The objective of monetary policy
The Government has defined an inflation target for monetary policy in Norway. The operational objective is an inflation rate of 2½ per cent over time. In general, the direct effects on consumer prices resulting from changes in interest rates, taxes, excise duties and extraordinary temporary disturbances are not taken into account. Norges Bank places particular emphasis on CPI inflation adjusted for tax changes and excluding energy products (CPI-ATE) when assessing underlying inflation.

Normally, Norges Bank sets the interest rate with a view to achieving an inflation rate of 2½ per cent two years ahead. Norges Bank operates a flexible inflation targeting regime, so that variability in both output and inflation is given weight.

Previous assessments
On 11 March 2004, Norges Bank's Executive Board decided to reduce the sight deposit rate by 0.25 percentage point to 1.75 per cent. It was also stated that "with a sight deposit rate of 1.75 per cent at present, the probability that inflation two years ahead will be lower than 2½ per cent is greater than the probability that it will be higher."

In Norges Bank's Inflation Report 1/04, mainland GDP growth was projected to pick up markedly this year and remain relatively high in 2005 and 2006. The output level will be slightly higher than the trend level would imply. This means that the output gap, as calculated by Norges Bank, will be marginally positive in 2005 and 2006, after having been slightly negative this year. In Inflation Report 1/04, CPI-ATE inflation was projected to remain somewhat below the inflation target next year. Two years ahead, there are prospects that inflation will move up to the inflation target of 2½ per cent. The analyses are based on the assumption that the sight deposit rate moves in line with forward interest rates prevailing at the beginning of March and that the krone follows expectations as reflected in the forward exchange market. This implied that the interest rate would be reduced to 1½ per cent by summer 2004 and thereafter increased gradually.

Economic developments
The Executive Board has placed particular emphasis on the following new information that has emerged since the previous monetary policy meeting:

• Underlying inflation is low. The rate of increase in the last three months was 0.5 per cent¹ annualised. In March, the year-on-year rise in the CPI-ATE was 0.3 per cent. The rise in prices was somewhat higher than projected in the Inflation Report, primarily due to developments in import prices and house rents. Prices for imported consumer goods are nevertheless 2.7 per cent lower than one year earlier.
• The krone, as measured by a broad index (I-44), is now approximately 3½ per cent stronger than before the monetary policy meeting in March. The krone appreciated in the first days after the last monetary policy meeting and after publication of the consumer price index for March.
• Global economic growth is broadly in line with projections in the Inflation Report. The recovery in the US has also taken hold in the labour market. Economic indicators for continental Europe provide mixed signals. The rise in US consumer prices accelerated in March. Inflation is very low in the Nordic countries. Equity prices in the US and Europe are at approximately the same level as at the beginning of March, while the recovery continues in Japan. Bond yields have increased markedly in a number of countries.
• Market participants have revised up their interest rate expectations for several countries. The key rate in the US is now expected to be increased by ¼ percentage point in late summer. Pricing in markets indicates that there is a small probability of an interest rate reduction in the euro area before the summer. In Sweden and Canada, interest rates have been reduced by 0.50 and 0.25 percentage point, respectively, to 2 per cent.
• Oil prices remain high at USD 30-35 per barrel. Prices for other important export goods such as aluminium and fish also remain high.
• Market participants have revised up their expectations concerning Norwegian interest rate developments. In financial and foreign exchange markets, pricing in the forward market points to expectations of an unchanged sight deposit rate up to the autumn of 2004 and then a gradual increase. The short-term interest rate level, which is currently lower than among our trading partners, is expected to be approximately on a par with interest rates abroad in summer 2005. Bond yields in Norway have increased somewhat more than in other countries.
• Activity in the Norwegian economy is picking up, in accordance with Norges Bank's assumptions in the Inflation Report. According to preliminary figures from Statistics Norway, mainland GDP rose by 0.8 per cent from the third to the fourth quarter of 2003. Goods consumption declined somewhat in February 2004, but this can fluctuate from one month to the next. New car registrations are increasing. According to preliminary figures from Statistics Norway, private mainland investment picked up somewhat in the fourth quarter of 2003, especially in service industries, but housing investment and manufacturing investment also rose. Housing starts have been high so far this year. Commercial building starts continue to decline.
• Activity in the housing market is high, with a sharp rise in prices for resale homes. Twelve-month growth in total credit to households and the mainland business sector fell to 5.2 per cent in December and remained unchanged in January. Household debt is showing high and stable growth, while growth in corporate debt remains low or negative.
• Employment has risen gradually, and unemployment is fairly stable, in line with the analyses in the Inflation Report.
• Results from groups that have completed wage negotiations in this year's wage settlement do not imply a substantial change in Norges Bank's projections for annual wage growth this year. Large groups of employees have yet to begin their wage negotiations.

The outlook and risk factors
The Executive Board has assessed the outlook and the following important risk factors:

• Price developments for imported consumer goods are uncertain. Our projections are based on a gradually slower decline in prices for these goods measured in foreign currency. There is still a risk that inflation among our trading partners may remain lower than projected in the period ahead.
• Projections in the Inflation Report are based on the assumption that import prices will pick up through 2004 as a result of the exchange rate depreciation in 2003. It cannot be ruled out that import prices in the next few months will rise faster than assumed by Norges Bank. On the other hand, the appreciation of the krone in the last few weeks, if it persists, will curb inflation at the one to two-year horizon.
• Labour shortages may emerge more rapidly than estimated. Wage growth may then rise at a faster pace than assumed in the Inflation Report, as for example, if growth in salaries for white-collar workers again accelerates. Weak competitiveness in Norwegian manufacturing may have the opposite effect.
• Rationalisation in the business sector may enable companies to increase output considerably without strong growth in employment. This suggests that there is room for somewhat stronger growth in the economy than earlier without the emergence of pressures on economic resources.
• Monetary policy is now generating a fairly strong stimulus to the Norwegian economy. Our experience of such a considerable and rapid monetary policy easing is limited. The effect on total demand for goods and services may be greater than we have estimated.

Assessments
The aim of monetary policy is higher inflation. With the current low level of inflation, it is appropriate to be particularly vigilant with regard to developments in consumer prices. However, consumer prices may show random variations from one month to the next. Later this year, we will receive confirmation of whether consumer prices are rising in line with our projections. When inflation increases from a very low level, this will provide a basis for gradually moving towards a more normal short-term interest rate level in Norway. This may counter excessive credit growth and excessive pressures on domestic resources in the medium term. Interest rate developments in other countries may also have a considerable impact on the krone and hence on Norwegian interest rates.

There are factors that support a further easing of monetary policy now.

• Following the monetary policy meeting on 11 March, Norges Bank stated that a path that is in line with the projections in Inflation Report 1/04 provides a reasonable balance between the prospects for reaching the inflation target and stable developments in the real economy. So far, demand, output and employment have generally developed in line with the projections in the Inflation Report. Inflation at the present time is somewhat higher than projected, but this alone does not imply higher inflation at the one to two-year horizon. On the other hand, the exchange rate has appreciated since the last monetary policy meeting. Past experience shows that in periods the krone is heavily influenced by developments in the interest rate differential between Norway and other countries. This is given weight in interest-rate setting. However, themes in the foreign exchange market shift, and Norges Bank does not have instruments to fine-tune the exchange rate. Nevertheless, a reduction in the key rate might partly offset the tightening which a stronger exchange rate represents.
• The krone depreciated in 2003. This will contribute to pushing up inflation through 2004. Apart from this, the overall price impulses to the Norwegian economy will be limited. Wage growth will probably be moderate. Productivity growth appears to be high and competition has increased in a number of markets. Prices for imported goods measured in foreign currency have fallen. Even though higher commodity prices may contribute to somewhat higher inflation in other countries and to curbing the decline in prices for imported consumer goods, external price impulses will probably remain weak.
• A period of too low inflation may influence inflation expectations among economic agents. Low inflation may therefore be self-reinforcing.

A number of factors also indicate that we should now await additional information before any further reduction of the interest rate.

• Although developments in continental Europe are still uncertain, the recovery in the global economy has gained a firmer footing, through strong growth also in the US labour market.
• Short-term interest rates in Norway are low. The impact of monetary policy occurs with a lag. Information that has emerged since the last monetary policy meeting confirms that activity in the Norwegian economy is moving up.
• After a surprisingly sharp fall in inflation in Norway last autumn and winter, inflation has stabilised and increased somewhat recently and is now slightly higher than projections in Inflation Report 1/04
• Household borrowing is high. In the months ahead, developments in corporate demand for credit may provide a clearer indication of to what extent the upturn in the real economy has also gained a footing in the business sector.

Summary
The Executive Board has considered two main alternatives: reducing the interest rate by 0.25 percentage point or keeping the interest rate unchanged at this time and awaiting additional information before any further reduction of the interest rate.

The Executive Board has come to the conclusion that it is appropriate to keep the key rate unchanged at this time. In reaching its decision, the Executive Board has weighed the objective of bringing inflation back to target and stabilising inflation expectations against the risk that output growth may eventually be too high. Furthermore, according to the Executive Board's assessment, with a sight deposit rate of 1.75 per cent at present, the probability that inflation two years ahead will be lower than 2½ per cent is greater than the probability that it will be higher.

Footnotes

¹Seasonally adjusted, centred three-month moving average recalculated as an annual rate

Charts - monetary policy meeting
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Charts - monetary policy meeting