øystein olsen : economic perspectives address by mr øystein olsen, governor of norges bank ( central bank of norway ), to the supervisory council of norges bank and invited guests, oslo, 16 february 2012. * * * demanding time for europe “ the year started without much hope, and it had to be expected that the pressure on business and industry would intensify, but however dim the prospects might have appeared, the outcome was darker than anyone had imagined. i need not enumerate the successive collapses that spread from country to country. ” this was the opening of the annual address delivered by norges bank director nicolai rygg 80 years ago. britain had abandoned the gold standard and one country after the other, including norway, followed suit. interest rates had increased. financial markets were turbulent. although the tremors were on a greater scale in the 1930s, nicolai rygg ’ s description could serve as an apt retrospective today as well. in the course of the past two years we have seen economic problems spread across debt - laden countries in europe. greece was the first country to experience a financial collapse. the greek government had to resort to external financial assistance in spring 2010, followed by ireland and portugal. the turbulence spread further in autumn last year. interest rates on public debt rose markedly for spain and italy and thereafter belgium and france. several euro area countries are now struggling with soaring public debt and weak competitiveness in addition to restructuring and public budget cuts. confidence in some countries ’ ability to service debt has been weakened. the monetary union is under pressure. ( chart 1 : current account ) the crisis has its roots in global trade imbalances, with high saving in emerging economies and comparably large deficits in many advanced countries. the imbalances drove down long - term interest rates to very low levels and the appetite for risk grew. inadequate financial sector regulation led to a further deepening of the imbalances. ( chart 2 : yield on 10 - year government bonds ) four years after the financial crisis engulfed the world, a european version has now emerged. both market participants and the authorities failed in their assessments after the introduction of a single currency. prior to the introduction of the economic and monetary union, there were wide differences between interest rates facing different european countries, which primarily reflected different inflation expectations across countries. but through the 1990s, long - term interest rates drifted down to german levels. over the next 10 years, sovereign interest rates were fairly similar –

inclusive public policy such as mahatma gandhi national rural employment guarantee act ( mgnrega ) has set a floor to rural wages and increased the bargaining power of the work force. it is not to argue that rural wage increase is not desirable as real wages remained stagnant for quite some time. admittedly, when gdp was rising faster, real wage increase could be somewhat benign, but real wage increase continued to remain significant even as gdp growth decelerated. thus the wage catch up period seems to have overshot economic growth cycle ( chart 5 ). as students of economics you know very well that the increase in wages if not commensurate with productivity gains could be inflationary. our food economy experienced a cost shock, which was reinforced by sustained wage increases buttressing demand. as supply did not increase commensurately, prices rose at a more than desirable level. while stylised facts may point towards the above conjecture, as economists you could test this formally in different ways. i attempted a simple structural vector auto regression ( svar ) of three variables of food price, material input price and rural wages with rainfall as an exogenous control variable. 2 the results show that material input cost has a sharp positive estimated with monthly data from 1994 : april to 2013 : november ; material cost includes prices of electricity, fertiliser & pesticide, and diesel. bis central bankers ’ speeches impact on food inflation. similarly wages have a significant positive impact. however, the impact of wages is gradual, but more persistent than material cost. now let me turn to the role of monetary policy. how should monetary policy respond to food inflation? from textbooks we learn that monetary policy should look through supply shocks such as a food price increase. but from experience we know that if the supply shock is persistent and becomes structural it will be a mistake for policy not to respond to it. for example, many central banks accommodated the oil price shock of the 1970s judging it to be a temporary supply shock. this was a major factor in subsequent worldwide inflation. the actual policy decision, however, may not be as simple and straightforward as that. another layer of complexity is added to this process by the state of inflation expectations in the economy. if inflation expectations are low and well anchored, the inflationary impact of a supply shock may turn out to be transitory ; this is because wages normally do not react to such inflation. however, if inflation expectations are high and not so well anchored even a temporary