Economic
perspectives
Annual address by Governor Ida Wolden Bache
to the Supervisory Council of Norges Bank
Thursday 15 February 2024
Economic
perspectives 2024
TILLIT at Økern © Lars Ø Ramberg / BONO 2023.
Along one of the major ring roads around Oslo stands an empty building.1
On its façade the Norwegian word for trust (TILLIT) shines towards us.
While the building has been empty for almost 20 years, the word is
certainly not. It is replete with meaning and implications. Trust forms the
leitmotif of my speech this evening - why trust is important and how we
can preserve it.
A well-functioning democracy is built on trust - political trust and
institutional trust. International comparisons show that Norway enjoys a
high degree of trust both between its people and between its people and
government.2 We are privileged to live in a country with such a high level
of trust capital. Perhaps trust is the most important capital we have,
which we also want to pass on to future generations.
Money is also grounded in trust. For thousands of years, economic life
has involved various forms of money. Money makes the exchange of
goods and services more efficient. What we are willing to accept as
money has naturally evolved over time from the world's first known
currency, cowrie shells, to today's electronic money. For money to
function as a medium of exchange, there must be trust in its value.
This year we are celebrating the 750th anniversary of the Code of
Magnus Lagabøte.3 The King was also a reformer of the monetary
system. He took seriously the importance of trust in the value of money.
The reforms he implemented have come to stand as a watershed
moment in Norwegian monetary history.4
In his time, the royal power was the guarantor of the value of money.
Today, most governments have delegated the conduct of monetary
policy to the central bank. By giving the central bank the task of ensuring
monetary stability and sufficient autonomy, the promise of preserving the
value of money becomes more credible. But that promise must be
followed by action. In today's situation, that means bringing inflation back
to the target of 2 percent.
Inflation is coming down
There are now clear prospects that many countries are succeeding in
doing so. In the aftermath of the pandemic and Russia's invasion of
Ukraine, inflation rose to the highest levels seen in multiple decades. Last
year, inflation eased substantially (Chart 1), and contrary to what many
had feared, unemployment has remained low so far. Euro area
unemployment is in fact at an all-time low.
The inflation surge two years ago spurred international debate. Several
well-known economists engaged in the debate and split into two groups.
One group argued that high inflation would be short-lived and that
inflation would by and large come down unaided. The group was
spearheaded by Nobel laureate Paul Krugman and became known as
"Team Transitory". The other group, by the name of "Team Persistent",
Chart 1 Lower inflation without high unemployment
Consumer prices. Twelve-month Unemployment. Three-month moving
change. Percent average. Percent.
12 12 14 14
10 10 12 12
8 8 10 10
6 6 8 8
4 4 6 6
2 2 4 4
0 0 2 2
0 0
2014 2016 2018 2020 2022 2024 2014 2016 2018 2020 2022 2024
Euro area Norway US Sweden UK
Sources: LSEG Datastream and Statistics Norway
argued that high inflation would linger, and that higher interest rates were
needed to bring it down. The former US Treasury Secretary Lawrence
Summers was a prominent member of this group.5 He contended that a
period of high unemployment was necessary in order to bring down
inflation.
So who was right? Even if inflation has not yet declined to the targeted
level, we now know part of the story. I would say neither Krugman nor
Summers was entirely right.
Much of the disinflation was caused by a reversal of the initial inflation
shock. Trade between countries is flowing more normally again, and
prices for energy and many other commodities have fallen. That doesn't
mean that monetary policy tightening was unnecessary. Inflation proved
stickier than many economists had expected. The interest rate increases
have eased pressures in the economy, and inflation would have been
higher without the increases.6
We are also benefiting from the preceding decades of low and stable
inflation. When inflation surged in the wake of the pandemic, confidence
in inflation targets was already pervasive, which may in and of itself have
increased the speed of disinflation. If households and firms had
expected inflation to remain high and had based their price and wage
setting on that expectation, we might have seen a self-reinforcing
inflation spiral. That would have required stronger monetary policy
tightening to bring down inflation, which could also have led to higher
costs in the form of increased unemployment.
Chart 2 Confidence in low inflation
US consumer prices. Twelve-month change. Percent
16 16
Expected inflation in 5 years
14 14
Actual inflation
12 12
10 10
8 8
6 6
4 4
2 2
0 0
1970 1977 1984 1991 1998 2005 2012 2019
Sources: LSEG Datastream and University of Michigan
US statistics for inflation expectations go back as far as the 1980s (Chart
2). At the beginning of the 1980s inflation was high, and people expected
inflation to remain high for several years into the future. After a period of
very tight monetary policy, inflation retreated. Since then, long-term
inflation expectations have been low and stable, also after the recent
years' surge in inflation. The situation is the same across many countries,
including Norway.7
There is an academic debate about the significance of inflation
expectations for actual price and wage setting.8 Whether households
and firms expect inflation to hit target precisely is not necessarily of
material importance. History has shown, however, that if confidence
starts to slip, the cost of bringing down inflation again may be substantial.
Therein lies a warning against loosening monetary policy prematurely
when inflation falls. In a study of inflationary episodes since the 1970s,
IMF economists find that countries that lowered interest rates early on
when inflation showed signs of slowing, experienced a resurgence in
inflation more often than other countries.9 It pays to be patient.
The credibility of inflation targets has been built up over time. To maintain
that credibility, the promise of returning inflation to target must be
fulfilled. With confidence in low and stable inflation over time, we are
better equipped to cope with future shocks and turbulent periods.
Developments in Norway and other countries are similar in several
respects. Inflation has fallen, and unemployment remains low despite a
moderate increase (Chart 1).
Chart 3 A weaker krone contributes to keeping inflation elevated
Exchange rates. Index. 6 January 2017 = 100
140 140
EUR/NOK
USD/NOK
130 130
SEK/NOK
Weaker krone
120 120
110 110
100 100
90 90
80 80
2017 2018 2019 2020 2021 2022 2023 2024
Source: LSEG Datastream
The external drivers of Norwegian prices are moderating. That will
dampen inflation ahead. At the same time, there are factors that could
contribute to keeping inflation elevated in Norway even amid falling
inflation internationally. Domestic wage growth has increased and last
year reached the highest level recorded in 15 years. Pay increases have
not been large compared with the increase in living costs, but combined
with low productivity growth and price increases for many intermediate
goods, Norwegian firms are facing substantially higher costs.
The krone depreciation over the past year and a half has also contributed
to keeping inflation elevated in Norway. The krone has depreciated
primarily against major currencies, such as the euro and the US dollar,
and less against smaller currencies such as the Swedish krona (Chart 3).
The krone depreciation means that holiday travel and imported goods
have become more expensive. Firms that rely on foreign suppliers have
seen their costs increase. At the same time, the krone depreciation has
also boosted profits in the export sector, which can in turn lead to higher
wage growth and keep domestic cost inflation at a higher level for longer.
With weaker growth prospects and inflation that was already too high,
the krone depreciation made monetary policy trade-offs more
challenging last year.
A floating exchange rate
When the krone depreciated, the question arose as to whether the Bank
should have done more to stabilise the krone. Some suggested foreign
exchange market interventions in support of the krone. However, the
experience of intervening in the foreign exchange market, as we did
when we operated with an exchange rate target, is not satisfactory.
The central bank may easily find itself in an undesirable game situation
with market participants.10 Moreover, research does not suggest that
interventions have anything but small and short-lived effects. The
threshold for intervening in the foreign exchange market to influence
the krone exchange rate is therefore very high.
Under a floating exchange rate regime, we must accept that the krone
fluctuates. This imposes some costs on both businesses and
households. Sometimes the krone will move in an undesirable direction
in the sense that monetary policy trade-offs become more difficult.
At the same time, there are also clear advantages to allowing the krone to
float. A floating exchange rate means that we are not bound to keeping
interest rates at the same level as in other countries and jurisdictions.
This is particularly valuable when the Norwegian economy is not at the
same stage of the business cycle as our trading partners. A floating
exchange rate provides freedom of action to set the interest rate based
on the outlook for the Norwegian economy and to engage in flexible
inflation targeting whereby we can also contribute to supporting high
employment.
Freedom of action nevertheless has some limits. Given free capital
movements and an inflation target identical to our trading partners, the
level of interest rates in Norway cannot deviate substantially from foreign
rates over time. The fact that policy rates among trading partners rose
faster and at one point were higher than the policy rate in Norway has
likely contributed to the krone depreciation over the past year and a half
(Chart 4).
Chart 4 The policy rate differential against other countries is of importance
Policy rate in Norway and among main trading partners. Percent
5 5
Trading partners
Norway
4 4
3 3
2 2
1 1
0 0
2017 2019 2021 2023
Sources: Bloomberg and Norges Bank
10 The literature does not provide any definitive conclusions on the effect of interventions, because the effects
depend on the situation in the particular country and on structural factors in foreign exchange markets. The
effects are often found to be small and short-lived. However, interventions can be effective when markets
are not functioning. See Arango-Lozano, L., L. Menkhoff, D. Rodríguez-Novoa and M. Villamizar-Villegas
(2020). "The effectiveness of FX interventions: A meta-analysis". Journal of Financial Stability, 100794. See
also Filardo, A., G. Gelos and T. McGregor (2022). "Exchange-Rate Swings and Foreign Currency Interven-
tion". IMF Working Paper No. 2022/158.
Moreover, we must maintain confidence in the inflation target. We must
react when there are prospects that inflation will rise above target, even
when the source of inflation is external. If monetary policy does not react,
the krone may depreciate substantially, leading in turn to higher imported
inflation, which could spill over into domestic price and wage inflation.
If we do not raise the policy rate when inflation increases, the exchange
rate may fuel a wage-price spiral.11
Within certain limits, a floating exchange rate provides leeway that we
can use to stabilise economic developments. A floating exchange rate
can also function as a shock absorber in a downturn and can support
structural changes, as witnessed for example after the oil price fall in
2014 when the krone depreciated sharply. If the only means of
strengthening competitiveness had been through a long period of lower wage
and price inflation than among our trading partners, as a fixed exchange
rate target would have required, we would probably have had to endure
a larger increase in unemployment.12
Challenging trade-offs
High and variable inflation entails substantial costs to society. It increases
uncertainty about future price developments and makes economic
planning difficult. It can also lead to a situation where long-term investments
have to give way to shorter-term investments. It is often those with low
incomes and the smallest buffers that are hit hardest when prices rise
rapidly and unexpectedly.
The operational target of monetary policy in Norway is inflation of close
to 2 per cent over time. But we are not solely focused on inflation. Inflation
targeting must be flexible, so that it can also contribute to high and stable
output and employment.
In the long term, there is no conflict between low inflation and high
employment. Price stability is a precondition for an efficiently functioning
economy. In the long run, we cannot trade off higher inflation for higher
employment.
In the short term, however, there may be a conflict between these two
considerations as we approach each policy rate decision. A trade-off
must therefore be made between the objectives of low inflation and high
employment. We interpret the mandate to mean that we must give
considerable weight to employment also in the current situation with
inflation markedly above the target.
Chart 5 We make use of our monetary policy leeway
CPI. Four-quarter change. Registered unemployment as a
Percent share of the labour force. Seasonally
adjusted. Percent
8 8 8 8
6 6 6 6
4 4 4 4
2 2 2 2
0 0 0 0
2014 2016 2018 2020 2022 2024 2026 2014 2016 2018 2020 2022 2024 2026
Inflation target
Sources: Norwegian Labour and Welfare Administration, Statistics Norway and Norges Bank
Since autumn 2021, we have raised the policy rate sharply and rapidly to
tame inflation. Throughout, we have emphasised the need to avoid a
sharp rise in unemployment. While we still have a ways to go, inflation is
now heading down. We could have brought inflation down faster, but
unemployment would probably have risen more. The trade-offs we make
are expressed in our forecasts (Chart 5). We expect inflation to gradually
approach target in the years ahead, with unemployment edging up to
about its pre-pandemic level.
We know that the fight against inflation comes at a cost. The quick
succession of interest rate hikes came on top of a rapid rise in prices.
After several years of weak income growth, household purchasing power
fell last year (Chart 6). Many people have less to spend, and some people
are having difficulty making ends meet. If the economy evolves as we
now expect, additional policy rate hikes will not be needed. Given lower
inflation and prospects that wages will rise faster than prices further out,
many people will see an increase in their purchasing power and lower
Chart 6 Weak income growth
Real disposable income. Index. 2019 = 100
110 110
100 100
90 90
80 80
70 70
60 60
50 50
40 40
30 30
1978 1981 1984 1987 1990 1993 1996 1999 2002 2005 2008 2011 2014 2017 2020 2023 2026
Sources: Statistics Norway and Norges Bank
Chart 7 Wide differences across industries
Output growth in the current quarter according to the Regional Network.
Seasonally adjusted. Percent
3 3
Construction
Retail trade
2 2
Manufacturing
Services
Oil services
1 1
0 0
2015 2016 2017 2018 2019 2020 2021 2022 2023
Source: Norges Bank
debt servicing costs. At the same time, we must be prepared for
somewhat higher unemployment.
The cost of reducing inflation is also being felt by businesses (Chart 7).
The interest rate hikes have hit construction and retail trade particularly
hard. The policy rate affects the economy broadly and cannot be used to
fine-tune developments in individual sectors. Nevertheless, when we set
the policy rate, we are conscious that pronounced impacts on individual
industries can have more persistent effects which may weigh on the
economic outlook. Even so, our primary objective remains the same. The
easing of inflation is of benefit to the entire economy, including the most
interest rate sensitive sectors.
If developments turn out as we now expect, inflation will return to target
without a sharp rise in unemployment, thanks in part to the effective
interaction of economic policy. A system of coordinated wage
determination, as is the case in Norway, where the parties give weight to
employment, reduces the risk of wage-price spirals. In interaction with
flexible inflation targeting, this reduces the cost of reducing inflation, as
the Holden commission recently concluded in its report on challenges to
wage formation and the Norwegian economy.13
A year ago, it was our view that the policy rate was close to peaking
(Chart 8). That didn't happen. Demand held up longer than expected,
and business costs rose more than anticipated. Moreover, the krone
depreciated. The result was a further rise in inflation, which is why the
policy rate has turned out to be higher than we projected one year ago.
We could always forecast the policy rate with perfect accuracy. But the
policy rate is a tool, not an objective. Monetary policy must constantly be
adjusted to the economic outlook.
Chart 8 We have raised the policy rate to bring down inflation
Policy rate. Percent
5 5
Projections MPR 4/23
Projections MPR 4/22
4 4
3 3
2 2
1 1
0 0
2020 2021 2022 2023 2024 2025 2026
Source: Norges Bank
We must be prepared for more pronounced and more frequent economic
shifts than in the decades prior to the pandemic. The consequences of
climate change are becoming increasingly visible, and a global transition
is necessary to reach net zero. Geopolitical tensions and the desire to
safeguard national supply lines are affecting trade and cross-border
cooperation. At the same time, technological innovations and artificial
intelligence may lead to an upheaval of the labour market.
These developments will pose a challenge to all aspects of economic
policy, including monetary policy. The job of ensuring price stability may
become more demanding. Large changes in some prices may be
necessary for the economy to adapt. With a flexible targeting regime, we
can look through temporary changes in inflation. But the most important
contribution monetary policy can make to support structural changes
and employment is to ensure low and stable inflation. The monetary
policy regulation was amended in 2018 following a thorough process.
I believe our mandate provides a solid foundation for meeting the
challenges we will face in the coming years.
The GPFG must be grounded in legitimacy
Exactly 50 years ago today, the Bratteli Government presented its white
paper on the role of petroleum activities in Norwegian society. The report
is both well-written and prescient. Even if only a few short years had
passed since the first oil discovery in the North Sea, the report highlighted
the necessity of investing a substantial portion of government petroleum
revenues abroad. As successive governments have set money aside over
nearly three decades, the Government Pension Fund Global (GPFG) is
now among the world's largest sovereign wealth funds (Chart 9).
The GPFG's very size is testimony of the Norwegian public's trust in
democracy and political institutions. That trust is based on broad support
for the overall framework for GPFG investment management. As
enshrined in law by the Storting, the objective of investment
management is to achieve the highest possible return at acceptable risk. Within
this framework, lies the requirement of responsible investing and an
important premise for what it should not be used for. It shall not be a tool
for achieving political goals other than purely financial ones.
The investment strategy has been developed over time. All of the
important changes to the investment framework have been approved by
the Storting. The broad consensus has enabled us to stick to our strategy
even in periods of substantial financial market volatility. This has served
us well. Trust has paid off, financially too.
In its equity portfolio, the GPFG holds a stake in close to 9 000
companies in more than 70 countries. We own a small slice of just about
everything. This is a sensible strategy for such a sovereign wealth fund.
This strategy ties us to the global economy for better or for worse.
Sustainable economic developments and well-functioning markets are
therefore in the GPFG's long-term interest.
Being an active owner enables us to influence companies in a more
sustainable direction. We let companies know what we expect and are
14
in a dialogue with them. We exercise our voting rights at general
meetings.
In recent years, we have raised our ambitions for responsible investment,
not least with regard to climate and the environment. When the Ministry
of Finance amended the investment mandate in 2022, it was specified
that the GPFG, while pursuing its long-term financial objective, was to
deploy efforts to bring the activities of its portfolio companies into
alignment with the goal of net zero in accordance with the Paris Agreement.15
Norges Bank has supported the new ambitions with a climate action
plan.16 We expect more of our portfolio companies and have reinforced
our engagement efforts. We make an active contribution to the
international work to develop binding standards and to improve climate
disclosures.
We believe that the work that we and other investors are doing is
making an impact. For instance, we note that the share of our portfolio
companies with concrete and realistic plans for achieving net zero has
increased. We also find that because the GPFG is large, the companies
listen to us. And we see that when we publish our voting intentions in
advance of general meetings, other investors follow.17
As owners we not only have rights but also obligations. For many
companies, the GPFG is among the largest shareholders. This also
entails responsibility. We cannot leave the task of ownership to others.
At the same time, there are dilemmas. We do not want the GPFG to be
perceived as a political actor. But when we seek to influence companies,
it may appear that way. As the Sverdrup commission pointed out in its
report The Fund in a changing world, this balancing act may become
more difficult ahead. A world of growing conflicts may blur the boundary
between the economic and political spheres.18 We already see that in
some markets, responsible investment practices are being politicised.
In the US, many large investors have therefore lowered their climate
ambitions. In exercising our ownership rights we must therefore act
responsibly ourselves. We must be ambitious, but our ambitions must
be realistic. We must be transparent, reliable and predictable. Our
expectations and views must be knowledge-based and rooted in
internationally recognised standards and principles. We must be clear about
the fact that the GPFG conducts its active ownership in pursuit of its
long-term financial objective. This will contribute to preserving the
GPFG's legitimacy globally and to fostering its growth and sustainability.
Conclusion
Let me conclude. The leitmotif today has been trust - the importance of
trust in the value of money and trust in the GPFG and the way it is
managed.
As an institution, Norges Bank is shown strong trust. The Bank manages
vast assets on behalf of the Norwegian people and has been given a
large degree of autonomy in interest rate setting.
In performing the tasks we have been given, we make judgements and
choices that can have substantial consequences for people's finances.
While central banks in earlier times were opaque about their reasoning,
we try to be as transparent as possible about how we carry out our
mission.19 It is important that you - the people and the political authorities
- can assess and evaluate us. It is equally important that we listen and
learn from others, even when they are critical of our choices.
Norges Bank's tasks are part of a greater whole. Together with other
policy areas - fiscal policy and wage determination - the aim is to
contribute to the highest possible level of welfare for our citizens.
The Norwegian word for trust is tillit and can be read both ways - from
left to right and from right to left. Trust also goes both ways - we trust
each other.
We trust that the political authorities and the social partners manage
their responsibilities in the area of economic policy in a sound manner.
In return, you can also trust that we will do our utmost to achieve the
goals you have set for us.