Svein Gjedrem: Economic perspectives
Address by Mr Svein Gjedrem, Governor of Norges Bank (Central Bank of Norway), at the meeting of
the Supervisory Council of Norges Bank, Oslo, 17 February 2005.
The Charts in pdf-format can be found on the Norges Bank's website.
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Introduction
This year, Norway is commemorating the centenary of the dissolution of the union with Sweden.
Historically, an important part of nation-building has been the establishment of a monetary system and
a central bank. In Norway, the stage was set for the introduction of a national currency in autumn
1814. With the prospect of a union with Sweden, a clause was included in the Constitution stipulating
that Norway should maintain its own bank and its own monetary system. The monetary unit was the
specie daler.
In 1875, the Storting (Norwegian parliament) decided to join the currency union that Denmark and
Sweden had established two years earlier. The specie daler was then replaced by the krone. One
Norwegian krone was worth 0.40323 grams of fine gold.
In the latter part of the 1800s, Norway benefited from free trade and free capital movements and
became a relatively prosperous country. The standard of living in Norway did not lag behind that of
Sweden.
The currency union was maintained after the political union with Sweden was dissolved. The
agreement lost its practical significance after the gold standard was suspended in 1914. The
agreement was not formally terminated until 1972.
From an economic viewpoint, the dissolution of the union in 1905 was a painless process. Former
Central Bank Governor Nicolai Rygg1 wrote: "For 1905, (Norges Bank) points to the bright aspects of
developments over the year, i.e. rising exports,..., but it takes time for confidence and the enterprising
spirit to grow sufficiently to generate greater vitality and activity". Norges Bank's role was primarily to
secure confidence in the monetary system. There were fairly large cash withdrawals from banks. Many
sought to safeguard their wealth by investing in foreign bonds. Banks had to resort to loans from
Norges Bank. The Board of Norges Bank nevertheless chose to leave the interest rate unchanged at
5 per cent. In Rygg's words, this would not contribute to undermining the confidence-inspiring calm
that marked major historical events.
Economic developments were favourable up to World War I.
International real interest rates have fallen
The interest rate level is lower today than in 1905. In fact, Norges Bank has not allowed the key rate to
be this low since the Bank was established in 1816. This partly reflects international conditions.
In many countries interest rates were reduced considerably when the economic situation deteriorated
early in 2000. Interest rates adjusted for inflation, i.e. real interest rates, are now also low.
The first decades following World War II were marked by stable nominal interest rates, moderate
inflation and low, but positive real interest rates. In subsequent periods, real interest rates have
fluctuated.
In the 1970s inflation surged. Nominal interest rates rose, but to a lesser extent than the inflation rate,
and real interest rates turned negative. Early in the 1980s, monetary policy was tightened considerably
in many countries. Real interest rates moved up. Inflation gradually fell and stabilised again at a low
level. This paved the way for a decrease in real interest rates in the 1990s before they fell further after
the economic turnaround in 2001.
Low real interest rates may be ascribed to several factors:
Inflation has been low for such a long period that savers require a low premium as a hedge against
unexpected inflation in the future.
In order to prevent an appreciation against the dollar many Asian central banks have been buying US
government bonds, exerting downward pressure on yields.
Low short-term interest rates in the US, Japan and euro area countries are inducing investors to shift
into more long-term securities, with an attendant fall in long-term interest rates.
The US and some other countries have increased their key rates, but expectations of the rate of
increase ahead have been dampened. The fall in long-term interest rates may be attributable to new
assessments of the growth outlook for the world economy.
In Norway, the real interest rate may deviate from external real interest rates when growth prospects
diverge. This will also lead to a change in the real krone exchange rate, so that the expected return on
investments in Norway and abroad become about the same. However, over time long-term real
interest rates have largely followed international rates, and in line with international developments
long-term interest rates in Norway have also fallen markedly.
Low risk?
Real interest rates abroad are unusually low, and the risk premium is also low. Savers and investors
are offered a wide range of investment options. Risk and expected returns are assessed when
choosing among the alternatives. The premium that investors require to take risk has fallen
considerably in recent months and is now generally low.
For example, there is little difference between government bond yields and yields on bonds issued by
private enterprises. The extra premium that emerging economies have to pay on loans is also small.
Moreover, premiums paid to hedge against future fluctuations in foreign exchange and equity markets
are small.
The low risk premiums may reflect fairly solid growth in the world economy and a strengthening of
corporate profits and financial positions. It seems that credit risks are fairly well diversified in securities
markets and international banks appear to be solid. Fewer major negative events have shaken the
markets in recent periods.
But another explanation may be that low interest rates have prompted investors to take more risk,
thereby pushing down risk premiums. In that case, lower premiums reflect an expansionary monetary
policy rather than low real risk.
Imbalances in the world economy
Low interest rates and risk premiums stand in stark contrast to the considerable imbalances in the
world economy.
There are particularly larges imbalances both with regard to the US trade and current account
balance. This partly reflects the US federal budget deficit. Moreover, US households have a high level
of consumption and a low level of saving. Strong demand in the US has sustained growth in the world
economy. The deficit in the US is matched by surpluses in Europe and Asia.
A persistent deficit has pushed up US foreign debt to a high level.
The US population is growing faster than that of other OECD countries. This may suggest 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 continue for a period. International capital markets are deep and liquid with an
ample supply of credit for US borrowers. If creditors begin to fear a fall in prices and withdraw, this
may still trigger substantial corrections. 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 demand for housing and consumption.
The Federal Reserve is now gradually increasing interest rates and the first measures aimed at
reducing the US budget deficit have been announced. This may curb growth in domestic demand and
imports of goods and services. However, the US authorities will probably not go as far as to bring
economic growth to a halt, with an accompanying increase in unemployment.
The US issues the world's most important settlement and reserve currency. States and agencies in the
US have access to dollar-denominated loans in major international capital markets. The exchange rate
risk lies with foreign creditors. The US may have a long-term interest in maintaining a stable dollar that
is used in international payments. But this may be weighed against short-term interests: If the dollar
depreciates, the US trade deficit will be reduced with a limited impact on domestic production.
The US is not the only source of trade imbalances. They also reflect very low growth in continental
Europe and the largely export-based growth in Asian countries. Countries other than the US must
therefore also contribute in order to prevent growth in the global economy from faltering.
With limited domestic growth capacity and high unemployment, many industrial countries are poorly
equipped to cope with a weaker dollar and lower US demand. The challenges are perhaps particularly
demanding in Japan and some large European countries.
The situation is not negative across the board. There is solid growth in a number of European
countries such as Spain, Ireland and the Nordic countries. In Germany, structural reforms are being
implemented, particularly in the labour market, which could promote growth. It is possible that low
long-term interest rates will boost investment. Nevertheless, there is uncertainty as to future economic
developments, which is not fully reflected in prices, interest rates and premiums.
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.
Low interest rates in Norway
Norges Bank's key rate, the sight deposit rate, is at a historically low level. Real interest rates are also
low. Between December 2002 and March 2004, the key rate was reduced by a total of
5.25 percentage points. The interest rate decline can be ascribed to a number of factors.
In late autumn 2002, inflation started to fall. The inflation projections were also revised down.
Gradually new information about the outlook for other countries and the Norwegian economy indicated
that inflation might be very low. Short-term interest rates fell by close to 4 percentage points.
It would seem that it is not only changes in the real interest rate that have an influence, but also the
level of real interest rates. Between December 2002 and March 2004, the interest rate has moved
from a high to a low level.
The real interest rate is now lower than a neutral interest rate. A real interest rate that is lower than the
neutral rate will stimulate activity even after the effects of the interest rate fall itself have been
exhausted. This was pointed out by the Swedish economist Knut Wicksell in 19072: "...the upward
movement of prices, whether great or small in the first instance, can never cease so long as the rate of
interest is kept lower than its normal rate".
Calculations seem to indicate that the neutral real interest rate for Norway is between 21⁄2 and 31⁄2 per
cent and it has probably fallen somewhat in recent years.
Monetary policy is functioning
It takes time for an interest rate reduction to have an impact on inflation. We are now seeing the
effects of monetary policy decisions some of which were taken two years ago.
The interest rate has affected inflation via the krone exchange rate and via demand for goods and
services. In particular, the rise in prices for domestically produced goods and services has picked up.
In addition, the reduction in the interest rate has probably contributed to holding up expectations of
future inflation even when inflation is low.
Norges Bank's key rate is an overnight rate. The interest rate on deposits and loans with longer
maturities will reflect expectations as to future interest rate decisions. As the key rate was gradually
reduced, expectations also fell, and banks reduced their lending rates. Monetary policy has had a
greater impact because market participants expected the low interest rate to persist over a period.
The first signs of the effects of the interest rate cuts appeared in the foreign exchange market. The
interest rate differential against other countries narrowed. It became more attractive to borrow and less
profitable to invest in the Norwegian krone. The movement in the krone exchange rate was reversed
and it depreciated through 2003 and into 2004. However, the impact on the krone exchange rate has
been considerably dampened because external interest rates have remained low. High prices for oil
and gas and other export goods also contributed to an appreciation of the krone last year.
The depreciation of the krone in 2003 contributed to restraining the fall in prices for imported goods.
The effect occurred gradually. Companies and importers may have preferred to observe changes in
the exchange rate over time before changing their selling prices.
After several expensive wage settlements and a short period of a strong krone had weakened
profitability in the Norwegian business sector, the depreciation of the krone contributed to curbing the
decline in activity and employment.
There is nevertheless uncertainty as to the magnitude of the impact of short-term exchange rate
fluctuations because companies engage in currency hedging.
There are different ways to hedge against currency fluctuations. Some enterprises buy intermediate
goods in the same currency in which they sell their products. Other companies raise a loan in the
same currency as that of the company's assets. In addition, companies can hedge against currency
swings in the forward exchange market and options market. The large volume of international trade in
currency derivatives, which is dominated by banks reduces, premiums and costs for other business
sectors and thereby promote cross-border trade in goods and services. It is not a good idea to throw a
spanner into the works.
The impact on household consumption and housing investment has been substantial. Business
investment is now picking up.
In Norway, household debt is higher than household deposits. The decline in interest rates has
thereby freed up funds. Households reacted relatively rapidly, and growth in consumption picked up.
The fall in interest rates pushed up house prices. Turnover in the housing market has been high.
Higher housing wealth provides increased borrowing opportunities and thereby also boosts demand
for consumer durables. Household debt has risen by around 11 per cent over the past year.
High resale home prices have made it more profitable to build new homes, and residential construction
is rising.
The fall in interest rates has also contributed to sustaining the market value of office premises and
commercial property even with a high vacancy rate. With the prospect of higher occupancy rates,
prices are now rising.
Owing to higher productivity and a drop in sickness absence, it may have taken time for the effects to
become visible in the labour market. However, higher demand for labour and falling unemployment is
gradually leading to a tighter labour market.
High interest rates in 2002 and fiscal discipline contributed to a deceleration in wage growth to a more
sustainable level.
Higher demand for companies' goods provides scope for increasing prices. Experience shows that
inflation is directly influenced by the level of capacity utilisation in the Norwegian economy. Some of
the rise in prices for domestically produced goods and services can be attributed to higher margins in
the business sector.
If there is confidence in monetary policy, economic agents will expect inflation to be close to target
over time. This will provide a basis for company budgets. This will then contribute to stabilising
inflation. Many companies change their prices only once or twice a year. When they change prices,
they probably take into account the expected rise in other prices.
It has been important to prevent inflation expectations from falling and becoming entrenched at a low
level. Surveys of inflation expectations nevertheless indicate that expectations are well anchored
around the inflation target in the long term.
The interest rate is a powerful instrument. The effects come through growth in private consumption,
higher house prices, increased residential construction, higher investment in various business sectors,
business start-ups, improved corporate profitability, higher employment and wage growth, higher profit
margins and higher imported inflation.
The effects of the interest rate decline on demand, output and employment have been pronounced. It
has taken time for inflation to pick up. This partly reflects low external interest rates and high oil prices,
which have moderated the impact on the krone exchange rate. Higher imports from low-cost countries,
competition and improved efficiency in Norwegian production have also kept inflation at a low level.
As a result of low inflation, we have kept interest rates low for a longer period. The impact on output
and employment is therefore more pronounced.
We cannot expect the interest rate to have the same impact from one period to the next. The economy
is also exposed to unexpected disturbances. As a result, we cannot fine-tune economic developments
using the interest rate, but avoid the largest effects when the economy is exposed to disturbances.
Experience seems to indicate that inflation expectations remain stable even if inflation varies
somewhat as long as the interest rate is used actively to curb effects. Given our highly open economy,
we may have to accept somewhat wider variations in inflation than some other countries.
The interest rate level can influence the timing of household and business investment. With the current
low interest rate level, many have found it advantageous to move forward purchases of property and
other investments which they would otherwise have delayed.
Housing demand 10 to 15 years ahead will depend on future income levels, population growth and
living patterns. The current level of interest rates has limited implications for housing demand in the
longer term. A high level of residential construction today will be followed by a lower level at a later
stage. The same may apply to commercial property investment.
There are examples showing that a period of higher-than-normal house prices can have an impact
over a very long period. At the end of the 1800s, house prices in Kristiania (now Oslo) rose sharply.
Some areas of Oslo are still marked by the massive volume of residential construction prompted by
the rise in prices. The housing market collapsed at that time. The demand for new dwellings was
saturated. It was not until the mid-1980s that real house prices returned to the level in 1899.
Household debt is now more than one and a half times as high as disposable income. The
accumulation of debt partly reflects structural adaptation over time to a deregulated credit market and
partly to low interest rates. The higher debt burden has made households more vulnerable. A period
will come when households prefer to stabilise debt and reduce consumption.
The fall in interest rates has sustained activity in Norway after a period of weak economic
developments abroad and high domestic wage and cost inflation. But an aggressive use of the interest
rate as an instrument may itself be a source of new fluctuations in the economy because it influences
the time profile for saving and investment. It is therefore important that growth is self-driven when the
interest rate has to return to a more normal level after a period.
The effect of Norway's interest rate also depends on external interest rates. Many countries have
raised their key rates during this cyclical upturn, also in several steps. Most recently, the Federal
Reserve increased its key rate by 0.25 percentage point, and it has also announced further interest
rate hikes. With the prospect of low inflation, Norway has lagged behind other countries in adjusting
interest rates to a more normal level.
Two years after we started to lower interest rates it would appear that inflation is moving up, albeit
slowly. Inflation is low, but the indices are also influenced by temporary and erratic disturbances. It will
still take time before we will have seen the full impact of low interest rates. It may appear that growth in
the Norwegian economy has become more self-driven. Capacity utilisation is close to normal and
rising. After a period, the interest rate can then gradually be raised to a more normal level.
Economic policy tasks
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 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 into account interest rate effects when wage increases are agreed.
• Moreover, the parties to public sector negotiations can take into account that the higher the
pay increases are, the fewer there are that can be remunerated over government budgets.
The interaction here came into clear evidence when employment in the general government
sector fell after the expensive wage settlement in 2002.
The authorities can achieve better economic policy results if they can commit in advance to a set of
credible policy rules. Households, enterprises and capital markets are forward-looking in their
decision-making. It is therefore important that the authorities do not sow doubt, but on the contrary act
in a long-term and predictable manner. There must be consistency between plans and actions.
Monetary policy's role is to ensure low and stable inflation. Experience shows that we cannot reduce
unemployment over time by simply accepting somewhat higher inflation. In many countries, also in
Norway, confidence that inflation will be held at bay has increased because interest rate setting has
been delegated to the central bank.
Budget norms are not new. The norm during the first 25 post-war years - and it was adhered to - was
that the annual budgets should show a surplus. The surplus was sufficient to finance an increase in
loans to state banks.
At the beginning of the oil age in Norway, in the early 1970s, the norm had to be assessed. The
relationship between the use of petroleum revenues and changes in industry structure was
highlighted.
Report no. 25 to the Storting from 1973-1974, "The role of petroleum activities in Norwegian society"
stated: "A transfer of production and employees between enterprises and industries can occur as a
result of higher domestic cost pressures" ... and further ... "Inflationary pressures will depend in
particular on the extent to which the Norwegian business sector is involved in petroleum activities and
the share of revenues that are used domestically". The implications for economic policy were also
clarified: "The risk of excessive inflationary pressures must be given considerable weight when
decisions are to be taken here". The government budget was at that time used to steer the activity
level in the economy. The interest rate was to be low - and kept unchanged. Today, with an inflation
target, inflationary pressures will be steered using the interest rate, while the value of the krone will
fluctuate. Today, this sentence would have to read: "The risk of an exchange rate that is too strong
must be given considerable weight when decisions are to be taken here".
We are now in a period where petroleum wealth is being invested in foreign financial assets via the
Government Petroleum Fund. The government is to gradually phase in petroleum revenues into the
domestic economy by using approximately the expected real return on the Fund.
The fiscal rule was established in 2001. 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. Since 2000, spending growth has averaged 6.3 per cent,
while GDP growth in value terms has been 4.5 per cent. We have limited overall knowledge about real
growth in public service production. Reliable measures of productivity and price developments have
not been developed.
The fiscal rule for the budget implies that the government can use 4 per cent of the Fund over time.
This year, a little more than 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.
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 this growth in spending to
lead to deteriorating competitiveness in Norwegian manufacturing, either through higher wages or an
appreciation of the krone. With stronger wage growth in Norway than abroad, the competitiveness of
Norway's manufacturing industry has weakened by about 15 per cent since the mid-1990s.
Competitiveness is about 5 per cent weaker than the average for the past 30 years. 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 10 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.
Over the past 30 years manufacturing has been scaled back in waves. The last wave occurred around
the turn of the millennium, but a substantial decline also occurred in the period 1977 to 1984 and from
1987 to 1992. Prior to these periods, the manufacturing sector's competitiveness deteriorated.
The usefulness of a fiscal rule is that it gives weight to long-term considerations when addressing
day-to-day economic policy challenges. The fiscal rule stabilises enterprises' expectations concerning
competitiveness and the krone exchange rate. This can prevent abrupt and pronounced swings in the
structure of the economy. If the government authorities disregard the rule, enterprises will lose an
important reference. A policy rule can make matters worse if economic agents have drawn up
long-term plans on a faulty basis.3
Both short-term and long-term considerations imply that the use of petroleum revenues as a share of
the Petroleum Fund should be curbed ahead.
The Norwegian economy is growing at a brisk pace.
The public sector has invested heavily in the care of the elderly, which should cover the needs of a
generation that was born just after World War I. The need for growth in public expenditure will be more
moderate in the coming years and marked by the small cohorts of the 1930s and war years, who are
now joining the ranks of the elderly. Moreover, the National Insurance Scheme, introduced in 1967, is
nearing maturity. In addition, a few years remain before the large post-war cohorts retire and add to
the demand for health services.
Hence, the conditions are now conducive to returning to the use of 4 per cent of the Petroleum Fund.
The current cost level in the Norwegian business sector is adapted to an expansion of the petroleum
sector and a steady phasing-in of petroleum revenues into the mainland economy. Costs rose sharply
from the mid-1960s to the mid-1970s and reached a very high level. In subsequent years, costs have
varied around this level. After a period, we will be able to cover a smaller share of our imports using
current petroleum revenues and drawings on the Petroleum Fund. Competitiveness must then have to
be improved. It may have to be brought back to around the level prevailing at the end of the 1960s
prior to Norway's emergence as an oil nation.4
The labour market
In the long run, wage growth must be consistent with labour productivity. When real wage growth is
higher than productivity growth, profitability in the business sector deteriorates and the business sector
will then recruit fewer employees and reduce their workforces. Likewise, employment in public entities
will decline if labour costs rise more than revenues. When the social partners engage in centralised
and local negotiations, they will therefore weigh employment against the usefulness of taking out
higher pay.
Compared with other European countries, income formation in Norway has been fairly flexible. Wage
growth has rapidly declined when unemployment has risen. This is why unemployment has not taken
hold at a high level.
The favourable results partly reflect the considerations underlying the wage settlements at a
centralised level. But perhaps it has been equally important that it has been possible to adjust
workforces and wage growth at a local level.
First, companies can adapt the use of labour to production by using overtime, part-time positions or
contract labour.
Moreover, the supply of labour is highly flexible. When demand rises, the number of job-seekers
increases. Those who are already employed work more. During an upturn, we have in particular
observed an increase in labour force participation among young people. Along the same lines, the
number of persons in education tends to rise when unemployment is rising.
When labour demand increases, we see an influx of job-seekers from our neighbouring countries. In
addition, close to 30 000 persons had some form of employment in Norway throughout or during parts
of 2001, but resided in Sweden. With the enlargement of the EU Norway has become part of a larger
labour market. Enlargement also provides scope for increased trade in services. This increases the
production capacity of the Norwegian economy. For example, it seems that capacity in the
construction industry has increased. The activity level is now very high, and there are still no signs of
rising wage growth. Hence, labour mobility can eliminate bottlenecks in the labour market.
Employment is also strengthened by local wage negotiations. Some of the newer industries apply
performance-related pay to a greater extent, allowing firms to reduce costs more easily while retaining
employees when earnings decline. There also seems to be wage flexibility in more traditional
industries. Differences in productivity growth and wage growth across Norwegian manufacturing
enterprises show that workers tend to accept lower pay increases in enterprises with low productivity
growth.5 This can provide companies with more time to adapt and curb the impact on unemployment.
Unemployment will vary over the business cycle, but there will always be job-seekers who are
temporarily without work. Fluctuations around the trend level of unemployment can be an expression
of the level of frictional and structural unemployment. If restructuring and job changes become more
common, the number of unemployed will also increase as a result of job changes. If economic activity
is high, most job-seekers will rapidly find a new position. Job-seekers with skills for which there is less
demand must seek employment for a longer period. In periods of major structural changes in the
economy, this group may increase. When there are few unemployed of this type, wage growth tends
to be high.
Even if Norway fares favourably in relation to many other countries, the Norwegian labour market also
has its weaknesses. Wage growth now probably accelerates at a higher level of unemployment than it
would have ten and twenty years ago. Many are also channelled from unemployment to social security
benefits