Yet the usual business cycle indicators are subject to a variety of measurement errors. As has been demonstrated extensively in the literature, the empirical proxies used to capture the output gap are subject to constant revision. 20 Clearly, policy-makers who rely exclusively on such assessments of the cyclical position can be seriously misguided in their real-time conjunctural assessment. To the extent that these indicators are central to the implementation of flexible inflation targeting, over-reliance on them may have led to an over-activist and at times inappropriate monetary policy stance. In particular, policy makers might also have formed an overly benign assessment of the situation prevailing in 2002–2004 if they relied excessively on output gap measures, as these measures were based on overly optimistic assumptions about potential growth. For instance, in early 2003 the IMF estimated the US output gap for that same year to be slightly above 2%. In early 2006 the estimate was revised down by 1 percentage point and one year later by another 1 percentage point. With the benefit of hindsight it turned out that in 2003 the output gap was basically nil (See figure 3). 21 Such considerations plague other composite indicators derived from the literature, such as the natural real interest rate. Understanding current inflation developments can also prove challenging. Headline inflation rates may be volatile in the short term, reflecting the impact of temporary relative price shocks. 22 Monetary policy-makers need to look through such noise. But conventional measures of so-called “core inflation” can themselves be misleading.

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.