Svein Gjedrem: The economic outlook and monetary policy
Speech by Mr Svein Gjedrem, Governor of Norges Bank (Central Bank of Norway), at SR-banken,
Stavanger, 18 March 2005.
The speech is based on the assessments presented at Norges Bank's press conference following the Executive Board's
monetary policy meeting on 16 March, Inflation Report 1/05 and on previous speeches. The text below may differ slightly from
the actual presentation.
The Charts in pdf-format can be found on the Norges Bank's website.
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The Norwegian economy is growing at a solid pace, and there are prospects that growth will remain
high in the year ahead. The recession was mild after the preceding expansion culminated two and a
half years ago. The higher rate of cost inflation in Norway relative to other countries was broken
without production being impacted to the same extent as during the recessions in the early 1980s and
around 1990. One of the main reasons for this is probably that low inflation in the 1990s and the
current monetary policy have anchored expectations of low and stable inflation among economic
agents.
The need to bring down inflation was the main reason why New Zealand, the first country to do so,
introduced an inflation target for monetary policy at the end of the 1980s. Canada, the UK, Sweden
and Australia followed suit later in the 1990s. Inflation targeting has gradually become the normal
monetary policy system in developed economies. In Norway, the Government introduced an inflation
target in 2001. The target is set at 2.5 per cent. In the euro area, monetary policy is oriented towards
price stability, defined as inflation below but close to 2 per cent.
Inflation targeting has proved to be a sound system and particularly well suited for small, open
economies. Normally, interest rate setting under an inflation targeting regime will also contribute to
stabilising output and employment. In periods of recession, with prospects of low and falling inflation,
the interest rate will be reduced to boost demand and prevent an inflation level that is too low. During
an upturn when there are prospects of high inflation, the interest rate will be increased. Inflation
targeting is softer around the edges than the exchange rate regimes Norway and many other countries
operated earlier. The system has proved fairly robust to disturbances.
Nevertheless, the soft landing of the Norwegian economy after several years of high domestic cost
inflation and a low level of activity abroad must not lead us to believe that output and employment
cannot show pronounced fluctuations in the future. 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 last time I was here, almost exactly a year ago, Norges Bank's Executive Board had just decided
to reduce the key rate by 0.25 percentage point to 1.75 per cent. Since then, the key rate has
remained at this historically low level.
Real interest rates are also low. From December 2002 to 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.
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.
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.
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 indicate that expectations are well anchored around the
inflation target in the long term.
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 when the krone exchange rate was high
had weakened profitability in the Norwegian business sector, the depreciation of the krone contributed
to curbing the decline in activity and employment. The recession was short-lived.
Together with private consumption and fixed investment in the petroleum sector, traditional exports
were an important factor underlying growth in the early stages of the upturn that started in the first half
of 2003. Prices for many of our most important export goods have risen as a result of strong growth in
new markets. Growth in Norway's total exports excluding oil and gas is, however, lower than import
growth among our trading partners.
Mainland fixed investment has gradually become an important driving force behind the upturn.
Investment has picked up in most industries and growth was stronger than expected towards the end
of 2004. Norges Bank's regional network has registered rising investment in all industries. Petroleum
investment in particular appears to be growing at a faster pace than projected. This may continue to
boost mainland output.
In the past few years, household demand has been underpinned by low interest rates, high real wage
growth and higher asset prices. According to preliminary national accounts figures, private
consumption increased by 4.3 per cent last year. House price inflation has slowed somewhat, but
remains high. Housing starts in 2004 were at the highest level for several years. Home refurbishment
is probably also rising sharply.
Overall, the supply of capital to households has increased sharply. Debt accumulation was slightly
higher than 11 per cent in 2004 and is now considerably higher than growth in household disposable
income. This largely reflects the sharp rise in house prices since the mid-1990s.
According to TNS Gallup's consumer confidence indicator for the first quarter of 2005, households are
still highly optimistic with regard to their personal finances and the domestic economy. Our regional
network confirms this view with reports of strong growth in companies that provide goods and services
to households. On the whole, household consumption and housing investment are projected to show
fairly strong growth over the next few quarters.
Despite the strong upturn in the mainland economy, the rise in the number of employed has been fairly
modest. Productivity rose quite sharply in the first few quarters after economic growth picked up.
Normally, strong productivity growth is gradually followed by an increase in employment. The current
upturn has lasted about two years. The fairly low level of growth in employment, as measured by the
number of employed, must be seen in the light of the sharp decline in sickness absence through 2004
after rising for several years. The decrease in sickness absence has increased companies' supply of
labour and reduced the need for new employees. Measured in person-hours worked, employment
growth was solid last year. Person-hours worked increased by 2.2 per cent from 2003 to 2004. A
corollary to the increase in the number of person-hours worked is partly reduced sickness absence
and partly three more working days in 2004 compared with 2003.
An increase in available person-hours and increased competition and rationalisation in many sectors
led to higher-than-normal growth in potential output last year. The economy has therefore been able to
grow a fairly rapidly for a period without the emergence of bottlenecks in the labour market.
In the business tendency survey, manufacturing industry reported higher output volumes and capacity
utilisation. Average capacity utilisation in the manufacturing sector is now close to its historical
average. Norges Bank's regional network reports that nearly half of the contacts would have some or
substantial problems in increasing production in excess of planned levels. This may indicate
approximate balance between supply and demand in the economy, and that capacity utilisation is
about normal. A normal level of capacity utilisation is consistent with an output gap - the percentage
deviation between actual and potential output - that is now close to zero.
Growth in demand and output is expected to remain high in the near term. Unemployment may fall
somewhat more quickly than has been the case over the past year. The output gap is expected to be
positive in 2005.
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.
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.
Initially, it was the fall in prices for imported consumer goods that pushed down underlying inflation.
After a period, the rise in prices for domestically produced goods and services also decelerated. This
was due in particular to increased competition in some goods and service markets. At the same time,
wage growth slowed as a result of lower capacity utilisation in the economy. A slower rise in house
rents also contributed. Inflation measured by the CPI-ATE reached its lowest level in the first months
of 2004. Inflation remained at less than 1⁄2 per cent until after the summer before picking up in autumn.
Inflation moved up primarily as a result of a slower decline in prices for imported consumer goods, but
the depreciation of the krone since the beginning of 2003 has also contributed. In addition, the rise in
prices for domestically produced goods and services stabilised, and towards the end of 2004 there
was a tendency towards a higher rise in prices for these goods and services.
At the beginning of 2005, inflation measured by the CPI-ATE was lower than expected. Prices for
imported consumer goods fell more than expected. It is uncertain whether this price decline was due
to abnormal seasonal patterns or a fall in underlying inflation. The fall in prices may be related to an
unusually warm winter, which has made it more difficult to sell winter clothing and sports equipment at
ordinary prices. On the other hand, there are indications that prices for imported consumer goods in
foreign currency may have fallen somewhat more than previously assumed.
The wide variations in prices for some imported consumer goods, especially clothing and footwear,
may entail wide monthly variations in consumer price figures. Excluding changes in prices for clothing
and footwear, the year-on-year rise in the CPI-ATE was 1.3 per cent in February, up from 1.1 per cent
in January.
Changes in indirect taxes and particularly in VAT rates make it difficult to interpret the most recent
price figures. The low level of inflation at the beginning of the year may be due to a lag in price
adjustment following the indirect tax changes.
Among the companies in our regional network, the share expecting a sharper rise in selling prices is
larger than the share expecting a slower rise in prices. TNS Gallup's business sentiment survey gives
a more neutral impression. Nevertheless, both surveys indicate expectations of a sharper rise in prices
in the service sector.
The other Nordic countries have also experienced falling inflation.
Inflation in the Nordic countries has declined, and is now relatively low in Sweden, Denmark, Finland
and Norway. According to the harmonised indices of consumer prices, inflation in February was
around 1 per cent in Denmark, Sweden and Norway, while the rise in prices remained unchanged in
Finland, as measured by 12-month changes. By comparison, price inflation in the euro area was close
to 2 per cent.
A common feature of the low level of inflation in the Nordic countries seems to be the trend in prices
for imported consumer goods, even though developments have not been entirely the same in all the
Nordic countries.
The upturn is broadly based, and its effects are no less pronounced here in Rogaland. Demand is
increasing in all sectors, particularly in oil-related industries and the construction sector.
The market outlook for export-oriented and oil-related industries in the next six months is very bright
and optimism is greater now than in the previous round of interviews. Domestically oriented
manufacturing has not experienced large fluctuations in demand and output to the same extent.
It appears that growth in investment will increase in the period ahead: the high level of investment in
the petroleum sector will contribute to higher investment growth in the offshore supplier industry. There
are signs of rising investment in the construction industry. "Repatriation" is also being considered in
Rogaland: the Gjestal Spinneri spinning company is looking at the possibility of investing in a new
facility in Oltedal, enabling the company to transfer production from the UK to Norway.
Employment is rising, with the most marked increase in the construction sector. Almost a third of the
enterprises report that shortages in the supply of qualified labour may constrain output growth.
Through the past year, there have been increasing reports of higher selling prices. One in four
manufacturing enterprises is expecting a higher rise in prices this year than in 2004. In retail trade, two
in three enterprises are expecting an accelerating rise in prices. The picture is mixed for the corporate
service sector.
Profitability is still improving considerably in all sectors. This reflects both an increase in volume and
cost reductions.
In the adopted budget for 2005, the structural, non-oil deficit increases compared with 2004. It
therefore appears that fiscal policy will provide some stimulus to growth this year. In the National
Budget for 2005, the underlying rise in expenditure over the central government budget was projected
at 5.2 per cent, which is somewhat lower than the previous year and somewhat lower than projected
nominal growth in mainland GDP. As from 2006, it is assumed that nominal growth in general
government expenditure will be approximately the same as nominal growth in general government
revenues and that the real tax level will remain unchanged.
Growth in the euro area and Japan was weaker towards the end of 2004 than projected in the
November Inflation Report. It appears that it will take time for structural changes that have been
implemented, in Germany for example, to contribute to an increase in output. In the US, on the other
hand, economic growth remains firm and capacity utilisation is rising. Even though developments in
the US economy are favourable, higher interest rates, among other factors, will gradually result in an
increase in household saving. At the same time, the plans call for a lower rise in government
spending. Weaker growth in US demand may imply slower growth also in other countries. In addition
to the euro area, economic growth is expected to slow in the UK and Sweden.
On balance, we assume that growth among our trading partners will slacken this year and stabilise in
the years ahead.
Growth in Asia, except Japan, and in Central and Eastern Europe is expected to moderate but to
remain strong.
Robust expansion in China and India has in particular pushed up prices for oil and other important
commodities. Growth impulses to the Norwegian economy may therefore be somewhat stronger than
the overall outlook for our most important trading partners would indicate. High demand for
commodities produced by Norway is boosting activity and is strengthening profitability for Norwegian
enterprises.
Partly due to very high growth in demand for oil, the average price of Brent Blend rose to almost USD
40 per barrel in 2004. Strong economic growth, particularly in the US and China, has resulted in high
energy consumption. So far this year, the price of Brent Blend oil has largely hovered around USD 45
per barrel, although the price rose to more than USD 50 per barrel at the beginning of March.
Oil futures prices have also increased. Little idle 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 demand growth in important oil-importing
countries, such as China and some other emerging economies.
On the other hand, US crude oil stocks are now far larger than they were at the same time last year
and the previous year. Petrol stocks are also relatively high. This reduces the risk that low stocks and
high petrol demand will push up the price of crude oil, as was the case last summer.
Planned, large-scale projects resulted in strong growth in petroleum investment in 2004. Due to
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 level is expected to remain high throughout the
projection period. Activity in the petroleum sector will have spillover effects on the mainland economy,
initially on the shipbuilding industry and the construction sector.
The scale of petroleum investment and its spillover effects are highly uncertain. The last time
petroleum investment showed a sharp increase, in 1997/1998, growth was substantially stronger than
had been assumed. An upturn occurred in the Norwegian economy as a whole at the same time. The
unexpected increase in petroleum investment contributed to an economic upturn that was substantially
stronger than projected. If oil prices rise further or remain at the current high level for a long period,
petroleum investment may again amplify the cyclical upturn more than projected.
Inflation among our trading partners is expected to be low over the next few years. It is likely that high
prices for oil and other commodities will continue to push up prices for goods where wages account for
a small portion of total costs. On the other hand, growth among most of our main trading partners will
probably be too low for idle resources to be utilised in the next few years. Particularly in the euro area,
wage growth is likely to be low as a result of moderate economic growth and high unemployment.
Overall, it would appear that international price impulses via consumer goods to the Norwegian
economy will remain negative this year and next. There is no indication that growth in imports from
low-cost countries is declining. For example, China's share of footwear imports to Norway increased
by 4 percentage points to 20 per cent in 2004. The share of clothing imports increased by 2
percentage points to 32 per cent. The decline in prices for clothing and footwear will probably continue
in the coming years. Prices for audiovisual equipment are still falling as a result of strong international
competition and high productivity growth.
We assume that the effects of structural changes in these markets will gradually be exhausted towards
the end of the projection period. External price impulses via consumer goods are expected to increase
in pace with unit labour costs among our trading partners.
The projections in Inflation Report 1/05, published on 16 March, are based on a gradual increase in
the interest rate. This is in line with financial and foreign exchange market expectations. The krone
exchange rate is assumed to move in line with the forward exchange rate. This implies that the krone
will remain fairly stable around the current level in the years ahead.
Growth in private consumption is expected to remain buoyant both this year and next, primarily
reflecting low real interest rates, strong growth in real disposable income and a continued rise in house
prices. In the period ahead, higher employment and wage growth will continue to fuel household
demand. On the other hand, household debt has risen sharply. This implies that a normalisation of
interest rates will increase household net interest expenses. After a period, growth in consumption
may be fairly low. However, we assume that households will spread consumption over time so that the
savings ratio will continue to fall in spite of an increase in interest rates.
Growth in housing investment is expected to ease through 2005. However, the projection for housing
starts is also very high for 2005. Such a high level of housing starts over several years probably
means that more dwellings will be constructed than implied by underlying demand. As a result,
housing investment is expected to decline after a period. Higher interest rates and weaker
developments in the Norwegian economy may also lead to a fall in residential construction after a
period.
The upturn in mainland fixed investment is broadly based. Stronger profitability, higher capacity
utilisation and solid export growth will contribute to continued investment growth in goods-producing
industries. Demand for services is expected to continue to grow for a period ahead with an attendant
increase in investment in service sectors. When growth in the economy gradually slows down,
investment growth will probably slacken.
Mainland exports of good and services from mainland Norway will also benefit from solid global growth
this year. Later in the period, a continued loss of market shares as a result of high cost levels will
dampen export growth.
Unemployment is expected to decline this year and next. In subsequent years, growth in demand and
output is expected to ease, and unemployment may edge up again when capacity utilisation
approaches a more normal level.
With a somewhat tighter labour market in the years ahead and rising inflation, wage growth may pick
up. Over the past year, low consumer price inflation has probably contributed to keeping nominal wage
increases lower than implied by labour market tightness in isolation. Low inflation has resulted in high
growth in household purchasing power, even with moderate pay increases.
With a path for the interest rate and the krone exchange rate in line with the baseline scenario in
Inflation Report
1/05, inflation may increase gradually from less that 1 per cent today to close to 2 per
cent in mid-2006. Under these assumptions, inflation may stabilise at around 21⁄2 per cent at the
threeyear horizon. However, continued shifts in trade patterns, with higher imports from Asia and intensified
competition in retail trade, may prolong the period of low inflation.
Developments in the krone exchange rate are uncertain. The real krone exchange rate measured by
relative labour costs is strong. Historically, the real krone exchange rate has tended to return to an
average measured over a longer period. Should this occur in today's situation, through a depreciation
of the nominal krone exchange rate, inflation will pick up somewhat faster than projected. If the krone
appreciates, on the other hand, there is a risk that inflation will not move up as quickly as projected.
Developments in line with the projections imply that the output gap will increase to about 11⁄4 per cent
in 2006. As the interest rate gradually increases to a more normal level, growth in private demand will
probably ease, and capacity utilisation may be brought down and stabilise. There is uncertainty
associated with developments in demand and output in the near term, partly because the interest rate
has been low for a long period. Higher growth may rapidly trigger stronger pressures in the economy.
Output growth in Norway is high, and capacity utilisation is rising. It may appear that growth has
become more self-driven. The low interest rate will probably contribute to an increase in the output gap
and inflation ahead. The operational objective of monetary policy is inflation of close to 2.5 per cent
over time. In the conduct of monetary policy, emphasis is also placed on curbing fluctuations in output
and employment.
The objective of stabilising developments in output and employment implies, in isolation, a higher
interest rate. This will reduce the risk that capacity utilisation in the Norwegian economy will become
too high. High capacity utilisation could give rise to bottlenecks in some sectors of the economy and
lead to a higher rise in property prices and household borrowing. This could be a source of instability
in demand and output in the somewhat longer run.
The objective of bringing inflation back to target and anchoring inflation expectations nevertheless
implies a continued expansionary monetary policy. International interest rates are rising, albeit slowly
and from a low level. There are prospects of continued low inflation for a period ahead. Even if
capacity utilisation in the Norwegian economy rises, there appears to be little risk that inflation will
rapidly move up to a level that is too high. Inflation was unexpectedly low in the first months of this
year, but in the light of our highly open economy we must perhaps expect somewhat wider variations
in inflation than some other countries.
The projections and assessments presented in Inflation Report 1/05 may as a whole imply that the key
rate can after a period, and then gradually, be brought up to a more normal level.
At its monetary policy meeting on 16 March, Norges Bank's Executive Board decided to leave the key
rate, the sight deposit rate, unchanged at 1.75 per cent. The Executive Board weighed the objective of
bringing inflation back to target and stable inflation expectations against the risk that output growth
may eventually be too high.