Svein Gjedrem: Economic policy challenges
Address by Mr Svein Gjedrem, Governor of Norges Bank (Central Bank of Norway), to the Executive
Board of the Confederation of Norwegian Business and Industry, 19 September 2002.
Charts for the speech can be found on the Norges Bank's website.
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A year and a half ago, the Government and the Storting adopted new guidelines for economic policy,
which call for an annual use of petroleum revenues equivalent to the expected real return on the
Government Petroleum Fund. At the same time, the Government issued a new operational mandate
for monetary policy. Norges Bank shall set the key rate with a view to maintaining low and stable
inflation.
The first sentence in the monetary policy mandate refers to the value of the krone. Stability in the
national value of the krone implies that inflation must be low and stable. This is the best contribution
monetary policy can make to economic growth and prosperity and is a necessary precondition for
stability in the financial and property markets. The regulation also states that monetary policy shall be
aimed at stability in the international value of the krone. The krone exchange rate fluctuates from day
to day, from week to week, and from month to month. We do not have the instruments for fine-tuning
the exchange rate.
The first paragraph of the mandate sets forth an objective. The last paragraph specifies what Norges
Bank shall do. The inflation target is set at 21⁄2 per cent. Monetary policy that is oriented towards low
and stable inflation will contribute to a stable krone exchange rate over time. If we take steps to
counteract an appreciation of the krone when there are pressures in the economy, we reduce the
possibility of curbing inflation and increase the risk of fluctuations in the economy. Maintaining stability
in the internal value of the krone must thus take precedence.
The implementation of monetary policy has been delegated to Norges Bank. Norges Bank sets the
interest rate on the basis of our understanding of the regulation. Our interpretation places emphasis on
the Government's rationale behind the regulation, on the objective as formulated in the first paragraph
and on our knowledge about the relationships between the interest rate, the krone exchange rate,
output, employment and inflation.
The interest rate influences price inflation indirectly via domestic demand and via its effect on the
exchange rate. When interest rates rise, it is more profitable to save and more costly to borrow. This
has a dampening impact on consumption and investment. Lower demand in turn curbs the rise in
prices and wages. Higher interest rates make it more attractive to take krone positions and borrow in
foreign currency. As a result, higher interest rates normally lead to an appreciation of the krone. This
reduces prices for imported goods. In addition, a strong krone curbs activity, profitability and the
capacity to cover labour costs in the internationally exposed sector.
It is important to be aware of the relationships between employment, output and inflation. If there is a
shortage of labour and other economic resources, a tight monetary policy stance will reduce inflation
through its effect on prices for imported goods and on aggregate demand for goods and services and
for labour. When monetary policy is aimed at stabilising inflation, it will also contribute to stabilising
aggregate output and employment.
If it appears that inflation, with unchanged interest rates, will be higher than 21⁄2 per cent, the interest
rate will be increased. If it appears that inflation, with unchanged interest rates, will be lower than
21⁄2 per cent, the interest rate will be reduced.
Monetary policy functions with considerable and variable lags. Therefore, the current level of inflation
does not provide an adequate basis for determining the level at which interest rates should be set
today. Our analyses indicate that a substantial share of the effects of an interest rate change will occur
within two years. Two years is therefore a reasonable time horizon for attaining the inflation target.
It is nevertheless conceivable that in a situation with a high rate of inflation and sluggish economic
growth, Norges Bank may decide to apply a somewhat longer time horizon than two years to reach the
inflation target of 21⁄2 per cent. By influencing inflation over time, monetary policy will not in itself cause
unnecessary disturbances in the economy.
Norges Bank has one instrument: the interest rate. Changes in the interest rate have a broad impact.
Monetary policy can therefore not be oriented towards stabilising developments only in the
internationally exposed sector, as has been advocated. This could easily create considerable
imbalances in the Norwegian economy.
The low interest rate policy and devaluations in the 1970s and 1980s are examples of how such a
policy can fail. Monetary policy was geared towards preventing a deterioration of competitiveness in
manufacturing. The krone was devalued on several occasions. But wage growth accelerated to
compensate for higher inflation. The result was a wage and price spiral that hit the entire economy. At
the same time, there was a sharp rise in the demand for loans, which created tensions in our financial
system in the 1970s and in the 1980s.
Monetary policy can be an effective means of influencing aggregate demand in the economy.
However, there is little monetary policy can do to counter disturbances on the output side of the
economy. Changes in wage formation, a decline in productivity growth or a sharp rise in prices for
important factor inputs must instead be countered by measures to improve the way the economy
functions.
Fiscal policy places emphasis on smoothing fluctuations in the economy with a view to ensuring
appropriate capacity utilisation and low unemployment. There is an overlap between the tasks that
monetary policy and fiscal policy are intended to perform. This makes it natural to raise the issue of
whether there is a need to coordinate fiscal and monetary policy decisions. Several reasons may lead
to the interplay between monetary and fiscal policy failing to function. Interplay functions well when the
decision-making bodies are conscious of how one body's decisions influence the decisions of the
others. Unless this fact is recognised, a decision will not produce the result that was planned. The
economy may move in a very undesirable direction, with high interest rates, sluggish economic growth
and a deterioration in the state's financial position.
Without coordination, a good result may still be achieved if fiscal policy acts as "leader" and monetary
policy as "follower", to use expressions taken from game theory. The fiscal policy authorities can
internalise the monetary policy response pattern. The central bank's response pattern must of course
be known so that the fiscal authorities can take this into account.
The social partners can similarly take any monetary policy response into account when wages are
being determined. The "leader" in this interplay - the social partners - can take the "follower's" - Norges
Bank's - response into account. This view is most relevant in centralised wage formation. In
decentralised wage formation, monetary policy will instead affect wage growth via market mechanisms
by stabilising aggregate demand.
A precondition for interplay that functions well is that monetary policy is known and remains firm.
The outcome of this year's wage settlement indicates that the social partners have not internalised the
monetary policy response pattern. Perhaps one of the stumbling blocks has been the choice of wage
settlements at industry level and the large wage increases for employees outside the two largest
employer/employee organisations (NHO and LO).
The high wage growth awarded to groups whose wages are determined through individual
agreements indicates that the labour market has been tight. The rise in salaries for white-collar
workers and managers may also reflect weak cost control in enterprises and organisations following a
long period of expansion.
For a long time, a stable exchange rate and labour costs among our trading partners formed an
anchor for wage determination. Since 1998, however, the rise in labour costs in Norway has been
around 2 percentage points higher than that of our trading partners. High wage growth, combined with
the global downturn and a strong krone, is having a severe impact on manufacturing.
It is the combined wage growth for all groups that influences the inflation outlook. However, substantial
wage increases for some groups can trigger wage spirals. Wages for salaried staff in the business
sector have exhibited sharp growth. This year, it appears that wage increases will particularly be high
in the public sector and in parts of the private service sector.
Over time, growth in real wages must be consistent with growth in labour productivity. With an inflation
target of 21⁄2 per cent and trend growth in the economy of 2 per cent, there will be scope for annual
nominal wage growth of about 41⁄2 per cent. These figures are consistent with developments in the
1990s. Wage growth averaged 41⁄2 per cent and productivity growth 2 per cent in this decade. This
resulted in an inflation rate of 21⁄2 per cent combined with a stable krone exchange rate.
An unexpected upward shift in labour costs will require an increase in interest rates in order to avoid
higher inflation. When wage growth reaches a level that is inconsistent with the inflation target, the
result over time will be higher interest rates, lower employment and higher unemployment. There is a
relationship between wage growth and interest rates. The lower wage growth is, the lower interest
rates will be, and vice versa. The differences between interest rates in various countries reflect to a
large extent differences in wage growth. Japan represents the one extreme, with an interest rate of
zero and no wage growth. At the other extreme are Iceland and Norway, with high interest rates and
high wage growth. The relatively high wage growth in Norway is the result of a tight labour market. In
other countries, the situation is different, with sluggish economic growth and abating inflation. As a
result, the interest rate is higher in Norway than in other countries.
Households are enjoying strong growth in income and are borrowing heavily. Wage growth is high.
Financial savings are low. There is strong growth in retail sales measured in current prices. House
prices are high. Petroleum investment is also high. On the other hand, we expect to see weak
developments in exports and for example in investment in commercial buildings.
The Norwegian krone has appreciated markedly this year. Developments in wage settlements have
probably been an important driving force. High wage growth leads to high interest rates, making it
attractive to take krone positions. As a result, the Norwegian krone appreciates.
We must be prepared for fluctuations in the krone exchange rate in line with that observed in other
countries. There is free trade in goods and services and free capital movements. The krone is floating.
cannot
This means that economic agents assume that the krone will be stable against the euro,
against the dollar or against a weighted average of foreign currencies.
The krone does not fluctuate any more or less than other currencies. A large share of petroleum
revenues is invested in foreign equities and bonds through the Petroleum Fund. Changes in oil prices
influence the size of the Fund, but have little effect on the domestic use of petroleum revenues. The
Petroleum Fund thus serves as a buffer against fluctuations in oil prices and shields the krone
exchange rate. Nevertheless, we have been prepared for fluctuations in the krone exchange rate on a
par with changes in other countries.
Over the last two years, the appreciation of the krone has been driven by the wide and increased
interest rate differential between Norway and other countries, which reflects the relatively high level of
wage growth in Norway.
The interest rate differential reflects high demand growth and high wage growth. There is a clear
relationship between wage growth, interest rate expectations and the krone exchange rate. The
appreciation of the krone dampens inflation, and at the same time weakens profitability, employment
and the capacity to cover labour costs in the internationally exposed sector.
The krone can move in both directions. It will not appreciate indefinitely. Sustained lower wage growth
will be accompanied by a narrower interest rate differential and it may reverse movements in the
exchange rate.
A declining level of wage growth would provide a strong impetus to the internationally exposed sector.
The interest rate could be reduced. This would lead to a depreciation of the krone, with a further
improvement in earnings and employment.
Over the last thirty years, manufacturing has been scaled back in waves. There was substantial
downscaling in the years from 1977 to 1984 and 1987 to 1992 in particular. In the years leading up to
the periods of contraction, profitability deteriorated in the manufacturing sector. It can take time before
such a deterioration translates into lower output and employment. But when the turnaround does
occur, it tends to be swift and hard-hitting. It now appears that a new period of downscaling is under
way.
Several factors point to this: First, productivity growth is higher in manufacturing than in other
industries. This has resulted in a trend decline in the numbers employed in manufacturing in Norway,
as it has in other OECD countries.
Second, manufacturing costs have increased sharply since 1998. Up to the summer of 2000, this cost
increase was to some extent offset by a weaker krone. The appreciation of the krone has highlighted
and exacerbated the deterioration in cost competitiveness. On balance, it appears that cumulative
wage growth in Norway will be a good 15 per cent higher than in other countries from 1998 to 2003.
The krone is now about 7 per cent stronger than the average for the 1990s.
Third, as a result of the fiscal guideline, the internationally exposed sector is subject to additional
pressure. Over time, the phasing in of petroleum revenues will lead to restructuring and the transfer of
resources from the exposed to the sheltered sector.
Fourth, the response patterns in stabilisation policy function in a different way from previously. Under
the "Solidarity Alternative", the response pattern consisted of countering labour market pressures and
strong wage growth by reducing growth in public spending (or, if appropriate, by strengthening
government revenues). This had a beneficial impact on manufacturing industry. Today, monetary
policy shoulders more of the burden. This may sometimes result in a strong krone exchange rate.
Fifth, growth in the global economy is sluggish while, at the same time, oil prices are high. The fall in
share prices curbs economic growth among our trading partners. Markets for Norway's export
industries are stagnating, but at the same time high oil prices are providing a stimulus for some
sectors of the Norwegian economy.
Interest rates were assessed by the Executive Board of Norges Bank yesterday. Interest rates were
left unchanged. Norges Bank's key interest rate, the sight deposit rate, therefore remains at 7 per cent.
According to Norges Bank's assessment, with an unchanged interest rate, the probability that inflation
two years ahead will be higher than 21⁄2 per cent is the same as the probability that it will be lower.
A sharp rise in labour costs is contributing to a relatively high rise in prices for goods and services
produced in Norway. A persistently strong krone will contribute to keeping down prices for imported
goods. The strong krone will have consequences for activity in the internationally exposed sector.
Together with prospects for low inflation internationally, the strong krone is the most important force
acting as a counterweight to the sharp rise in domestic costs.