Svein Gjedrem: Monetary policy and the economic situation
Speech by Mr Svein Gjedrem, Governor of the Central Bank of Norway, at a meeting of the Troms
Fish Farming Association, Harstad, 13 March 2003.
The address is based on the assessments presented at Norges Bank's press conference following the Executive
Board's monetary policy meeting on 5 March and on previous speeches. Please note that the text below may
differ slightly from the actual presentation.
The Charts in pdf can be found on the Norges Bank's website.
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The operational target of monetary policy as defined by the Government is inflation of close to
21⁄2 per cent over time. Norges Bank sets the interest rate so that future inflation will be equal to the
inflation target of 21⁄2 per cent. Interest rates were reduced this winter in response to the change in the
inflation outlook. The inflation projections were revised downwards as a result of weaker cyclical
developments in the world economy, a sharp drop in interest rates internationally and a strong krone.
In addition, the Norwegian business sector is feeling the effects of the high Norwegian cost level.
Moreover, growth in domestic demand has slowed. Household purchasing power has been reduced
as a result of higher electricity prices. The weak prospects at home and abroad are in turn having an
impact on the Norwegian labour market and the outlook for wage growth and inflation in the years
ahead.
The inflation target provides economic agents with an anchor for their decisions concerning saving,
investment, budgets and wages. Households, businesses, public entities, employees and employers
can base decisions on the assumption that inflation in Norway will be 21⁄2 per cent over time.
High demand for goods and services and labour shortages normally point to higher inflation in the
future. When interest rates are increased, demand falls and inflation is kept at bay. When demand is
low and unemployment rises, inflation will tend to slow. Interest rates will then be reduced. The
inflation target is a vehicle for, not an obstacle to, monetary policy's contribution to stabilising output
and employment. This intention is also expressed in the Regulation on Monetary Policy.
The inflation target of 21⁄2 per cent is broadly in line with the inflation targets of our trading partners. It
is also an anchor for developments in the krone exchange rate. The krone fluctuates. We have open
trade with other countries and free capital movements. We do not have the instruments to fine-tune
the krone exchange rate.
The krone has been strong. As a result, prices for imported goods have fallen. This has led to low and
stable inflation in spite of sharp wage growth.
The krone exchange rate fluctuates. This is not surprising because other countries' currencies also
fluctuate. The Swedish krona, sterling and the New Zealand dollar have fluctuated considerably in
periods.
The krone exchange rate is the price of our currency measured in terms of 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.
Currency swings are driven by cross-border capital movements. Capital flows were heavily influenced
by investor focus on stock market returns until the downturn began. In the US, equity prices almost
trebled between 1995 and 2000. Stock markets in other countries followed suit. The decline was
amplified after the downturn in the global economy deepened as a result of terror and fears of war.
Investors sought to avert the risk in the stock market. Capital inflows into the stock market resulted in a
strong dollar. However, expectations concerning corporate earnings were higher than later proved to
be warranted. When expectations were lowered, equity prices fell. Demand for bonds increased,
resulting in low long-term interest rates.
In response to heightened uncertainty and fears of war, traditional safe havens for capital, such as the
Swiss franc and gold, have become increasingly attractive. The Swiss franc appreciated after the
terrorist attacks on 11 September 2001 and towards the end of last year. Gold prices moved up
sharply after UN Security Council Resolution 1441 was adopted in November last year.
Oil prices fell markedly after 11 September 2001, but have since risen. Fears of war in Iraq have
increased the uncertainty surrounding global oil supplies. Strategic oil reserves have risen, while
private reserves are low. This has exerted upward pressure on oil prices. The strike in Venezuela has
also had an impact.
The oil market is unstable. The extraordinary conditions in the oil market will not prevail indefinitely.
Major economies such as the US, Germany and France are struggling with stagnation and fears of
recession. Substantial tax relief and low interest rates are holding up activity in the US. The Japanese
economy has been in a deflationary recession for a long period.
In recent years, the krone exchange rate has shadowed the difference between Norwegian and
foreign short-term rates. This is why the krone has been strong. In addition, high oil prices have had
an influence. The effect of the interest rate differential on the krone has been intensified by conditions
in capital markets. Investors have been favouring carry trades. Risk premiums in major currency
markets have been low, which seems to indicate that investors have until recently been less prone to
speculate in exchange rate fluctuations.
As equity prices fell, investors started seeking alternative vehicles. This made the krone market more
attractive. The krone appreciated at the same time as foreign stock markets and domestic equity
prices fell. Bonds and other interest-bearing securities have been of particular interest.
The interest rate differential between Norway and trading partners has contributed to a strengthening
of the krone. Norges Bank has reduced the sight deposit rate from 7 to 5.5 per cent since
11 December. Since mid- January the krone has depreciated, partly reflecting expectations of lower
interest rates. Monetary policy has been relaxed.
In January 2003, competitiveness in business and industry was close to 15 per cent below the
average for the last 30 years. Following such substantial deviations, competitiveness has historically
always returned to the average fairly rapidly. Market participants weigh the interest rate differential
between Norway and other countries against the likelihood of a depreciation of the krone in the future.
Cyclical divergence may cause the krone to overshoot its future level in the short term.
With the krone exchange rate prevailing at end-January, competitiveness had weakened by a little less
than 25 per cent since 1996. The krone was about 10 per cent stronger.
On 10 March, the krone was about 3 per cent stronger than in 1996. The rest of the deterioration in
competitiveness is primarily due to the high level of wage growth.
Wages in Norwegian manufacturing grew by close to 15 per cent more than wages among trading
partners between January 1996 and end- January 2003. In the years around the millennium, the
depreciation of the krone veiled the underlying deterioration in competitiveness. In May 2000, the
krone exchange rate reached its lowest level in six years. The krone has since appreciated, and the
effect of high wage growth has gradually come into evidence in company accounts.
In the ten years following the banking and currency crisis in 1992, the economy featured a long period
of balanced growth. However, towards the end of the upturn the economy was facing labour
shortages, higher wage growth and a sharp increase in household consumption and debt. Interest
rates had to be kept at a high level in Norway.
The turnaround abroad took place two years ago, but the Norwegian economy continued to show a
high level of activity. This led to a widening of the interest rate differential against other countries. The
main explanation for the wide interest rate differential is not that interest rates are high in Norway, but
that interest rates are at a historic low abroad. Interest rates in the US have not been at such a low
level since the 1960s. A further jump in wages in 2002 amplified the imbalances in the economy and
fuelled the rise in prices for goods and services produced in Norway. This is why monetary policy has
been tight.
The real interest rate, i.e. the interest rate adjusted for inflation, rose in 2000 and was thereafter
somewhat higher than the average for the past 30 years. With the reductions in the key rate this
winter, the real interest rate is no longer particularly high. The tight monetary stance is reflected in the
strong krone.
Over the autumn and winter, it has become clear that global growth is weaker than we and other
observers had expected. Several central banks have responded by reducing interest rates further.
Interest rates in the US and Europe are unusually low.
Global growth is still expected to pick up gradually towards a more normal level, but the upturn may
come at a later stage than previously assumed. However, we cannot rule out that the world economy
is headed for a fairly long period of stagnation. Low interest rates in the US and Europe are a
reflection of this risk.
Weak external developments have had negative spillover effects on the Norwegian economy through
the appreciation of the krone, the fall in equity prices and lower demand for Norwegian exports.
Unemployment has increased, primarily in service industries. The prospects for manufacturing industry
are deteriorating. High wage growth is forcing many businesses and municipalities to cut costs and
reduce their workforces.
In 2002, inflation was close to target at 2.3 per cent, but has been somewhat lower in recent months.
The strong krone is the primary factor behind low price inflation. The rise in prices for domestically
produced goods and services is marked by the considerably higher wage growth in Norway relative to
trading partners. Wage growth moved up further last year, even in industries where profitability had
been sharply eroded. A situation where wage growth does not react to the labour market outlook, can
give rise to substantial real economic costs.
Developments over the past year show that monetary policy is effective and that inflation can be kept
at a low and stable level also in periods with high domestic cost inflation. However, if developments in
the real economy are to be satisfactory over time, real wage growth must be adapted to underlying
productivity growth.
A precondition for countering a possible downturn by means of monetary policy easing is slower
growth in labour costs. Monetary policy cannot prevent an increase in unemployment that is caused by
a significantly higher rate of growth in labour costs in Norway compared with other countries. Nor can
an expansionary fiscal policy counter a cost-driven rise in unemployment.
Growth in real wages is far higher than the underlying growth in productivity. If higher costs cannot be
passed on to customers, earnings decline and the wage share increases1. Many businesses will have
to adjust their workforces to maintain profitability. This leads to a fall in employment and increased
productivity. For some companies, this may be a prerequisite for maintaining operations in Norway.
The alternative is to close down or relocate production to another country.
While the wage share has risen sharply in manufacturing, it has remained fairly stable in other
industries. Import firms have wider margins, suggesting that the appreciation of the krone has not fully
benefited customers. We also know that employment in some service industries has fallen. Many
companies in the service sector have adjusted their workforces to maintain profitability. To some
extent, higher costs can also be passed on to customers through higher prices in this sector.
Manufacturing employment is declining. In the public sector, where employment growth has been
strong the last few years, budgets will only allow a moderate increase in employment in 2003. Overall,
employment is projected to fall by 1⁄2 per cent in 2003 and remain unchanged in 2004. Employment
followed a similar course in the early 1980s. At that time, employment rose markedly as a result of
continued strong growth in the labour force. Labour force participation in Norway is currently at a
record-high level, and the demographically determined supply of labour is low. At the same time,
labour force growth may be lower than implied by demographic trends for various reasons. More
people may choose to study until the situation in the labour market improves. Some of the unemployed
may exit the labour market on retirement schemes. Outflows from the labour market and low labour
force growth as a result of demographic trends may limit the increase in unemployment.
Nevertheless, unemployment is projected to rise, especially in manufacturing. The increase through
2002 primarily reflects a rise in unemployment in the service sector. Manufacturing unemployment
remained stable until end-2002, but has increased substantially in the last few months. More lay-offs
and lower expectations regarding manufacturing employment point to increased unemployment in the
manufacturing sector ahead. In addition, statistics show a 40 per cent reduction in the number of
vacancies in manufacturing advertised in the last year. Demand for labour, measured in terms of
advertised vacancies, is also low in other industries, indicating that unemployment may also increase
further in the sheltered sector in the period ahead.
Registered unemployment is projected to increase from 31⁄4 per cent in 2002 to 4 per cent in 2003 and
up to 41⁄4 per cent in 2004. Unemployment is projected to stabilise at this level in 2005.
There are wide regional variations in unemployment. At the end of February, the number of registered
unemployed in Troms County came to 3.6 per cent of the labour force, which is lower than the national
average of 3.9 per cent.
Agriculture and fisheries combined account for a larger share of employment in Troms County than in
other counties. The internationally exposed sector is relatively small in the county. The food industry
accounts for about half of manufacturing employment.
As in the rest of the country, the public sector and some private service segments are important for
employment in Troms. Business and financial services account for a smaller share than the national
average.
The work on the Inflation Report drew on information from the regional network that was established
last year. We will have six rounds of talks each year with business and community representatives
concerning financial developments in their enterprises and industries. There will be a total of about
200 visits in each round. We have divided the country into 7 regions and established links with
regional research institutions in six of them. These institutions will hold meetings with the
representatives on behalf of Norges Bank. Region North is covered by Kunnskapsparken in Bodø.
Companies in the north are reporting lower demand and deteriorating profitability. The same tendency
can be observed in most industries with the exception of retail trade and construction. The krone
exchange rate, combined with a costly wage settlement, has contributed to weakening
competitiveness in internationally exposed industries. As a result, demand and turnover in sectors that
supply goods and services to this industry have fallen markedly.
Retail companies have recorded growth in turnover and solid profits in recent months, and our
contacts expect this situation to continue over the next months.
Some activity growth is being reported for the construction industry. The increase in activity primarily
reflects higher public sector demand.
Workforce reductions in both the public sector and manufacturing industry have been reported. More
workforce reductions and lay-offs are planned for the period ahead.
Developments in the Norwegian economy may prove to be weaker than projected in the October
Inflation Report. In spite of the interest rate cuts and a stimulatory central government budget, overall
economic policy has been tight because the krone has been strong. The weakening of the krone since
January has, however, led to an easing of monetary policy. Several years of deteriorating
competitiveness will, nevertheless, have a dampening impact on growth in the period ahead.
The business confidence survey for manufacturing industry shows that manufacturing leaders'
sentiments about future developments are negative. Companies report a decline in production,
employment and orders for both the export and domestic market. Many companies have moved
abroad or are planning to move all or parts of their production out of Norway.
In recent years, the shipbuilding and engineering industries have sustained the activity level in
Norwegian manufacturing. Shipyards experienced a sharp increase in new orders before end-2000
prior to the elimination of support to the shipbuilding industry in Norway and many European countries.
The level of new orders has since then been very low, and the order backlog is nearly exhausted. A
sharp increase in petroleum investment could provide positive growth impulses to the offshore-related
industry. The demand impulses from petroleum investment to the mainland economy may, however,
be weaker than has been the case earlier. Construction and installations with a high import content will
account for a large share of the increase in investment from 2002 to 2003. Due to the high cost level in
Norway, a growing number of contracts are also being awarded to foreign companies. At the same
time, Norwegian shipyards are increasingly using foreign subcontractors in low-cost countries. This is
having an impact on the Norwegian engineering industry.
Many service industries have had to adjust capacity in pace with changes in operating parameters.
Investment in service sectors has fallen sharply, and is expected to continue to fall. There is
considerable excess capacity in the commercial building market. Over the past year, there has been
extensive restructuring and downscaling, especially in the ICT sector and the airline industry. With the
prospect of continued weak developments in the global economy and an uncertain stock market,
reductions in capacity may still be necessary.
The fall in share prices reflects weaker expectations concerning future earnings. This may prompt
enterprises to postpone or cancel investment plans. When share prices are low, companies may also
find that raising capital by means of new issues is not an attractive alternative.
Strong growth in private consumption has contributed to sustaining activity in the Norwegian economy.
Sharp wage growth, combined with reductions in direct and indirect taxes, resulted in close to 5%
growth in household real disposable income last year. Real income growth will be considerably lower
in 2003 and probably lower than projected earlier. Imbalances in the Norwegian electricity market have
resulted in a sharp increase in electricity prices. This implies a considerable reduction in household
real income growth. The interest rate reductions this winter will have the opposite effect. In addition,
developments in employment are expected to be weaker and wage growth somewhat lower this year
than previously projected.
During the last six months, households have become less optimistic about the economic outlook.
Increased uncertainty in the labour market and lower confidence point to heightened caution and
increased saving in the household sector. Lower interest rates have the opposite effect. Household
saving behaviour may also be affected by high electricity prices. On the whole, a moderate, temporary
decline in household saving is expected in 2003.
Next year, a normalisation of electricity prices will contribute to increasing real income growth
compared with 2003. At the same time, we have assumed that a share of the increased use of
petroleum revenues over the central government budget will entail increased transfers or tax cuts for
households. These factors, combined with lower interest rates, may fuel relatively brisk growth in
private consumption in the next few years.
In the last few months, house prices have risen at a slower pace than in previous years. Activity in the
housing market has declined and it takes longer to sell a dwelling. Growth in household borrowing
remains high, but has eased somewhat recently. Weaker developments in house prices and reduced
household optimism may further restrain credit growth in the future.
Growth in mainland GDP is projected to be lower than trend growth, at 11⁄4% in 2003 and 2% in 2004.
In 2005, growth is projected at 21⁄4%.
The underlying rise in prices in the coming year will be marked by the appreciation of the krone over
the last two years. Despite high wage growth, the year-on-year rise in consumer prices adjusted for
tax changes and excluding energy products (CPI-ATE) will most likely range between 11⁄2 and 2% until
the summer. Subsequent developments will partly depend on externally generated inflationary
impulses, changes in the exchange rate and how these changes feed through to consumer prices in
Norway. The sharp rise in electricity prices may also affect other consumer prices. Wage
developments this year and next will play an important role over the next one to two years. The
inflation projections depend on the assumptions concerning the interest rate and the exchange rate.
In the Inflation Report, we presented two alternative paths for the Norwegian economy. We judged that
a gradual easing of monetary policy seemed appropriate. In one scenario, the tight monetary policy
stance was held unchanged. Inflation then fell below target over the next few years. In another
scenario, monetary policy was relaxed in line with market expectations. Inflation then moved up and
was higher than the inflation target.
Actual developments may, however, deviate from both paths. Norges Bank will continuously assess
developments in the global economy, the Norwegian economy and the krone exchange rate, and set
the interest rate with a view to achieving the inflation target.