's wage negotiations as it was last year, but the outlook for employment is favourable.

Employment may fall somewhat from next year.

Unemployment was projected rise to about 41/2 per cent in 2000 in the December Inflation Report.Norges Bank's projections indicate that the turnaround will not be as pronounced as the at the end of the 1980s, partly owing to the fact that households and enterprises are equipped to cope with a downturn today than at the end of the 1980s.

The financial po households is much stronger.

The enterprise sector is more solid, and the banks' cor ratios are substantially higher.

Price and wage inflation was much more out of step situation in 1986 and 1987, with double-digit inflation.I am not saying this to trivialise the challenges at hand.

It is always a challenge economic policy when faced with such a substantial decline in income alongside imbalan the labour market.

Developments in the 1970s and 1980s showed that a higher rise in Norway relative to other countries leads to a slacker labour market.

This will also be time.

## 5) Pressures on the exchange rate of commodity-based economiesThere is a correlation between price inflation and the exchange rate.

As mentioned, the rate has a significant influence on prices and costs through its effect on imp Furthermore, a precondition for maintaining a stable exchange rate against European cou that inflation in Norway is over time on a par with the inflation rate prevailing in th The high rise in costs in 1998 was probably the main factor that weakened confidence krone.Trade-weighted exchange rates in commodity-based countries (Percentage change from 15 Jan. 1997}International conditions also played a significant part.

In 1998, the world economy was financial crisis in Asia, Russia and Brazil, falling commodity prices and widespread international financial markets.

The Asian crisis proved to be more serious and prolo envisaged, and the contagion effects were more severe than most observers had antic Weaker global demand contributed to a sharp fall in commodity prices, which in turn severe impact on commodity-based economies such as Norway, Canada, New Zealand and Australia.

For all these countries, the terms of trade worsened and exchange rates deprThe Asian crisis also made investors more cautious, with an outflow of investment countries perceived as risky.

After it became clear that Russia would not, in practice, its foreign debt, market participants became highly risk-averse.

The unrest spread tofinancial markets and Norway.

Investors fled to safe-haven countries such as Germany, and Switzerland, and the currencies of countries with less liquid and more volatile markets depreciated.

This included countries such as Norway and Sweden.

The Norwegian k depreciated sharply from around 101 against the ECU index at the beginning of the year t October, or the weakest rate since the objective of exchange rate stability against th adopted.

## 6) Monetary policy in 1998Norges Bank responded to the sharp depreciation of the krone by raising its key rates steps in 1998.

These rates were first raised in March, after the krone weakened in the months of the year from 101 to about 103.5 against the ECU index.

The krone then appre slightly and stabilised for a period.

Pressure on the krone increased during the summe Bank responded by raising its key rates on six further occasions.

Following the last i 25 August, the deposit rate and the overnight lending rate were 8 and 10 per cent, re i.e. 4.5 percentage points higher than at the beginning of 1998.Interest rate movements in 1998Source: Norges BankIt is difficult to predict the direct short-term effect of changes in interest rates rate.

It is particularly difficult in instances where fluctuations in the exchange rat as a result of speculation, hedging and portfolio shifts in financial markets.

## 7) The Exchange Rate RegulationNorges Bank's use of instruments in 1998 was in keeping with the Exchange Rate Regulati 6 May 1994:

## 'Section 1The international value of the Norwegian krone is determined on the basis of exchange the foreign exchange market.

## Section 2The monetary policy to be conducted by Norges Bank shall be aimed at maintaining a krone

exchange rate against European currencies, based on the range of the exchangmaintained since the krone was floated on 10 December 1992.

In the event of significant in the exchange rate, monetary policy instruments will be oriented with a view to ret exchange rate over time to its initial range.

No fluctuation margins are established, n appurtenant obligation on Norges Bank to intervene in the foreign exchange market. underlining)Pursuant to these guidelines, Norges Bank raised the deposit and overnight lending r percentage point on 25 August.

In connection with the increase in interest rates the B that instruments were subsequently to be oriented 'with a view to returning the exch over time to its initial range'.

In the opinion of Norges Bank, the situation in the fi was such that it would not be appropriate to make further use of its instruments.

The pressure on the krone towards the end of October hardly reflected economic fundament Norway.

## 8) InterventionsExchange-market

interventions are an important instrument of monetary and exchange policy.

Norges Bank intervened to support the krone for the equivalent of NOK 29 billi period from mid-October to mid-December.

Unrest in international financial markets in t of the financial crisis in Russia intensified the speculative pressure on the krone.

It view that this speculation was not justified by economic fundamentals in Norway. therefore necessary to defend the krone through interventions in order to prevent reinforcing and unnecessary weakening of the krone.Norges Bank will continue to consider using interventions if market conditions so war example, a central bank may have to intervene directly in order to stabilise th particularly if international turbulence leads to panic-like market reactions.From a somewhat longer-term perspective, the experience of large-scale and pers interventions is mixed.

When the central bank intervenes heavily to defend the krone participants may easily move into a game situation and perceive central bank intervent interesting opportunity to make a profit.

Market operators know that a situation in krone is perceived as 'artificially strong' because Norges Bank is buying kroner cannot is then tempting to take reverse positions in the foreign exchange market in relation t bank.

This means that heavy and prolonged interventions may be self-reinforcing ove steadily increasing the necessary volume of intervention purchases required to maintain exchange rate.The foremost example of such a game situation in Norway's exchange rate policy histor Friday, 20 November 1992, when we made intervention purchases for NOK 37 billion from time the market opened until the market closed.Norges Bank does not want to intervene in such a way that this type of game situatio However, the Bank will use interventions if the krone moves substantially out of line we consider to be reasonable based on fundamentals or in the event of exceptional sh volatility.

It may also be appropriate to reinforce a desired development in the exchan has already been observed in the market.

In such a situation, it is assumed that the ri up in a game situation against exchange market players is marginal.

However, we must ta account that the krone exchange rate cannot in the long run deviate substantially from implied by economic fundamentals.The instrument available to Norges Bank for influencing economic fundamentals is the i rate.

Over time, therefore, the interest rate is the most important instrument of mexchange rate policy.

This is also recognised in the formulation of the guidelines fo policy.

According to the National Budget for 1999, 'Interest rates must be adjusted i avoid persistent and large-scale interventions'.

## 9) Formulation of monetary policyNorges Bank reduced its key rates by 0.5 percentage points effective from today.

This came in response to developments in money and foreign exchange markets and the prospe reduced pressures in the real economy.The outlook for the Norwegian economy has changed since Norges Bank raised its key rat August.

The forecasts for growth in the world economy have been revised downwards persistently low oil prices have reduced demand in the oil sector.

In addition, a tight budget for 1999 and the high interest rate level are having a restraining effect on gr same time, the krone has appreciated recently.

This lays the foundation for slower price inflation in the years ahead, as estimated by Norges Bank in its December Inflation Developments in recent weeks have confirmed this picture, providing room for a slight r in interest rates.According to the Exchange Rate Regulation, '...

in the event of significant change exchange rate, monetary policy instruments shall be oriented with a view to retur exchange rate over time to its initial range'.

The guidelines provide considerable discretion in the conduct of monetary policy.

It is Norges Bank's task to exercise thisInterest rates are set with a view to returning the krone exchange rate over time t range.

Even with this interest rate reduction, the interest rate differential agai countries is substantial.A precondition for maintaining a stable exchange rate against the euro is that price inflation is on a par with that of euro countries over time.

When the krone exchange ra Norges Bank therefore sets the interest rate with a view to low price inflation.

At th we must avoid a situation whereby interest rates are so high that monetary policy contr downturn that undermines confidence in the krone.

Interest rates are set based o considerations.This is not a new policy.

In an address to the annual general meeting of Forex Norge i last year, Kjell Storvik stated:'I would point to the well-known fact that a lower krone exchange rate may contribute to inflation expectations and that such expectations may in turn generate expectatio weakening of the krone exchange rate, thereby reinforcing depreciation pressures expectations may thus prove to be a self-fulfilling prophecy.

The interest rate level now been established should, in addition to directly contributing to stabilising exchange rate, also limit price expectations...'I should also like to quote the following from the Revised National Budget for 1994:'A stable exchange rate can generate expectations of continued low inflation, which influence both price and wage determination.

Moderate price and wage inflation is necessary condition for a stable exchange rate over time.'A prerequisite for the conduct of monetary policy is that fiscal policy generally co stable economic developments.

Fiscal policy influences the total level of domestic act thereby the rise in the prices and costs of goods and services produced in Norway.

In with a high level of economic activity, an expansionary fiscal policy will tend to pu and wage inflation.

This in turn will influence expectations in the foreign exchan concerning future movements in the exchange rate, fuelling depreciation pressures and impeding the implementation of monetary policy.

A fiscal policy adapted to the ec situation, on the other hand, will contribute to facilitating the implementation of monIn the current economic situation, the pressure in the economy should be dampened tightening in the National Budget for 1999 of 3/4 per cent of GDP will help to curb wage inflation and alleviate the pressure on monetary policy.

## 10) ConclusionWe

are thus facing a period of slower growth.

Given the pressure that has built u economy, particularly in the labour market, such a correction is inevitable as a production constraints.

However, the prospects are much brighter than after the fall i and the wage settlement in 1986.

The Norwegian economy - including both households and business sector - is now in a stronger position to cope with a cyclical turnaround.

A f slower growth will also have a favourable effect on price and wage inflation in Nor thereby on the more long-term growth capacity of the economy.

Norges Bank's projec indicate that price and wage inflation could drop to the level of our trading partners of the millennium.

Lower domestic demand will also contribute to curbing the strong growth recorded in recent years, thus improving the current account.As mentioned, forecasting is a challenging task when the economy is on the verge turnaround.

It is not easy to predict the exact timing of the turnaround.

It will be di some adjustment through a slackening in the labour market.

Even if there are already some slackening, we must bear in mind that the market is still very tight.

A modera settlement this spring - with the social partners taking future developments into acc contribute to maintaining the level of employment.Monetary policy instruments are oriented with a view to returning the krone exchange r time to its initial range.

The guidelines provide considerable scope for discretion in of monetary policy.

It is Norges Bank's task to exercise this discretion.

A precon maintaining a stable exchange rate against the euro is that price and wage inflation with that of euro countries over time.

When the krone exchange rate is weak, Norge therefore sets the interest rate with a view to low price inflation.

At the same time,a situation whereby interest rates are so high that monetary policy contributes to a do undermines confidence in the krone.

Interest rates are set based on these considerations