Øystein Olsen: The economic outlook
Address by Mr Øystein Olsen, Governor of Norges Bank (Central Bank of Norway), to invited
foreign embassy representatives, Oslo, 29 March 2011.
The address is based on the assessments presented at Norges Bank's press conference following the Executive
Board's monetary policy meeting on 16 March, Monetary Policy Report 1/11 and previous speeches. Please note
that the text below may differ slightly from the actual presentation.
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Excellencies, Ladies and Gentlemen,
I am happy to continue the tradition of my predecessor by inviting you to Norges Bank to
discuss economic developments in Norway.
Economic trends
During the past few weeks, the world's attention has been focused on the sufferings caused
by the earthquake in Japan, as well as escalating political unrest in Middle East countries.
The economic impact of these events is still uncertain. Apart from these, the economic and
financial news of the past year has, on balance, been positive. The global recovery has
gained strength, even though uncertainties persist.
A common feature of the countries that fared well through the financial crisis was that they
had kept their house in order. Norway falls into this group, although our abundant natural
resource wealth puts us in a unique and favourable position. Against this backdrop, I would
like to comment on our experience with implementing the prevailing frameworks for monetary
and fiscal policy.
Today we can look back at ten years of inflation targeting and the fiscal rule. Despite the
financial crisis, this has been a golden period for Norway. Economic developments have
been influenced by changes in global trade patterns. Asia has replaced Europe as our main
trading partner for many goods, and Norway has reaped significant gains from terms-of-trade
effects. National income is almost 30 per cent higher in real terms than ten years ago.
While in the 1980s the advanced economies clearly dominated the performance of the global
economy, the contribution to global growth of the emerging economies during the last
decade, substantially exceeded that of the advanced economies. Moreover, during the global
crisis of 2008-2009, growth in emerging economies was sustained, while it fell sharply in the
OECD area.
As growth in the advanced economies now remains depressed, emerging economies will
continue to dominate the performance of the global economy.
This tendency is reflected in developments in the global oil market, where the composition of
crude oil consumption has shifted from advanced to emerging market economies.
During the last decade, global demand for oil increased by slightly more than 12 per cent.
Over the same period, demand for oil in OECD countries fell by nearly 5 per cent.
Commodity-intensive industrialisation and strong per capita income growth in emerging
economies are likely to reinforce the upward shift in aggregate commodity demand.
The Norwegian macroeconomic framework
The changing structure of the global economy helps to explain the economic shift
experienced in Norway during the 2000s. Prices for Norwegian exports, such as oil, gas,
metals, minerals and fish, rose markedly, while prices for imported goods fell. In the seven
years leading up to the financial crisis, the volume of mainland GDP expanded at an average
annual rate of 3.4 per cent.
Exactly ten years ago today, Norges Bank was charged with the task of setting the interest
rate with a view to keeping inflation low and stable. At the same time, new fiscal policy
guidelines, also known as the fiscal rule, were implemented, charting a course for petroleum
revenue spending. Norway's sovereign wealth fund, which is now called the Government
Pension Fund Global, was designed to prevent fluctuations in oil prices from feeding through
to the mainland economy.
A decade of inflation targeting
The inflation target for monetary policy provides a sound anchor for inflation expectations.
Over the past decade, CPI inflation has varied to some extent. Underlying inflation has
naturally been more stable, but has been both higher and lower than the target. If we look at
the ten-year period as a whole, inflation has been 2 per cent, that is to say close to the
target.
Still, over the past ten years, the conduct of monetary policy has been tested. During this
period, we have gained insight into the functioning of the Norwegian economy under an
inflation-targeting regime. Let me touch upon some of these insights.
At the beginning of the decade, we learned that it can be demanding to strike a balance
between different monetary policy considerations in a small, open economy. When the key
policy rate is raised to restrain a pronounced rise in domestic cost inflation, it can have a
strong impact on the krone exchange rate, as observed in 2002-2003. This influences both
the real economy and the inflation outlook.
Midway through the decade, inflation rapidly declined. China's entry into world trade and
increased imports to Norway from Asia led to a persistent fall in prices for many goods. The
combination of low inflation and strong economic growth posed a challenge to the conduct of
monetary policy. Interest rates - both at home and abroad - were set at low levels. At the
same time, this amplified the cyclical upturn in Norway.
Towards the end of the decade, during the financial crisis, the interest rate was reduced
sharply and to record-low levels. The decision to lower interest rates was undoubtedly not a
difficult decision to make at the time. A persistently low interest rate, on the other hand, can
pose a challenge to financial stability in an economy where there is a strong willingness to
borrow and property prices are rising.
Despite challenges met over the past decade, inflation has been fairly stable and close to the
target, which shows that monetary policy has been effective. Compared with the 1980s, for
example, inflation has been considerably lower and growth in the mainland economy has
been markedly higher. There has been no conflict between low inflation and high economic
growth, as previously claimed by economists.
The guidelines and the financial crisis
The financial crisis in 2008 put our economic policy guidelines to a severe test.
The interest rate cuts that followed from the inflation target led to a reduction in households'
annual interest expenses of around NOK 40 billion, or around 4 per cent of their disposable
income. The krone depreciated and acted as a buffer. The burden on leveraged companies
was eased and investment projects became profitable in an environment of lower interest
rates. Altogether, monetary policy made a substantial contribution to Norway's resilience to
the crisis.
Well anchored inflation expectations made monetary policy effective - the reduction in
Norges Bank's key policy rate was perceived as a decline in the real interest rate. Other
central banks experienced that there was little scope for reducing the real interest rate to a
sufficiently low level.
This downturn contrasts sharply with the downturn in the 1980s when the interest rate had to
be maintained at a high level to defend the krone exchange rate. At that time, there was a
lack of confidence in both monetary policy and fiscal policy. The costs were substantial.
Unemployment increased, in line with that experienced in some European countries today.
When the financial crisis reached Norway in 2008, we were in a much better position. A long
period of substantial petroleum revenues - and a clear savings plan - had provided us with
considerable leeway. As a result, fiscal policy could also be used effectively during the
downturn. The guidelines stipulate that the government budget deficit shall over time be
equivalent to 4 per cent of the capital in the Government Pension Fund Global, - more in bad
times, less in good times.
A fall in output and employment automatically leads to reduced taxes while unemployment
benefits increase. An important aspect of the fiscal rule is that it allows these effects to
translate into a weaker budget balance. These automatic stabilisers generated strong
impulses through 2009 and 2010, amounting to more than NOK 40 billion for the two years
as a whole.
The increase in the Government Pension Fund Global provided, under the fiscal rule, room
for a NOK 25 billion increase in spending. The government and the Storting approved
additional spending, bringing the overall contribution from fiscal policy to more than
NOK 100 billion, equivalent to 5.5 per cent of mainland GDP, over these two years. Few, if
any other countries provided such strong fiscal stimulus during the crisis.
The guidelines from 2001 provide a clear long-term framework for monetary policy and fiscal
policy. They also provide for cyclical adjustments in economic policy - in part automatically
and in part by discretion. In this way, the guidelines reconcile the need for a flexible approach
to macroeconomic management with the gains brought by a commitment to more long-term
operational objectives.
Lessons from the financial crisis
Even though Norway has fared well through the financial crisis, helped by a sound economic
policy framework, some concerns related to financial stability remain. In particular, there is
one area in which Norway differs from other countries in a manner we perhaps do not like:
Norwegian households are among the most heavily indebted in Europe.
As activity in the Norwegian economy is gathering momentum, pressures are mounting in the
housing market. Consumer confidence has improved and house prices have risen in recent
months. Housing starts are moving up, although from moderate levels.
So far, the low interest rate level has not led to a pronounced increase in household
borrowing. However, the household debt burden is at a historically high level and is expected
to increase further.
Rising debt and property prices are mutually reinforcing phenomena. Higher asset prices
lead to higher collateral values for loans and increased borrowing opportunities for buyers.
This increases the overall risk of the financial system.
While monetary policy and fiscal policy have been anchored within a long-term, operational
framework over the past ten years, there has been no coherent regulatory system for
financial markets. Requirements are currently imposed on individual banks, but without
adequate regard to overall risk in the financial system. The financial crisis highlighted the
need to strengthen the current framework.
Regulation of the financial sector must secure financial stability, but at the same time protect
the public against losses. This is now on the agenda in Norway and in other countries.
I would like to highlight three main aspects of the new regulations that are now underway:
First, the financial crisis revealed that banks held insufficient capital, excessive short-term
market funding and inadequate liquidity buffers. The new Basel III framework sets out stricter
requirements.
Second, the new framework includes macroprudential tools that can be applied when
necessary. Banks may be subject to additional capital requirements if credit growth in the
wider economy is excessive.
Third, the authorities must acquire tools that enable banks to be wound up in an orderly
manner. Owners and creditors - not taxpayers - must bear the losses. The interest rate on
banks' funding will then reflect the risk they take rather than an implicit government subsidy.
The outlook
Despite some concerns regarding financial stability, the Norwegian economy must be
characterised as strong. Productivity fell somewhat through the downturn, but has picked up
again. Compared to our neighbouring countries, unemployment in Norway is low, around
3 per cent of the labour force. In 2010 the return on our oil fund was close to 10 per cent, and
the capital has passed 150 per cent of mainland GDP.
In the twelve months since January 2010, oil prices have risen to over USD 100. This
development is primarily demand-driven, fuelled by strong growth in the global economy, and
in emerging market economies in particular. More recently, oil prices have increased further
as political unrest in North Africa and the Middle East has led to uncertainty regarding future
oil supply.
Norwegian manufacturing industries are also benefiting from high commodity prices.
Increased profitability for many firms and rising real disposable income may boost the
demand for labour. With the prospect of continued high commodity prices and falling import
prices, Norway's terms of trade should hold up in the period ahead.
This, together with a tight labour market, may fuel wage growth. Looking ahead, cost inflation
is most likely to edge up. On the other hand, high net immigration may have a dampening
impact on wages.
In 2010, the population rose by 62 000, an increase of 1.3 per cent. Low unemployment and
a relatively high wage level have made the Norwegian labour market attractive to job seekers
of foreign origin.
Going forward, continued high labour immigration is expected to result in solid growth in the
labour force. At the same time, improved terms of trade will led to higher activity in the
Norwegian economy. Capacity utilisation is expected to revert to a normal level in the second
half of 2011. In the coming years, output in the mainland economy is expected to increase at
an annual rate of 3-4 per cent.
A strong krone and low external price impulses will continue to have a dampening impact on
inflation, and inflation will remain below target for some time. Further ahead, higher capacity
utilisation and profitability in the business sector point to a pickup in wage growth. At the
same time, the fall in import prices will slow.
To conclude: Norway has weathered the financial crisis better than most countries, and the
economic recovery in Norway is now on a firm footing. Currently, interest rates are low, with
the key policy rate at 2 per cent.
In the years ahead, there are prospects for fairly strong growth in the Norwegian economy,
driven by solid income growth, rising investment and high population growth.
On balance, the consideration of stabilising inflation, as well as developments in output and
employment, imply a gradual increase in the key policy rate towards a more normal level.
Thank you for your attention.