Øystein Olsen: The Norwegian economy - macroeconomic
developments and monetary policy
Speech by Mr Øystein Olsen, Governor of Norges Bank (Central Bank of Norway), at the Finance
Norway's Capital Markets Day 2018, Oslo, 6 April 2018.
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Accompanying slides
First of all, I would like to thank Finance Norway for the opportunity to speak to you today about
macroeconomic developments and monetary policy in Norway. As you may be aware, a new
regulation on monetary policy came into force earlier this spring. I will return to the regulation and
its implications for the conduct of monetary policy and the interest rate outlook. But first, let me
start abroad.
Chart: Economic growth following the financial crisis
The advanced economies have emerged from a challenging period. Ten years ago the world
economy was hit by a shock and thrown into the deepest recession since the 1930s.
The economic downturn that followed the financial crisis stands apart from earlier recessions. It
was both deeper and longer. Potent measures were deployed to address the crisis, but it has still
taken time to get the world economy back on its feet.
Monetary policy had to play a substantial role in the wake of the crisis. Without powerful
economic policy measures, there was a risk of a self-reinforcing recession.
Chart: Global real interest rates
Central banks were led into unknown territory and implemented unconventional measures.
Already low long-term real interest rates were brought down even further.
Ten years of historically low interest rates and large-scale asset purchases give cause for
reflection. An important question is what responsibilities should rest with a central bank. A related
theme is what is meant by the objective of low and stable inflation.
Chart: Inflation in Norway
The primary objective of monetary policy is to maintain monetary stability, as part of the central
bank's responsibility for the monetary system.
Inflation that is either too high or too low has undesired consequences, such as arbitrary wealth
redistribution, underinvestment and resource misallocations. The result is lower activity and
lower welfare.
Since 1990, an increasing number of countries have chosen to link monetary stability to a
numerical inflation target. Since the financial crisis, all of these countries have maintained their
inflation targeting regimes. This reflects the overall positive experience with this framework. It did
not get in the way of a powerful response to the financial crisis.
In Norway too, inflation targeting has functioned well. Inflation has remained low and stable since
it came down in the early 1990s, and the inflation target has anchored inflation expectations.
During the period of inflation targeting, the Norwegian economy has been exposed to major
shocks. A flexible inflation targeting regime has helped dampen their impact on output and
employment. Employment variability has been lower since 2001 than in previous periods.
Lessons have been learned along the way. Initially, central banks had high ambitions to steer
inflation to target within a clearly defined time horizon. But experiences with the regime provided
useful insight, and the ambitions were later adjusted. When confronted with shocks, small open
economies in particular experienced that a rapid return to the inflation target could have
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undesired consequences for the real economy. Norges Bank has addressed this concern by
giving greater weight to output and employment. The inflation target horizon has been extended
and monetary policy has gradually become more flexible.
A few weeks ago, on 2 March, the Government adopted a new, modernised regulation on
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monetary policy. The new regulation clarifies the monetary policy mandate and underpins the
Bank ́s flexible approach to inflation targeting. In Norges Bank  ́s assessment, the new regulation
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will not result in significant changes in the conduct of monetary policy. Let me elaborate
somewhat on the implications of the new regulation.
"Monetary policy", according to the new regulation, "shall maintain monetary stability by keeping
inflation low and stable."
The regulation thus clarifies the primary task of monetary policy. Price stability is the best
contribution that monetary policy can make towards sound and stable economic developments
over time.
It does so by ensuring that inflation stays within a range somewhat above zero, while being kept
under control. Since inflation targeting was introduced in Norway, inflation has been close to, but
on average somewhat below, the previous target of 2.5 percent. Inflation has consistently
remained within a band where the deviations from the target cannot be said to have entailed
significant economic costs.
According to the new regulation, "the operational target of monetary policy shall be annual
consumer price inflation of close to 2 percent over time."
It is not possible to quantify precisely an optimal inflation target for the Norwegian economy. A
numerical target of 2 percent is, however, consistent with the inflation target of most of Norway ́s
trading partners.
In 2001, when inflation targeting was introduced, the Norwegian economy faced the prospect of
gradually increasing oil revenue spending. It was widely expected that the phasing-in of revenues
would entail an appreciation of the real exchange rate. At the time, the nominal target was set at
2.5 percent. An expected real appreciation could then occur partly in the form of wider price and
cost differentials between Norway and its trading partners. The period of rising oil revenue
spending now appears largely to be over. Thus, it is difficult to find compelling arguments for
setting an inflation target in Norway today that differs from that of our trading partners.
The new regulation is consistent with how monetary policy has been conducted in practice in
recent years. The regulation states that: "Inflation targeting shall be forward-looking and flexible
so that it can contribute to high and stable output and employment and to counteract the build-up
of financial imbalances."
As long as there is confidence that inflation will remain low and stable, monetary policy can
contribute to stabilising the economy. When the economy is exposed to shocks, the central bank
can respond rapidly by adjusting the key policy rate, as we did in 2008 and when oil prices fell in
2014. A flexible inflation targeting regime can reduce the risk of unemployment becoming
entrenched at a high level following economic contractions. Nevertheless, monetary policy
cannot assume primary responsibility for high output and employment. The level of output and
employment over time depends on overall economic policy, including the tax and social security
system, the wage formation process and the functioning of the labour market. Monetary policy is
only one component of such an overall framework.
The importance of financial markets and financial stability was underestimated before the crisis -
also by central banks. The financial crisis revealed how harmful financial imbalances can be.
Monetary policy can in given situations take account of the risk of a build-up of financial
imbalances. But monetary policy cannot take primary responsibility for heading off a gathering
storm. Regulation and supervision of financial institutions are the primary means of addressing
shocks to the financial system.
The build-up of financial imbalances has in recent years been given little weight in monetary
policy among the major central banks. Their focus has been on counteracting a deeper and more
prolonged downturn and on preventing deflation.
In countries that were less affected by the financial crisis, more attention has been devoted to
financial stability considerations. In high-tech, global financial markets, capital moves rapidly
between different currencies. A wide interest rate differential could have a substantial impact on
the exchange rate, with repercussions on inflation, output and employment. This is why low
interest rates in large economies that were severely hit by the financial crisis quickly led to lower
rates in countries where the cyclical situation, in isolation, would have implied higher rates. This
was the case in Norway until oil prices fell. Other small open economies have been in the same
situation.
Chart: House prices
These countries have imported low interest rates and experienced rapidly rising house prices
and debt. They have introduced measures to limit elevated debt in order to prevent imbalances
from building up further. In Norway, stricter mortgage lending requirements have been imposed
on banks. These measures have probably contributed to the recent correction in Norwegian
house prices. Over the past year, house prices have fallen. The shift in the housing market has
reduced the risk of an abrupt and more pronounced decline further out. Household credit growth
remains high, but over time lower house price inflation will dampen credit growth.
The exchange rate places a limit on how far Norwegian interest rates can deviate from foreign
rates. But with a floating exchange rate, monetary policy can help to stabilise the economy when
it is exposed to shocks. In the previous monetary policy regulation, there was a reference to the
stability of the krone exchange rate. This has been omitted from the new regulation, but will not
lead to material changes in the conduct of monetary policy. How Norges Bank will react to
movements in the exchange rate will depend on how these fluctuations affect the outlook for
inflation, output and employment.
Chart: Exchange rate and oil prices
A recent example is the monetary policy response to the negative oil price shock in 2014. The
exchange rate served as a shock absorber. With confidence in the inflation target, monetary
policy was able to underpin a weaker krone. The krone depreciation, combined with moderate
wage settlements, contributed to a marked improvement in business profitability and
competitiveness.
Chart: GDP for mainland Norway
Let me now turn to the outlook for the Norwegian economy. Two years after the cyclical trough
was reached in Norway, growth has gained a firm footing. In our latest Monetary Policy Report,
the negative output gap is projected to narrow and close early next year.
There are prospects for solid growth in business investment and renewed optimism in the
petroleum industry. A number of large development projects will contribute to a rebound in oil
investment in the coming years. The impetus from abroad has strengthened and exports are
picking up. On the other hand, housing investment has fallen, and is likely to decline further.
Growth in household consumption picked up markedly last year. Higher real wage growth and
continued employment growth should support consumption growth ahead, while higher interest
rates will likely have a dampening effect.
Chart: Inflation
After falling markedly in the period to autumn 2017, inflation has edged higher. While underlying
inflation is still low, rising capacity utilisation will probably push up price and wage inflation further
out. Core inflation is now projected to rise to a little above 2 percent in 2021.
Chart: The Executive Board's assessment and interest rate forecast
At its monetary policy meeting in March, the Executive Board gave weight to the sustained upturn
in both the global and the Norwegian economy. The Executive Board decided to keep the key
policy rate unchanged at 0.5 percent. The Board's current assessment is that the key policy rate
will most likely be raised after summer this year.
The March Monetary Policy Report is the first report since the new regulation on monetary policy
came into force. Although the new regulation will not result in significant changes in the conduct
of monetary policy, the interest rate outlook is to some extent affected by the lowering of the
numerical inflation target.
Chart: Factors behind changes in key policy rate since MPR 4/17
The effect on the key policy rate from the new inflation target is summarised in this chart. The
black line shows the change in the key policy rate forecast since the previous meeting in
December. The contribution from the new inflation target is shown by the red bars, while the
other bars show the effect from other factors.
Over time, lower inflation owing to a lower inflation target will result in a correspondingly lower
nominal interest rate, so that the long-term real interest rate is unchanged.
In the near term, however, a lower numerical target implies a slightly less expansionary monetary
policy as actual inflation is somewhat closer to target. But because the inflation targeting regime
is flexible, with weight given to developments in output and employment, the effect on the key
policy rate in the short to medium term will be marginal.
Let me conclude. The global economy finally appears to have recovered from the prolonged
weakness that followed the financial crisis. Growth has also strengthened in Norway after the
decline following the oil price collapse. The outlook for the Norwegian economy suggests that
the key policy rate may be increased this year for the first time in seven years - this is a good
sign.
1
See for example Wheeler G. (2014): "Reflections on 25 years of Inflation Targeting", Reserve Bank of New
Zealand, speech delivered on 28 November 2014 and Norges Bank (2017): "Experience with the monetary
policy framework in Norway since 2001", Norges Bank Papers 1/2017.
2
See Ministry of Finance (2018): "New regulation on monetary policy," Press release of 2 March 2018, or Meld. St.
8 (2017-2018). Ny forskrift for pengepolitikken. (White Paper from the Ministry of Finance. In Norwegian only.)
3
See Norges Bank (2018): "Modernisation of the Regulation on Monetary Policy",Norges Bank ́s letter of 28
February 2018 to the Ministry of Finance.