Furthermore, the Executive Board decided that the key policy rate should lie in the interval 4-5 per cent in the period to the publication of the next Monetary Policy Report on 27 June 2007, conditional on economic developments that are broadly in line with projections. According to the Executive Board’s assessment, the prospects and balance of risks suggest that it would be appropriate to raise the interest rate gradually to about 5 per cent in the course of this year and to a somewhat higher level in the period to summer 2008. Developments in the krone exchange rate will also influence the pace of interest rate hikes because a considerably stronger krone may result in inflation that is too low. Under an inflation targeting regime, it is important to be mindful of the effects of higher interest rates on the krone exchange rate when inflation is low. The interest rate differential against trading partners may widen somewhat further ahead in the projection period. Since such a development is already widely expected in financial markets, we have assumed that it will have limited effects on the krone exchange rate. However, there is considerable uncertainty surrounding the exchange rate projection. The projections are shrouded in uncertainty. The projections for inflation, output, the interest rate and other variables are based on an assessment of the current economic situation and the functioning of the economy. We have illustrated the uncertainty surrounding the projections for the interest rate, inflation and capacity utilisation with fan charts.

In the early phases of the upturn, output growth primarily reflected a strong increase in the number of person-hours worked partly owing to the marked increase in average working hours when sickness absence fell in 2004. A high level of inward labour migration after EU enlargement in 2004 also contributed to increasing economic capacity. Historically, there has been a close relationship between the change in prices for domestically produced goods and services and the level of capacity utilisation, here measured by the output gap. This relationship broke down in 2006. Surprisingly low inflation through 2006, despite appreciably stronger output and employment growth, may indicate that developments have been influenced by conditions on the production and supply side of the economy. The present economic expansion differs from previous upturns in that inflation has remained low so far despite strong growth and increasing capacity utilisation. There are probably several reasons for this. First, low import prices and high prices for our commodity exports have improved Norway’s terms of trade considerably. Prices for oil and gas, shipping, fish, industrial commodities and engineering products have increased considerably. Moreover, Norwegian importers have gained access to new markets in central Europe and Asia which offer considerably cheaper consumer goods. The terms of trade have improved by about 40 per cent since 2002. A similar situation has not been seen since World War I when earnings in the shipping industry and other export industries were exceptionally high for a period. Second, an ample supply of labour has boosted output growth.