Economic
perspectives
Annual address by Governor Ida Wolden Bache
to the Supervisory Council of Norges Bank
Thursday 16 February 2023
Economic
perspectives 2023
This is a day I have been looking forward to for some time. At long last, we
can hold this event as it should be held - at our traditional Norges Bank
venue filled to the brim. Three years have passed since last time - three
years less ordinary.
We have endured a pandemic and the most restrictive measures seen in
a time of peace. We have witnessed Russia's brutal war campaign against
Ukraine. The war is a deep tragedy for the people of Ukraine and a dire
threat to peace and stability in Europe.
Both the war and the pandemic have had far-reaching economic
consequences. Over the past year, inflation has reared its head, with
inflation rates reaching multi-decade highs.
The costs of high inflation have come into clear evidence. What started
as a rise in a few prices ended up as a rise in a broad range of goods
and services prices. Rapid and unexpected price increases are eroding
peoples' finances and are impacting those with small margins hardest.
The surge in inflation is also putting monetary policy and Norges Bank to
the test. It is our responsibility to bring it down. That is something I have
been mindful of during my first year as central bank governor.
The 1970s - high and variable inflation
Let us go back in time 50 years. In the first half of 1973, the global
economy is in full expansion. The preceding few years have been marked
by mounting inflationary pressures (Chart 1).
In Norway, too, prices are rising quickly. "Price problems", as they are
called, are a source of political concern. In summer 1973, the Price
Problems Commission, headed by Deputy Governor Hermod Skånland,
presents its report. The commission recommends closer cooperation
between the authorities and the social partners to bring inflation under
control. But the recommendation is not immediately followed.1
The price problems prove to be much worse than feared. On 6 October,
war breaks out in the Middle East. The war is not only fought with military
weapons, but also with economic weapons. The Arab OPEC countries
impose an oil embargo on the major industrial economies in response
to their backing Israel. Oil prices nearly quadruple. Petrol prices not only
soar, but there are petrol shortages. Those of you a few years older than I
am may remember the Norwegian ban on weekend driving.
The following year, consumer prices in Norway rise by more than 10
percent, triggering a price wage spiral. Workers are compensated for
higher prices, and higher labour costs spills over into consumer prices.
Inflation becomes entrenched.
Towards the end of 1973, the global economy moves into recession.
Inflation begins to come down. Many central banks, including the Federal
Reserve, cut their policy rates. But after a few years, inflation rebounds
(Chart 2).
It is widely believed at the time that monetary policy is poorly suited to
bringing down inflation, as it is primarily fuelled by a rise in commodity
and food prices.2 Other measures, such as price controls and incomes
policy are regarded as more appropriate.
Chart 2 Bringing inflation down in the US was costly
Consumer prices. Four-quarter change. Unemployment as a percentage of the labour force.
Percent.
16 12
Unemployment (rhs)
14 11
Consumer price inflation (lhs)
12 10
10 9
8 8
6 7
4
6
2 5
0 4
1974 1976 1978 1980 1982 1984 1986
Source: Refinitiv Datastream
It turns out that these measures are ineffective over time. It is gradually
recognised that monetary policy must bear more of the responsibility. In
1979, President Jimmy Carter appoints a new Chairman of the Federal
Reserve, the economist Paul Volcker. He is known as a hawk, willing to do
what it takes to break the back of inflation. Under Volcker's leadership,
interest rates were raised sharply. Inflation is eventually brought under
control, but at considerable cost. Between 1979 and 1982, unemployment
in the US nearly doubles.
At the time, Norway has a fixed exchange rate regime. And the exchange
rate target and interest rates are set by the Government, not by Norges
Bank.
In the years after 1973, wages in Norway rise quickly and faster than
among our trading partners. To prevent competitiveness from
deteriorating and unemployment from rising, the Government devalues
the krone. Between 1976 and 1986, the krone is devalued as many as 10
times (Chart 3). Imported goods become more expensive, and inflation in
Norway remains high.
Chart 3 Frequent devaluations in Norway
Krone exchange rate. Index
8.4
Krone in terms of the
8 currency basket index
Weaker krone
Currency band for
the exchange rate target
7.6
Devaluations
7.2
6.8
6.4
6 Stronger krone
5.6
1973 1976 1979 1982 1985 1988
Source: Norges Bank - Historical Monetary and Financial Statistics
The devaluations reflect a well-known economic policy problem. The
authorities can draw up a long-term plan, such as maintaining a fixed
exchange rate. But because it will be tempting to deviate from the plan to
reap short-term gains, any promises to stick to it are of little value. In the
3
economics literature, this is called the "time-inconsistency problem".
A new monetary policy framework emerges
Over the following decades, economic reforms are implemented in both
Norway and other countries. Many of the changes are directly motivated
by the experience of the 1970s.
It had turned out that it was difficult for the authorities to commit to an
objective of price stability. It had also proved impossible to bring about
a permanent decrease in unemployment by pursuing an expansionary
monetary policy over time. Eventually, such a policy will only cause wages
and prices to surge. And if high inflation becomes entrenched, it can be
costly to bring it back down.
In the 1980s and 1990s, central banks in many countries are granted
greater independence from the political authorities. This mitigates the
time-inconsistency problem. Central banks can - and should - make
unpopular decisions when necessary.
Central banks are given the responsibility for ensuring low and stable
inflation. An explicit numerical inflation target is introduced in more
and more countries. The first one to do so was New Zealand in 1990. In
Norway, the authorities continue to pursue a fixed exchange rate policy
for a while, but in 2001, the Government introduces an inflation target in
Norway.4
In the initial period of inflation targeting, central banks are concerned with
building confidence in their targets. Many central banks practice inflation
targeting fairly rigidly and seek to guide inflation back to target relatively
quickly after a deviation. Once confidence is established that inflation
will remain low and stable over time, central banks can give more weight
to other considerations, such as promoting high and stable employment.
Inflation targeting gradually becomes more flexible.
Norway's experience with inflation targeting is positive. In spite of a
global financial crisis and large swings in oil prices, inflation remains low.
Monetary policy is used actively to stabilise the economy. In the revised
monetary policy mandate adopted in 2018, it is specified that monetary
policy shall be forward looking and flexible.
But monetary policy does not operate in a vacuum. An appropriate
division of roles in economic policy is decisive.
The experience of the 1970s also prompts many countries to change
their views on the appropriate orientation of fiscal policy. There is less
emphasis on fiscal policy as an instrument of economic stabilisation and
more emphasis on fiscal sustainability. A number of countries introduce
rules that place limits on government spending. Norway adopts the fiscal
rule, which is designed to address long-term fiscal policy considerations
but at the same time provide flexibility in helping to stabilise the economy.
If a fall in demand triggers a severe economic downturn, reducing
the policy rate is not always enough. Fiscal policy can then make a
contribution. And when there is little spare capacity and inflation is high, it
is advantageous when monetary policy and fiscal policy act in concert.
At the same time, monetary and fiscal policy differ in their effects. The
policy rate affects the economy broadly and primarily impacts aggregate
demand. Fiscal policy measures can, within budgetary limits, be more
targeted when groups or sectors are hit especially hard.
Economic stability also depends on a well-functioning wage
determination process. Wage determination in Norway is highly
coordinated. Compared with in the 1970s and 1980s, the social partners
today take greater account of competitiveness and employment. This
process enables wages to adjust more quickly to cyclical shifts and
contributes to keeping unemployment low.
Norges Bank analyses have found that real wage flexibility, measured as
the correlation between real wage growth and unemployment, has been
stronger in Norway than in most other countries, as shown in the chart
(Chart 4).5
Chart 4 Real wages are flexible
Fall in real wages in response to higher unemployment
Average of
Norway New Zealand UK Denmark Germany France US Sweden Canada 23 countries
0
Source: Norges Bank
5. The results are based on an estimated real wage relation for a sample of OECD countries,
inspired by the earlier analysis of Olivier Blanchard and Lawrence F. Katz (1999). "Wage Dynamics:
Reconciling Theory and Evidence." American Economic Review, 89 (2). In the estimated relation,
real wages depend on inflation surprises, productivity changes, unemployment and the labour
share of income. The latter captures the fact that real wages often rise (fall) whenever real wages
are low (high) relative to productivity. The result that shows a high degree of real wage flexibility in
Norway is in line with other earlier studies. See, eg, Miquel Clar, Christian Dreger and Raúl Ramos
(2007). "Wage Flexibility and Labour Market Institutions: A Meta-Analysis". Discussion Paper No.
2582, The Institute for the Study of Labor (IZA).
Real wage flexibility lessens the risk of wage price spirals. This also
reduces the need to tighten monetary policy in response to a cost shock
than would otherwise be the case. We can bring down inflation while
avoiding a substantial increase in unemployment.
But wage determination alone will not ensure low and stable inflation.
That is the job of monetary policy, in Norway too.
If the foreign exchange market is not confident that monetary policy will
be tightened when inflation rises, the krone may depreciate.6 A weaker
krone pushes up imported inflation. A weaker krone may also drive
up wage growth, because the manufacturing sector's wage capacity
improves.7 Price and wage inflation can become self-reinforcing.
Over the past three decades, low and stable inflation has been the
rule, and in Norway we have avoided prolonged periods of high
unemployment. The reform of the economic policy framework deserves
a large part of the credit, but we have also benefited from global
developments. Globalisation, especially China's expanded role in world
trade in the early 2000s, ushered in a period of low prices for globally
traded goods.
In many countries, the concern was that inflation was too low, not too
high. And some were perhaps misled into believing that inflation was a
thing of the past.
The return of inflation
But it turns out that inflation was not dead (Chart 5). Two events reawaken
inflation.
Chart 5 The return of inflation
Consumer prices. Four-quarter change. Percent
16
Inflation
14
Inflation target
12
10
8
6
4
2
0
1960 1968 1976 1984 1992 2000 2008 2016
Sources: Statistics Norway and Norges Bank
6. See Richard Clarida og Daniel Waldman (2008). "Is Bad News about Inflation Good News for
the Exchange Rate? And, If So, Can That Tell Us Anything about the Conduct of Monetary Policy?"
In: John Campbell (ed.) Asset prices and monetary policy. National Bureau of Economic Research
Books, University of Chicago Press.
7. The mechanism can be described based on the Aukrust model. A weaker krone increases
the wage capacity of the manufacturing sector, which sets the wage norm. Increased wage
capacity can lead to higher negotiated wage increases. Since wage growth in manufacturing sets
the standard for wage growth in the rest of the economy, wage growth in sheltered sectors will
also increase. These sectors can more readily pass on higher costs to prices, driving up overall
inflation. Higher inflation can, in turn, lead to a further krone depreciation, if the foreign exchange
market does not have confidence in monetary policy.
First, the world is hit by a pandemic. We know the story: Much of the
economy is locked down, large-scale government support is provided,
and central banks pursue a highly expansionary monetary policy. In May
2020, Norges Bank reduces its policy rate to zero.
Global supply chain disruptions lead to a rise in prices for a broad range
of goods. When the pandemic restrictions are lifted, economic activity
quickly rebounds in both Norway and other countries. The unusually
high level of saving during the pandemic gives an additional impetus to
demand. And two years after the onset of the pandemic, the Norwegian
economy is operating above potential.
On 24 February 2022, Russia invades Ukraine. Energy and commodity
prices soar. Sharp price increases for important goods hit an economy
already in high gear - reminiscent of developments in 1973.
Higher energy prices and input costs have pushed up business costs,
which in turn have spilled over into consumer prices.
The surge in inflation also reflects strong demand and little spare
capacity in the Norwegian economy. Unemployment is very low, and
many Norwegian firms have reported labour shortages. Wage growth has
accelerated and in 2022 was at its highest since 2008. Strong demand
may have made it easier for firms to pass on higher costs to their own
selling prices.
A sharp rise in prices can also be self-reinforcing. When we analyse
inflation in Norway, we find that a rise in the prices of some goods more
readily leads to a rise in prices of other goods when inflation is high than
when inflation is low.8 Some of the firms in our regional network point out
that customers more readily accept a price increase when many other
prices rise.
When it is widely expected that prices will continue rising rapidly, that
may also have a self-reinforcing effect on inflation. The chart shows
inflation expectations one, two and five years ahead in Norway among
households, firms, specialists in economics and the social partners
(Chart 6).9 Over the past year, inflation expectations over the next few
years have shown a clear increase. Longer-term expectations have
increased less.ll
The expectation that inflation will be high one year ahead is not
necessarily a warning signal. But we must be vigilant towards any
significant increase in longer-term inflation expectations. If high inflation
gains a foothold, it may prove more costly to bring it down again, as
experienced in the 1970s and 1980s.
When my predecessor stood here last year, Norges Bank embarked on
a gradual normalisation of the policy rate (Chart 7). But when inflation
accelerated over spring, it became clear that the policy rate was no
longer appropriate for the economic situation in Norway. Over summer
and autumn, we raised the policy rate faster and in larger steps than had
been the norm.
As mentioned, the main driver of the jump in inflation has been higher
prices for energy and imported inputs. So why does it help to raise the
policy rate in Norway, some might ask.
We cannot influence energy and commodity prices. But by softening
demand, we can help avoid price increases for those prices spilling over
to other prices and wages, and ushering in a period of high inflation.
Chart 7 The policy rate was raised rapidly
Policy rate. Percent
9
8
7
6
5
4
3
2
1
0
2001 2004 2007 2010 2013 2016 2019 2022
Source: Norges Bank
And even if Norges Bank cannot influence global prices in foreign
currency terms, we can influence the exchange rate. A higher interest
rate normally leads to a stronger krone exchange rate and weaker
imported price inflation.
Inflation does not come down on its own. The chart shows our forecasts
from December (Chart 8). We expect energy prices to fall further out
and imported inflation to ease, thereby curbing consumer price inflation
ahead. Domestic inflation is likely to remain elevated for longer.
The labour market is still tight, and business costs have increased. The
effects of this will persist for a while and will contribute to propping up
inflation.
Had we not raised the policy rate, we would have run the risk that
households and firms had started planning for high inflation in price and
wage setting. In that case, it could have been necessary to tighten even
more at a later stage to bring down inflation, which we want to avoid.
The policy rate is being set with the aim of bringing inflation down towards
the target of 2 percent. We could have raised the policy rate higher and
faster than we have so far. Inflation might then have come down faster.
The reason we are taking a while to bring down inflation is that our job is
also to contribute to keeping as many people in employment as possible.
We do not want to restrain the economy more than that required to tame
inflation.
Many people are now worried about trying to make ends meet. Borrowers
are facing higher interest rates on top of high inflation. Many families are
facing tighter budgets, which will be hard for some groups. But by raising
the policy rate, we are helping to bring down inflation.
The road ahead
The past few years have reminded us that price stability cannot be taken
for granted. We have also been reminded that events that constrain the
supply of goods and services can have a substantial impact on prices.
We must be prepared for potential threats to price stability in future too.
Some of the driving forces that kept inflation low in the decades up to the
pandemic may be going into reverse.
Globalisation has been met with growing opposition. Already before
the pandemic, new trade barriers were erected - often to promote
a country's own economy. The pandemic and Russia's invasion of
Ukraine have demonstrated that long global value chains and trade in
strategically important goods make us vulnerable. Lower trade globally
and measures to build more robust supply chains could lead to lower
productivity and higher prices.
Demographic trends are also shifting. In many countries, the working
population is on the decline. This can reduce the supply-side flexibility of
the world economy. Combined, these shifts can make the job of keeping
inflation low more demanding.
How this will play out is highly uncertain. But there is one thing I am
certain about. The global economy must make an absolutely necessary
transition to a low-carbon economy.
There are evermore signals of the urgency to achieve that transition. The
number and intensity of heat waves, floods and droughts are on the rise.
The transition is fraught with uncertainty and proceeding too slowly.
For each year the transition is too slow, the more likely it becomes that
stronger and more costly measures will be needed later on.
To reach the targets, governments have a range of instruments at their
disposal. Carbon pricing is particulary effective in that it sends a clear
message as to what we should do less of and what we need more of. The
rising costs of emissions is one of the main drivers behind today's
investments in renewable energy and more energy efficiency solutions
(Chart 9). We can see that price mechanisms work.
Chart 9 Transition to a low-carbon economy
Carbon price in the EU Emission Trading System. EUR per tonne of
CO2e
100
90
80
70
60
50
40
30
20
10
0
2010 2013 2016 2019 2022
Source: Refinitiv Datastream
The transition will not be seamless. Over the past year, we have seen
fluctuations in energy prices, among other things, that are caused by
the fact that clean energy is not being built up as fast as the use of fossil
fuels is being phased out. We may see more similar price effects ahead.
We must also be prepared for a situation where some prices might for a
transitory period be higher than they will be in the longer run.
The main contribution monetary policy can make to climate transition is
to ensure low and stable inflation. The transition requires investments -
many with uncertain earnings that lie far into the future. It is safer to make
those investments in an environment of low and stable inflation. When
inflation is low, it is also easier to distinguish between changes in relative
prices and the general rise in prices. The signal from, for example, higher
carbon prices is easier to capture. This pushes the transition in the right
direction.
Conclusion
Over the past year, inflation has risen to a high level. Developments are
reminiscent of the situation 50 years ago. Just like then, the economy
has been hit by a cost shock - energy prices have soared. Just like then,
the shock has hit us in an environment of strong demand and little spare
capacity.
But there is also much that is different. Today, we have a solid fiscal policy
framework. We have a coordinated wage determination system where
both parties attach importance to low unemployment and business
profitability. And Norges Bank has been assigned a clear responsibility
for ensuring price stability. We are well poised to tackle inflation while
avoiding large costs in the form of high unemployment.
The Storting has granted Norges Bank independence to set interest
rates. With that independence comes substantial responsibility. The
decisions we make have far-reaching consequences for a great many
people. That is why it is important for us to be open about the basis for
our assessments and the trade-offs we make. It is a sign of a healthy
society that we engage in debate about different issues, including
monetary policy.
Transparency also involves acknowledging uncertainty. The past few
years have reminded us that unexpected events can abruptly change the
economic outlook. But there should never be any doubt that Norges Bank
will do the job we have been given - to ensure low and stable inflation.