Svein Gjedrem: Monetary policy and aspects of economic developments
Speech by Mr Svein Gjedrem, Governor of the Central Bank of Norway, Ålesund, 12 October 2005.
Please note that the text below may differ slightly from the actual presentation. The speech is based
on the assessments presented at the Central Bank of Norway's press conference following the
Executive Board's monetary policy meeting on 21 September, Inflation Report 2/05 and on previous
speeches.
The Charts in pdf format can be found on the Central Bank of Norway's website.
* * *
Monetary policy in Norway is oriented towards low and stable inflation. This is also the most important
contribution monetary policy can make to sound economic developments in the long term. Low and
stable inflation provides the economy with a nominal anchor. This contributes to predictability for those
taking decisions about saving and investment today, although the result depends on how the economy
develops in the future. In addition, we will seek to prevent unduly wide fluctuations in output and
employment in the short and medium term. In the long term, output in an economy is determined by
the supply of labour, capital and technology.
Monetary policy influences the economy with long and variable lags. This means we must look ahead
when setting interest rates. I would therefore like to comment briefly on our assessment for the next
three years, based on the analyses in the most recent Inflation Report published in June (Inflation
Report 2/05) and updates at the most recent monetary policy meetings.
The economic situation
The Norwegian economy is in an upturn and is now expanding at a brisk pace. Inflation remains low,
but has edged up since last year. The risk of a fall in the level of prices and markedly lower inflation
expectations has diminished. At the same time, there appears to be little risk that inflation will rapidly
move up to a level that is too high.
The interest rate reductions through 2003 and into 2004 have resulted in low real interest rates. For a
period, the real interest rate has been considerably lower than normal. The low level of interest rates is
supporting the high activity level in the Norwegian economy.
The economic upturn is broad-based. At the beginning of the recovery, activity was primarily fuelled by
private consumption, traditional exports and petroleum investment. In addition, growth in mainland
fixed investment has gradually gained considerable momentum.
Monetary policy easing and low inflation have resulted in strong growth in household real disposable
income. Private consumption and housing investment have risen sharply. House prices have
continued to rise. Debt growth remains high.
The economic upturn has continued this year. High petroleum investment, the international upturn and
higher commodity prices have boosted output and earnings in the manufacturing sector. Statistics
Norway's business tendency survey indicates continued favourable prospects for Norwegian
manufacturing. Activity is expected to increase in service industries and the construction sector in the
near term.
Capacity utilisation in the Norwegian economy now appears to be close to a normal level. In
manufacturing, capacity utilisation is close to its historical average. According to Norges Bank's
regional network, about 40 per cent of companies will have some or considerable difficulty in
increasing production.
Even though growth in the Norwegian economy has been high for a long period, substantial pressures
have not yet emerged in the labour market. The rise in the number of employed in the first half of the
year was fairly modest in relation to output growth. This may be due to lagged effects of the sharp fall
in sickness absence through 2004. In many companies, the large increase in available person-hours
was probably not fully utilised immediately. A considerable share of output growth may be the result of
improved utilisation of company workforces. According to the quarterly national accounts, employment
rose by 0.5 per cent from the first half of last year to the same period this year. Measured by the
Labour Force Survey (LFS), the number of employed rose by 12 000 from May to June and by a
further 2 000 from June to July.
The use of foreign labour has increased in the year that has passed since the enlargement of the EU.
The scope is relatively moderate, but appears nonetheless to have reduced bottleneck tendencies in
some industries where demand has increased sharply. Traditionally, many workers from our
neighbouring countries have contributed when the labour market in this country has been tight. In
2001, close to 30 000 persons resident in Sweden were employed in Norway for all or part of the year.
Swedes who have registered as residents of Norway come in addition.
An increased supply of labour from new EU member states to Norwegian enterprises may lead to a
higher-than-normal increase in potential output for a period.
Many of the foreign workers work for a shorter period in Norway without being employed in a
Norwegian enterprise. Examples include foreign contractors and self-employed in the construction
industry who carry out various building projects in Norway, as well as others who carry out other types
of projects. Aker Kvaerner, for example, has contracted 300 consultants based in India to work on the
Ormen Lange project in North-West Norway. An increase in the use of these short-term contracts will
appear as an increase in Norway's service imports, and contributes to increasing the supply of goods
and services without drawing on domestic resources.
Protectionist measures may dampen the impact on the Norwegian economy of an increased supply of
labour from the new EU member states. The transitional rules from 1 May last year stipulate that
foreign workers shall have Norwegian wages and working conditions. At the same time, resources and
appropriations for the supervision and control of foreign workers' wages and working conditions have
been increased. As a result, foreign suppliers of services are losing much of their competitive edge in
relation to Norwegian enterprises.
The latest Directorate of Labour figures show that seasonally adjusted unemployment was
3.4 per cent in September. This is in line with the developments we envisaged in the June Inflation
Report (2/05). Statistics Norway's Labour Force Survey (LFS) presents a somewhat weaker picture of
unemployment.
Registered unemployment is on the decline in all regions. North-West Norway is no exception; this
region has experienced a marked fall in the number of unemployed.
Manufacturing is important for employment in North-West Norway. The share of employment in
manufacturing in this region is higher than the national average. Activity is to a great extent
export-oriented, as in the fishing, furniture and processing industries. Developments in the krone
exchange rate are therefore important for North-West Norway. In this context, fiscal policy and the use
of petroleum revenues play a key role. North-West Norway is, perhaps more than any other region,
dependent on the fiscal rule being followed.
With the current level of oil and gas production, shipyard order books are full. Large-scale projects
such as Ormen Lange also have local spillover effects. The project provides contracts for
subcontractors, and has also resulted in improvements in infrastructure in local areas.
Information from Norges Bank's regional network is important for Norges Bank's analysis of the
Norwegian economy. Information about the state of the Norwegian economy is available earlier than
information provided by official statistics, and it is useful to have closer contact with the labour market
and business and industry throughout the country.
According to the latest reports from the regional network, the situation in Region North-West is very
favourable. Enterprises in the network report that employment is high and profitability is rising in
tandem with the level of activity. This applies both to manufacturing for the domestic market and to the
export industry. The construction industry will soon reach capacity limits. Enterprises in the region
envisage a slight rise in prices in the period ahead.
Inflation decelerated markedly from summer 2003 and continued to fall in the beginning of 2004.
Consumer price inflation has subsequently picked up, albeit at a gentle pace. In September, the
year-on-year rise in consumer prices adjusted for tax changes and excluding energy products
(CPIATE) was 1.3 per cent. Adjusted for the interest rate's direct effect on house rents, the year-on-year
rise in the CPI-ATE is estimated at 1.5 per cent in September. The CPI rose by 2.0 per cent in the
same period.
Prices for domestically produced goods and services rose by 2.0 per cent in the twelve months to
September this year. Higher capacity utilisation is providing the basis for higher margins in some
industries. Service prices, which showed little rise last year, have increased again this year. In many
industries, including the airline industry, where price competition is strong, low profitability has led to
an increase in prices. High oil prices have also resulted in increased prices, for example for transport
services.
On the basis of the pay increases agreed upon in this year's wage settlement, combined with the
estimates for wage drift and wage carry-over, annual wage growth is projected at around 31⁄2 per cent
this year. Lower-than-projected wage growth may be related to the fact that there were few signs of
improvement in labour market conditions prior to this year's wage settlement. Lower-than-projected
consumer price inflation last year may also have contributed. Low wage growth will in turn contribute
to curbing the rise in prices for domestically produced goods and services.
Prices for imported consumer goods have continued to fall. The decline in prices may reflect high
productivity growth in the production of some goods and large investments to increase production
capacity, particularly in China. This has led to strong competition and a low rise in prices for
internationally traded goods. The shift in imports, for example clothing imports, towards low-cost
countries seems to be substantial again this year.
Structural changes in world trade have been important for the Norwegian economy, not least for the
rise in prices for imported goods and services. The shift in imports towards low-cost countries has
come gradually. We have expected that the import pattern would gradually become more stable, but if
the shift continues, the price-dampening effects of increased imports from low-cost countries in Asia
and Central and Eastern Europe may persist longer than assumed.
The change in China's exchange rate regime in July, with a 2 per cent revaluation of the Chinese
currency, may over time have an impact on price developments for imported consumer goods.
The global economy
Economic growth among trading partners appears to be somewhat lower this year than in 2004. In the
years ahead, growth is expected to be relatively stable.
The outlook for growth in different regions indicates that the imbalances in the global economy, with a
large deficit in the US and large surpluses in a number of other countries, will persist.
There are particularly large imbalances both in the US balance of trade and current account.
Persistent trade deficits have pushed up US foreign debt to a high level. This is partly due to the
federal budget deficit. Moreover, US households have a high level of consumption and a low level of
saving. This may be related to a more rapid rise in the US population than in other OECD countries.
This suggests in isolation that saving in the US is somewhat lower and investment somewhat higher,
but the impact is now considerably greater than implied by demographic factors alone.
The imbalances may persist, and may increase. International capital markets are deep and liquid with
an ample supply of credit for US borrowers. So far, there is no indication that the US has problems in
financing its deficit. If creditors begin to fear a fall in prices and withdraw from the market, substantial
corrections may nevertheless be triggered. This may lead to higher interest rates and perhaps also a
fall in US equity markets that spills over to other countries' financial markets. In that case, the dollar
will also depreciate.
The household debt burden in the US may be another source of instability if households abruptly
reduce both housing demand and consumption.
Strong demand in the US has sustained growth in the world economy. We assume that growth will
slow somewhat in the US in the period ahead. A more pronounced downturn cannot be ruled out,
however. An abrupt and pronounced downturn might fairly rapidly lead to declining growth in the entire
OECD area.
The US is not the only source of trade imbalances. They also reflect very low growth in continental
Europe and largely export-based growth in Asian countries. Therefore, countries other than the US
must also contribute in order to prevent a decline in world economic growth.
With limited domestic growth capacity and high unemployment, many industrial countries are poorly
equipped to cope with a weaker dollar and lower demand from the US. The challenges are perhaps
particularly demanding in some large European countries, whereas it appears that the Japanese
economy is becoming more self-driven.
There is also a risk that large imbalances in world trade and low employment in Europe will trigger
protectionism, which could reduce growth capacity even further. A pronounced slowdown in growth in
the entire OECD area is also likely to lead to markedly slower growth in China and emerging
economies in Asia because exports are an important driving force behind growth in the region. This
could lead to an appreciable fall in prices for oil and other commodities and weak developments in the
shipping industry. Just as Norway has benefited strongly from the sharp international upswing in
recent years, the Norwegian economy could be affected by such a downturn.
The recent change in China's exchange rate regime and the revaluation of the Chinese currency by 2
per cent will probably not cause substantial changes in the imbalances in world trade. At the same
time, daily fluctuations of 0.3 percentage point between the yuan and the dollar are now possible. This
allows for considerable variation and it cannot be ruled out that more pronounced changes in the
same direction will gradually occur. So far, the Chinese authorities have maintained a stable course.
It will probably be appropriate for both China and other Asian countries to shift more of their production
towards domestic markets, which will reduce the large current account surpluses as well as curb the
build-up of the official foreign exchange reserves. As part of this adjustment, the relative cost level will
gradually increase.
Very high growth in demand for oil is one of the factors behind record high oil prices. In the first half of
this year, the price of Brent Blend fluctuated for the most part between USD 45 and USD 55 per
barrel. Oil prices have risen further this past summer, gradually reaching more than USD 60 per barrel.
In the last few days, prices have been falling.
Oil futures have also increased.
Little excess production capacity in OPEC countries, combined with the prospect of lower production
in non-OPEC countries, has probably influenced oil prices. At the same time, there are prospects of
continued strong growth in demand in important oil-importing countries, such as China and a number
of other emerging economies.
Rising or persistently high oil prices may gradually dampen growth among our most important trading
partners. The slowdown may occur gradually and will not necessarily be very pronounced, but there
are now growing concerns that high oil prices may result in higher inflation and inflation expectations.
High oil prices have a different impact in Norway than in oil-importing countries. A rise in oil prices
improves our terms of trade. Other countries perceive this as an externally imposed tax.
As a result of persistently high oil prices and expectations that oil prices will remain high, investment in
the petroleum sector may reach record levels this year. The investment intentions survey for the
petroleum sector points to very high growth.
The scale and spillover effects of petroleum investment are highly uncertain. The last time petroleum
investment showed a strong increase, in 1997/1998, the rise was considerably sharper than had been
assumed. At the same time, the rest of the Norwegian economy was experiencing an upturn. The
unexpected increase in petroleum investment contributed to substantially stronger-than-projected
economic growth. If oil prices rise further or remain at the current high level for a long period,
petroleum investment may again reinforce the cyclical upturn more than projected.
Monetary policy
The analyses in Inflation Report 2/05 are based on a baseline scenario where the key rate shadows
forward interest rates up to 2007, and then rises somewhat more rapidly. The krone exchange rate is
assumed to shadow the forward exchange rate, which remains broadly unchanged over the next three
years. Capacity utilisation in the Norwegian economy is expected to increase this year and next and
exceed its normal level. There are prospects that inflation will gradually pick up and be close to 21⁄2 per
cent at the three-year horizon. Since the publication of the June Inflation Report, prices for
domestically produced consumer goods have risen slightly less than expected. At the same time, oil
prices have been somewhat higher than assumed. Energy prices are pushing up consumer price
inflation.
New information since the publication of the June Inflation Report does not provide grounds for
changing the assessment of developments in the real economy. Growth among trading partners
seems on the whole to be approximately as expected in the June Inflation Report, but the risk of more
sluggish developments has increased, according to the IMF and the OECD. High oil prices may result
in somewhat higher inflation abroad than previously projected.
The objectives of bringing inflation back to the target of 2.5 per cent and anchoring inflation
expectations imply a continued low interest rate.
On the other hand, there are expectations that high output growth will persist. The objective of
stabilising developments in output may, in isolation, imply a higher interest rate. Inflation is gradually
picking up. High capacity utilisation may generate a continued sharp rise in property prices and
household borrowing. This could be a source of instability in demand and output in the somewhat
longer run.
The Executive Board's assessment in the June Inflation Report was that the interest rate may
gradually - in small, not too frequent steps - be brought up towards a more normal level if economic
developments are approximately as projected in the Report. Such an interest rate path was
considered to provide a reasonable balance between the objective of stabilising inflation at target and
the objective of stabilising growth in output and employment. It was the Executive Board's assessment
that the sight deposit rate should lie in the interval 13⁄4 - 23⁄4 per cent in the period up to the publication
of the next Inflation Report on 2 November.
Following the monetary policy meeting on 21 September, the Executive Board stated that
developments in output, demand and underlying inflation had been consistent with the projections in
the June Inflation Report. The Executive Board also stated that its monetary policy strategy and
assessments indicate that the interest rate should be gradually increased in the period ahead. One
option was to increase the interest rate at this meeting, but the Executive Board found it appropriate to
leave the interest rate unchanged.
Household credit growth
Monetary policy easing through 2003 and into 2004 has resulted in low real interest rates. Short-term
real interest rates may now be considerably lower than the level that implies long-term balance in the
economy - the neutral real interest rate. A low real interest rate, and expectations of a continued low
real interest rate, will contribute to stimulating activity even after the effects of the interest rate fall
unwind.
Although the projections are based on rising real interest rates, the real interest rate will be lower than
the neutral rate during the entire period. The monetary policy stance is therefore expansionary. So far,
the effects do not appear to be stronger than expected, but we have little experience of such low
interest rates. How quickly prices and wages will react when growth in output and employment picks
up is uncertain. There is also a risk that an interest rate that is kept low for a longer period may lead to
expectations of a persistently low interest rate. This may involve a risk that capacity utilisation will
remain high and that inflation will eventually overshoot the target.
Household debt has increased at a faster pace than income over the past ten years. Norges Bank's
calculations indicate that debt growth may largely be due to the sharp rise in house prices in recent
years. Higher house prices have a fairly prolonged effect on household debt growth. Even though the
rise in house prices is expected to slow, credit growth will therefore remain high for a fairly long period.
Given the assumptions underlying our projections, it is likely that debt will continue to grow at a faster
pace than disposable income through the entire projection period.
The household debt burden has increased over the past year and is now record high. The interest rate
burden is, however, relatively low. A normalisation of interest rates will increase households' net
interest expenses, but according to the projections the interest burden will not be higher than it was at
the end of the 1990s. Households will be vulnerable if unexpected disturbances result in
higher-thanexpected interest rates.
Challenges ahead
Petroleum activities give us an economic base that is not available to many other countries. But it also
presents us with many challenges.
First, our petroleum resources are part of our national wealth. When oil is extracted and sold,
petroleum wealth is transformed into financial assets. This wealth belongs not only to our generation,
but also to future generations. It is reasonable to distribute our petroleum wealth equitably among
generations.
The size of the cash flow from petroleum activities also varies considerably. If petroleum revenues
were to be used as they accrue, this would lead to wide fluctuations in demand in the Norwegian
economy. Cyclical fluctuations would be much more pronounced.
Third, the use of petroleum revenues will have an impact on competitiveness in Norwegian business
and industry. The level of and fluctuations in the use of petroleum revenues will have a considerable
impact on the exchange rate and thus on growth in regions with extensive export activities.
The Government Petroleum Fund was established in 1990 with a view to safeguarding long-term
considerations in the use of petroleum revenues. In March 2001, the fiscal rule and new guidelines for
monetary policy were introduced. The fiscal rule implies that the central government budget deficit
shall be equivalent over time to the expected real return on the Government Petroleum Fund. The new
guidelines for economic policy received broad support in the Storting.
The rule specifying that only the real return on the Petroleum Fund is to be used means that the
capital in the Fund shall not be depleted. The capital in the Petroleum Fund will increase as long as
there is a positive cash flow (to the central government) from petroleum activities. When the
conversion from petroleum wealth to financial assets has been completed, the objective will still be to
restrict withdrawals so that the real value of the Fund's capital is maintained - in principle, indefinitely.
The Petroleum Fund functions as a buffer against movements in the krone exchange rate when oil
prices vary. The cash flow from an increase in oil prices will accrue to the Fund and be invested
abroad. In this way, the Fund contributes to limiting an appreciation of the krone and maintaining a
stable exchange rate. At times, it seems that participants in the foreign exchange market
underestimate the Petroleum Fund's buffer mechanism.
Since summer 2004, the krone, measured by the trade-weighted exchange rate index (TWI), has
appreciated by about 5 per cent. The chart shows the exchange rate and the price of oil since 1999.
There does not appear to be any clear relationship between the nominal exchange rate and oil prices
over time. The krone has appreciated in periods with high oil prices, but the same has occurred when
oil prices have been low.
The correlation between the oil price and the krone exchange rate has varied over time. Since inflation
targeting was introduced in March 2001, the average correlation has in fact been zero. This result is
worth noting and indicates that the export of capital via the Petroleum Fund has protected the nominal
exchange rate from price fluctuations in the oil market. Therefore, there is cause for some optimism
concerning the possibility of shielding the mainland economy from the effects of swings in oil prices. In
the long run, however, petroleum revenues and their use will affect the level of costs in Norway.
An increase in oil prices may generate expectations of higher use of petroleum revenues in the future,
particularly if high oil prices are expected to persist. Such expectations may exert appreciation
pressures on the krone. It may also generate expectations of higher returns in the Norwegian stock
market than in foreign markets, which also can and has contributed to an appreciation of the krone.
Our assessment is that developments in oil prices and an increased cash flow have been responsible
for the appreciation of the krone since the spring of 2004.
We are approaching a peak in petroleum production in Norway and must expect a substantial
reduction in the next decades. In addition, there is considerable uncertainty associated with future
petroleum production. In recent years, there has been a tendency to overestimate projections for
production a couple of years ahead. It is especially demanding to estimate production for the many
large fields that have reached maximum capacity.
The fiscal rule provides a long-term anchor for fiscal policy. It provides a stable framework that
contributes to curbing some of the fluctuations in the Norwegian economy.
Nonetheless, the use of petroleum revenues in the Norwegian economy has been increasing over the
past few years. Petroleum investment has increased significantly. In addition, the government uses
more of the petroleum revenues than before. Growth in public expenditure started to accelerate in
1997 after having been low in the mid-1990s. Spending growth has also been fairly strong in recent
years, but perhaps somewhat slower than earlier.
The fiscal rule for the budget implies that the government can use 4 per cent of the Fund over time.
This year, around 6 per cent is being used. The deviation partly reflects an unexpected shortfall in tax
revenues in recent years. The government budget deficit is the difference between total revenues and
total expenditure. They each account for about half of total GDP in Norway. Even small deviations
from expenditure and revenue projections can have a major impact on the deficit. Exchange rate
changes will also lead to fluctuations in the value of the Petroleum Fund. For these reasons alone, the
use of petroleum revenues may in periods deviate from the 4 per cent rule. Spending was also
increased in response to the economic downturn. We can, therefore, safely affirm that the fiscal rule
has been normative for fiscal policy.
Together with the fiscal rule, the monetary policy guidelines provide the framework for economic policy
in Norway. The various components of economic policy have varying effects. This is why they have
different functions:
•
Monetary policy steers inflation in the medium and long term and can also contribute to
smoothing swings in output and employment.
• The central government budget - growth in public expenditure - influences the krone and
the size of the internationally exposed business sector in the medium term. Government
expenditure and revenues must be in balance in the long term.
•
Wage formation, the structure of the economy and incentives determine how well and how
efficiently we utilise our labour resources and other economic resources.
There is also an interaction:
•
In its budget resolutions, the government authorities will attach importance to the effects of
the budget on the Norwegian economy and will therefore take account of interest rate
effects. In this way, they avoid a situation where growth in public expenditure and the interest
rate push the economy in different directions.
• With a known monetary policy response pattern, the parties to the centralised income
settlements can take interest rate effects into account when wage increases are negotiated.
•
Moreover, the parties to public sector negotiations can take into account that the higher pay
increases are, the fewer people that can be paid over government budgets. The interaction
here became clear when public sector employment fell after the expensive wage settlement
in 2002.
In the years following 1997, with strong growth in public expenditure, the fiscal rule pointed to a
continued increase in the use of petroleum revenues. We had to expect that this increase would lead
to a deterioration in the competitive position of Norwegian manufacturing, either through higher wages
or through an appreciation of the krone exchange rate, and with Norway's relatively higher wage
growth, competitiveness has been weakened by approximately 15 per cent since the mid-1990s.
The krone exchange rate has been influenced by high oil and gas prices and prices for other
Norwegian export goods. Monetary policy has also influenced the path for Norway's relative costs, but
the nominal value of the krone is about the same as ten years ago. Strong growth in public
expenditure and expectations of moderately higher growth in the use of petroleum revenues now
seem to have been factored into the cost level.
Even at the beginning of the oil age in Norway in the early 1970s, the relationship between the use of
petroleum revenues and changes in industry structure was raised as an issue. Manufacturing industry
was scaled back in waves in the course of this period. The last wave occurred around the turn of the
millennium, but a substantial decline also occurred in the periods 1977 to 1984 and 1987 to 1992.
Prior to these periods, the manufacturing sector's competitiveness deteriorated. Today, about 55, 000
fewer persons are employed in manufacturing than was the case in 1998.
The share of our imports that can be covered by current petroleum revenues and some of the
Petroleum Fund will gradually diminish. Competitiveness must therefore be improved.
Competitiveness may have to return to a level we have not experienced since petroleum production
began. Rough estimates indicate that the real exchange rate that safeguards the balance of trade
when Norway's oil wealth no longer has the same weight in the economy will be more in line with the
real exchange rate we had in the 1960s.
Thank you for your attention.