Jarle Bergo: Cyclical developments and monetary policy
Speech by Mr Jarle Bergo, Deputy Governor of Norges Bank (Central Bank of Norway), at Regional
network, Region East, Oslo, 10 November 2004.
The text below may differ slightly from the actual presentation. The address is based on the assessments presented at Norges
Bank's press conference following the Executive Board's monetary policy meeting on 3 November, Inflation Report 3/04 and on
previous speeches.
The references and the Charts in pdf-format can also be found on the website of the Norges Bank.
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Price stability, in the sense of low and stable inflation, is the objective of monetary policy in a number
of countries. Historically, the experience of Norway and other countries is that high inflation has
resulted in unstable output and employment. In addition, a fall in the price level will often occur in
tandem with a downturn. The first inflation target was introduced in New Zealand in 1990. Canada
followed in 1991, the UK in 1992, and Sweden and Australia in 1993. A number of other countries
have followed suit. In Norway, the Government issued a regulation introducing an inflation target in
2001. Monetary policy in euro area countries and Switzerland is also aimed at price stability, even
though this is not referred to as inflation targeting in these countries.
Inflation targeting has proved to be particularly appropriate in very open, small and medium-sized
economies. Commodity exports play a particularly important role in several of the countries that were
the first to introduce inflation targeting.
The objective of monetary policy is to safeguard the value of money in the long term, and seek to
contribute to stabilising economic developments in the short and medium term.
The most important contribution monetary policy can make to sound economic developments in the
long term is low and stable inflation. The inflation target provides an anchor for economic agents'
expectations concerning future inflation. We have a very open economy with free capital movements.
Stable inflation expectations also contribute to more stable krone exchange rate expectations.
Inflation targeting means setting the interest rate so as to achieve a numerical target for inflation.
Norges Bank sets the interest rate with a view to stabilising inflation at 2.5 per cent within a reasonable
time horizon, normally 1-3 years. The more precise horizon will depend on disturbances to which the
economy is exposed, and how they affect the path for inflation and output. The inflation target
represents a framework for, not an obstacle to, monetary policy's contribution to stabilising output and
employment. We have chosen flexible inflation targeting, i.e. variability in output and employment as
well as in inflation is given weight.
The objective of monetary policy is low and stable inflation. The instrument is the interest rate. The
interest rate influences inflation with a lag and with varying intensity. As interest rates fall, household
and local government consumption and investment tend to pick up. Higher demand leads to higher
output and employment. Wage growth may pick up. Higher wage growth combined with higher profit
margins will result in higher inflation. Lower interest rates normally lead to a depreciation of the krone.
Imported goods then become more expensive and inflation accelerates. Expectations play a key role
in price and wage formation, and they are influenced by the interest rate. Expectations concerning
inflation and economic stability have considerable impact, not least in the foreign exchange market.
Petroleum activity constitutes an important part of the Norwegian economy. Oil gives us an economic
base that is not available to many other countries. At the same time, the extent of, and fluctuations in,
petroleum activity pose a challenge to economic policy in Norway. In a long-term perspective,
Norway's petroleum wealth is to be distributed across generations. The authorities must therefore
exercise fiscal discipline, taking into account long-term considerations. In the short term, the
substantial capital revenues from the petroleum sector must be managed in such a way that they do
not amplify cyclical fluctuations.
The Government Petroleum Fund was established in 1990 with a view to safeguarding long-term
considerations in the use of petroleum revenues. The idea behind the Petroleum Fund is that the cash
flow from an increase in oil prices should accrue to the Fund and be invested abroad and that the
increase in oil prices should not affect the wider budget. As a result, the increase in the cash flow does
not affect the domestic economy. Likewise, a fall in oil prices does not have an impact on the domestic
economy, but results in a lower accumulation of foreign assets. The Fund thus acts as a buffer against
disturbances. By building up the Fund, the aim of ensuring that several generations will enjoy the
benefits of our petroleum wealth is also taken into account.
In 2001, the Storting adopted new economic policy guidelines in Norway. At the same time as the
inflation target was introduced in monetary policy, a strategy was drawn up for the use of petroleum
revenues over the government budget, i.e. the fiscal rule. The fiscal rule is designed to prevent swings
in the petroleum sector from spreading to the mainland economy. This ensures that petroleum
revenues are phased in at a steady pace. The guideline specifying that only the real return on the
Petroleum Fund is to be used means that the capital in the Fund is not depleted over time.
Norges Bank has no set target for the level of the exchange rate. Nevertheless, developments in the
krone are of considerable importance to interest-rate setting because the exchange rate has an impact
on inflation and output. An important channel for monetary policy is the foreign exchange market and
the krone exchange rate.
Although the krone fluctuates, the krone exchange rate is not particularly unstable compared with
other countries' currencies. The krone exchange rate is the price of our currency measured in a
foreign currency. Developments in other countries are just as important for the krone as developments
in the Norwegian economy. Capital flows freely and flows can change rapidly. This can spill over to
exchange rates and interest rates as well as output and employment. There is a cost involved for
businesses in hedging against fluctuations in the krone. A krone that is stable - but too strong - also
entails social costs in the form of low activity. Likewise, a krone that is stable - but too weak - is a
source of high inflation.
Norway is running a current account surplus as a result of sizeable oil and gas exports. Owing to high
oil prices, the current account surplus is rising this year. An increase in the current account surplus will
normally result in higher net demand for the domestic currency. In Norway, however, the additional
foreign exchange revenues that accrue to the Norwegian state as a result of high oil prices will be
invested in foreign securities through the Government Petroleum Fund. As a result, they will not have
a direct impact on the balance in the Norwegian foreign exchange market. Oil companies hold a large
share of their financial capital in foreign currency, and higher revenues in these companies therefore
results in an increase in capital outflows.
The effects of changes in the current account on net demand for the Norwegian krone can be
illustrated by adjusting the basic balance for transfers to the Petroleum Fund and oil companies'
estimated cash surplus. Even though the current account surplus is increasing from 2003 to 2004 as a
result of high oil prices, the adjusted basic balance is falling. In isolation, this is contributing to a
decline in demand for the Norwegian krone. The decline is due to high import growth, which is
reducing the current account surplus.
In the Government's budget proposal, the use of petroleum revenues remains virtually unchanged
between 2004 and 2005. In spite of this, the krone exchange rate has appreciated recently. This
reflects short-term capital inflows and may indicate that foreign exchange market operators expect that
the use of petroleum revenues will increase in the years ahead. A levelling off or a fall in oil prices and
a stable use of petroleum revenues could reverse these short-term capital flows.
Inflation has been low this year. Consumer price inflation adjusted for tax changes and excluding
energy products (CPI-ATE) was very low up to the end of the summer, but moved up slightly in
September. Inflation is still being curbed by the fall in prices for imported consumer goods, in spite of
the depreciation of the krone through 2003 and the global rise in producer and commodity prices. This
is partly due to the increasing share of Norwegian imports from low-cost countries. Strong competition
and high productivity growth in many industries in Norway have also exerted downward pressure on
inflation.
As a result of the prospect of low inflation and moderate growth in output and employment, the key
rate (the sight deposit rate) was reduced by a total of 5.25 percentage points between December 2002
and March 2004. The key rate has been kept unchanged at 1.75 per cent since then. The reductions
in the interest rate have contributed to the depreciation of the krone. Measured by an index of
44 trading partners (I-44), the krone depreciated through 2003 by almost 11 per cent from its highest
level in January of the same year. The krone has appreciated again somewhat through 2004.
Growth in the world economy has been strong over the past year, particularly in the US and China.
The recovery has also gradually broadened. A number of countries raised their key rates in the course
of 2004. The Federal Reserve has raised its key rate three times, by a total of 3⁄4 percentage point. The
Bank of England has raised its key rate by 1 percentage point. In October, the People's Bank of China
raised its key rate for the first time in nine years.
After rising sharply for several quarters, economic growth in the US slowed somewhat in the second
and third quarters of 2004. Looking ahead, growth among our trading partners is projected to
moderate, but resource utilisation is expected to increase gradually. Increased global activity has led
to rising commodity prices. Oil prices are high. There are still expectations of an increase in
international interest rates, but market participants have lowered their growth and interest rate
expectations as a result of high oil prices.
Growth in the Norwegian economy picked up during the second half of 2003. The low interest rate has
contributed to strong growth in private consumption and housing investment. Activity has picked up in
service industries and the construction sector. High petroleum investment, the global economic
recovery and a weaker krone through 2003 have improved conditions for manufacturing. Profitability is
improving for mainland enterprises. There are signs of renewed growth in investment in a number of
industries. Imports have expanded markedly.
Potential growth in the Norwegian economy is estimated to increase somewhat more than normal this
year as a result of increased competition and rationalisation in many sectors. This will contribute to
fairly high growth in the Norwegian economy without the emergence of constraints on the supply of
labour or productive capital. The high rate of growth in output nevertheless implies that the output gap
will approach zero towards the end of 2004.
The output gap is a measure of the difference between the actual level of output and potential output.
Developments in the output gap provide a basis for assessing cyclical developments and can thus
shed light on domestic price and cost pressures in the economy. It is difficult to know how high
capacity utilisation is at any given time. Output and employment figures are often revised and do not
therefore always present an accurate picture of the current economic situation. Norges Bank therefore
also uses a number of other indicators to gauge the temperature of the Norwegian economy.
It appears that fiscal policy in 2004 will be somewhat more expansionary than assumed in the Revised
National Budget. The Government estimates that underlying nominal spending growth over the central
government budget will be close to 11 per cent between 2003 and 2005. Local government revenues
are estimated to rise by slightly more than 11 per cent in nominal terms during the period. which is
more than nominal growth in mainland GDP.
Employment has picked up. The number of persons employed in the second quarter of 2004 was
0.2 per cent higher than in the same quarter of 2003. Employment growth has mainly occurred in retail
trade, commercial services, education and health and social services. Manufacturing employment is
still falling. Companies often wait to increase employment until the recovery has gained a firm footing.
Compared with the recoveries in 1982 and 1991, employment growth in the current recovery has been
weaker relative to output growth. The moderate increase in employment indicates that companies are
still reaping the benefits of rationalisation measures.
Household demand is one of the most important driving forces in the Norwegian economy. Low
interest rates, high growth in real wages and rising housing wealth are stimulating private
consumption. Consumption is projected to rise by about 5 per cent in 2004, then slow through the
projection period as a result of lower growth in real disposable income. Looking ahead, an increase in
employment and a tighter labour market are expected to result in somewhat higher wage growth. For
2005, the Government has proposed income tax reductions for households, but the effect on real
disposable income will be partly offset by a higher rise in prices as a result of the increase in VAT.
Debt accumulation in the household sector has been approximately 11 per cent in the last year. Debt
has risen at a markedly faster pace than income. Our projections are based on a gradual increase in
the interest rate in line with forward interest rates. Rising debt and higher interest rates will contribute
over time to lower growth in household disposable income.
In the first three quarters of 2004, imports increased markedly compared with the same period last
year. This may indicate that some of the growth in demand has resulted in an increase in imports
instead of higher domestic output. Imports as a share of mainland GDP are rising. This is a result of an
increase in the international division of labour, due in part to the removal of trade barriers. The rise in
the share of imports must also be seen in relation to low prices for imports from many low-cost
countries and the weak competitiveness of domestically-oriented industries.
The deterioration in Norway's competitiveness relative to other countries stems from high wage growth
over several years since 1998. The nominal krone exchange rate measured by the trade-weighted
index (TWI) is now approximately at the level prevailing in the mid-1990s, while labour costs in
manufacturing have risen considerably more than among our trading partners in the same period. The
business sector is still burdened with the loss in competitiveness that can be attributed to high wage
increases in the period 1998-2002. The exposed sector has been scaled back. Companies that are
still in operation may be in a better position to cope with the high wage level. A more efficient service
sector may also have strengthened the export industry. Nevertheless, costs may have negative impact
on activity and employment.
The cost level with the current krone exchange rate is close to 15 per cent higher than in the
mid-1990s and about 6 per cent higher than the average for the past 30-35 years. Norwegian
businesses are losing market shares in domestic and foreign markets partly because of the strong real
krone exchange rate. In the face of major restructuring as a result of shifts in the international division
of labour, it is a disadvantage for Norwegian business and industry that costs are high.
Reports from Norges Bank's regional network confirm the picture of an expanding economy. In the
August/September round of interviews, our contacts throughout the country reported continued growth
in all the main industries. In Region East, the rate of growth in manufacturing is somewhat lower than
earlier this year, while growth in the building and construction sector is increasing. Residential
construction is still driving activity in this sector. Although commercial building activity now appears to
be picking up in other parts of the country, this does not as yet apply to Region East. Business sector
demand for services is rising. The market for commercial services and IT and telecommunications
services is showing marked improvement. The retail trade sector reports rising demand, particularly for
consumer durables such as cars and furniture. Our contacts in services and retail trade report a
moderate increase in investments in the year ahead.
Signals from the regional network indicate that employment is continuing to increase in the building
and construction sector, while manufacturing reports a slight decline. Employment in the service sector
is rising for the first time since the network was established in October 2002. Directorate of Labour
figures show that unemployment has fallen most in Region South and Region East since the
beginning of 2004. In Region East, an important sector is commercial services, accounting for close to
15 per cent of employment. It is in this sector, in addition to manufacturing, that unemployment has
fallen most on a nationwide basis.
Since July, oil prices have varied between USD 34 and 52, the highest nominal levels recorded.
Measured in real prices, oil prices are nonetheless clearly lower than the levels recorded in the
beginning of the 1980s. In contrast to earlier periods of sharply rising oil prices, the main reason
behind the current rise in oil prices is a surge in demand and limited excess production capacity.
Growth in oil demand has been particularly strong in regions where production is relatively
energy-intensive, such as China and other non-OECD countries. China alone accounts for about 1/3
of global growth in oil demand this year. Moreover, there has been a marked reduction in excess
production capacity in OPEC countries. Small production problems have therefore affected prices
more than would otherwise have been the case.
In the short term, oil prices constitute the greatest risk to the outlook for the global economy. High oil
prices may contribute to a sharper-than-expected slowdown in global economic growth. This could in
turn result in lower demand and lower commodity prices. High oil prices have mixed effects on the
Norwegian economy. Lower demand abroad will have a negative impact on parts of the Norwegian
economy. At the same time, domestic demand is normally stimulated by higher petroleum investment.
The balance in the Norwegian foreign exchange market will not be affected to any appreciable extent.
So far, the effects of high oil prices on developments in the real economy have been relatively limited.
Credit developments in the past year have given ambiguous signals to our interest-rate setting.
Growth in household debt is high. Enterprises have been reducing their debt for some time, but
developments over the past months may suggest that this trend has been reversed.
Norwegian enterprises and households borrow primarily at variable rates. Loans with no form of fixed
rate agreement account for over 80 per cent of the value of loans to the household and enterprise
sector. The current interest rate level is very low. Long-term investments cannot be made based on
the assumption that this interest rate level will persist. According to money market expectations, the
interest rate will eventually stabilise at close to 51⁄2 per cent. This interest rate, plus a premium for
banks' margins, provides a more realistic indication of the interest rate level that will apply over the
loan's life than the variable interest rates prevailing today.
Growth in the Norwegian economy is now solid. It appears that growth will also be high in 2005. From
2006, growth is expected to slow gradually to, and eventually somewhat below, the level of growth in
potential output. In Inflation Report 3/04, the output gap is projected to become clearly positive in the
course of 2005 and to remain positive until the end of the projection period. Inflation is projected to
show a marked increase over the next year. In the short run, the depreciation of the krone in 2003 will
continue to exert upward pressure on imported consumer goods. We also assume that the
pronounced fall in prices for some goods and services last autumn will to some extent be reversed. In
the somewhat longer term, inflation will show a more gradual rise. Higher resource utilisation in the
Norwegian economy will lead to somewhat higher wage growth and will also make it possible for
enterprises to increase their operating margins. However, inflation will still be restrained by low
external price impulses. The positive contributions from the exchange rate depreciation in 2003 will
unwind in the course of spring 2005. The contribution from the exchange rate to inflation will then
gradually become slightly negative. There are prospects that inflation will reach the inflation target
towards the end of the projection period.
There is uncertainty surrounding the projections. The projections are partly based on our analysis of
relationships in the economy, the exchange rate assumption and the forward interest rate assumption.
We can give some indication of the uncertainty surrounding the projections on the basis of historical
deviations between projected and actual price developments. Based on these calculations, inflation at
end-2007 is projected with a probability of 50 per cent to be between 1.75 and 3.25 per cent.
Consumer prices may show erratic variations from one month to the next. These fluctuations may be
due to temporary conditions. At other times, they may reflect more lasting changes. When the figures
deviate from our projections, more observations are therefore needed before an assessment can be
made of whether inflation is in line with the projections.
The projections in the Inflation Report are based on the assumption that the interest rate moves in line
with financial market expectations. This implies that Norges Bank maintains the key interest rate at the
current level in the period to summer 2005, with a gradual increase thereafter.
It is the Executive Board's assessment that the projections seem to provide a reasonable balance
between the objective of increasing inflation and at the same time avoiding excessive growth in output
and employment. The projections imply a sight deposit rate in the interval 11⁄4 - 21⁄4 per cent in
mid-March 2005. Uncertainty as to the effects of previous monetary policy easing and the unusually
low interest rate level imply, on the one hand, that we should exercise caution with regard to further
interest rate reductions. On the other hand, the prospect of continued low inflation for a period ahead
implies that wide deviations from projected economic developments would be required before interest
rates should be increased. The prospect of continued low inflation in Norway also implies that we
should lag behind other countries in setting interest rates at a more normal level.
At its monetary policy meeting on 3 November, the Executive Board decided to leave the sight deposit
rate unchanged at 1.75 per cent. At this meeting, the Executive Board did not see any clear
alternatives to leaving the interest rate unchanged. In reaching its decision, the Executive Board has
weighed the objective of bringing inflation back to target against the risk that output growth may
eventually be too high.