The objective of monetary policy
The Government has defined an inflation target for monetary policy in Norway. The operational objective is a rise in consumer prices 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
Interest rates were left unchanged at Norges Bank's Executive Board meeting on 21 April 2004. Norges Bank's key interest rate, the sight deposit rate, remained at 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 gradually be slightly higher than the trend level would imply. In Inflation Report 1/04, CPI-ATE inflation was projected to remain somewhat below the inflation target next year. According to the report, there are prospects that inflation will move up to the inflation target of 2½ per cent two years ahead.

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

• In Inflation Report 1/04, Norges Bank projected that growth in the global economy would pick up through 2004 and would also be solid in 2005. At present, growth among trading partners as a whole appears to have been somewhat stronger in the first quarter than assumed by Norges Bank. Market participants now expect interest rates to rise at a somewhat faster pace in a number of countries. It is now expected that the key interest rate in the US will be increased at the end of June and that the ECB will raise its key rate towards the end of the year. There are signs of a somewhat sharper rise in consumer prices internationally than projected in the Inflation Report, partly as a result of the rise in prices for oil and other commodities. The spot price for oil has increased and has recently been around USD 38 per barrel. Oil futures have also risen markedly, by USD 2-4. Prices for other internationally traded goods are also moving up.
• In both March and April, inflation in Norway was approximately as projected in the Inflation Report. In April, the year-on-year rise in the CPI-ATE was 0.2 per cent. Adjusted for some temporary factors, the year-on-year rise was 0.5 per cent.¹ The rate of increase in the last three months² was 1.1 per cent annualised. TNS Gallup's expectations survey indicates that expectations concerning inflation ahead remain stable at about 2½ per cent.
• The krone exchange rate, as measured by a broad index (I-44), has appreciated by about 4 per cent since the publication of Inflation Report 1/04. The krone is approximately 1 per cent stronger than before the last monetary policy meeting on 21 April.
• Pricing in markets indicates that there has been little change in market participant's expectations concerning short-term interest rates in Norway for the next year, but expectations have been revised upwards for our trading partners. At a horizon of more than 1-1½ years, interest rate expectations in Norway have increased more than among our trading partners.
• Activity in the Norwegian economy is picking up. Goods consumption continued to expand in the first quarter. TNS Gallup's consumer confidence indicator fell slightly in the second quarter, but remains at a high level. Housing starts in the first quarter were at approximately the same level as in the first quarter of 2003, but commercial building starts have declined. Statistics Norway's business tendency survey for the first quarter of 2004 suggests clearly positive developments for manufacturing. Unemployment is stable, despite solid output growth. Employment is rising only moderately, which indicates high growth in productivity.
• Norges Bank's regional network reports that activity levels are increasing in most industries. The growth outlook for the next six months is considered favourable. The network reports moderate growth in investment plans for the private and public sectors. Employment in the business sector is rising moderately with the exception of manufacturing. Employment in the public sector and manufacturing is reported to be approximately unchanged. Annual wage growth is projected to be lower in 2004 than in 2003. Profitability is reported to have improved in the business sector.
• After having climbed since the summer of 2003, house prices fell slightly from March to April. Growth in household borrowing edged up to 11.1 per cent in March. Corporate debt shows negative growth.
• The government accounts for 2003 show a larger, structural non-oil deficit than estimated in the National Budget for 2004. As a result, the fiscal stimulus from 2002 to 2004 will be stronger than previously planned. Measured in value, underlying spending growth over the government budget is estimated at nearly 5 per cent in both 2003 and 2004. At the same time, it is likely that local government revenues will increase by 11 per cent from 2002 to 2004.
• Results from groups that have completed wage negotiations in this year's wage settlement do not imply a change in Norges Bank's projections for 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:

• Growth in the Norwegian economy is probably somewhat stronger than projected in Inflation Report 1/04, but capacity utilisation at the end of 2003 may have been somewhat lower than projected earlier. Consumer prices have moved approximately in line with projections in Inflation Report 1/04.
• The appreciation of the Norwegian krone in recent months will, if it continues, push inflation down at the 1-3 year horizon.
• Inflation in other countries remains subdued, but there are signs of somewhat higher consumer price inflation in the US, the euro area, Sweden and China. In the short term, the rise in oil prices and other commodities will contribute to somewhat higher inflation in other countries. On the other hand, shifts in import patterns from high-cost to low-cost countries may be more pronounced than assumed earlier.
• Monetary policy is generating a strong stimulus to the Norwegian economy. We have limited experience of the effects of such a low nominal interest rate level abroad and in Norway. Labour shortages may emerge more rapidly than estimated. Wage growth may then rise more than expected.
• Inflation is unusually low. This may contribute to a greater extent than assumed earlier to low nominal wage growth ahead.

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. We now have several monthly observations showing a rise in prices that is consistent with the most recent forecasts. Later this year, we will receive further confirmation of whether consumer prices are rising in line with our projections. We also place emphasis on avoiding imbalances in the real economy. The economy is probably approaching a normal rate of capacity utilisation. 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 abroad may also have a considerable influence on movements in the krone exchange rate. The inflation outlook in Norway implies that Norway will not be the frontrunner when other countries increase interest rates.

Some factors support a reduction in the interest rate.

• The exchange rate is stronger than projected in Inflation Report 1/04 and will contribute to pushing down inflation in the next couple of years. 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.
• 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 small and 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 a decline in prices for imported consumer goods, external price impulses will probably remain weak. As mentioned previously, the stronger krone in recent months will also curb price impulses.

Other factors indicate that the interest rate should not be reduced at this time.

• Short-term interest rates in Norway are low. The impact of monetary policy occurs with a lag. There are signs that demand and output are picking up at a somewhat faster pace than projected in the Inflation Report. Capacity utilisation may gradually be fairly high.
• After a surprisingly sharp fall in inflation in Norway last autumn and winter, inflation has stabilised and in March and April was approximately on a par with projections in the 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.

The Executive Board has come to the conclusion that it is appropriate to keep the key interest 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. 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. The inflation outlook in Norway implies that Norway will not be the frontrunner when other countries increase interest rates.

Footnotes

¹Adjusted for the effect of the interest rate's direct impact on house rents, changes in day-care rates and for special factors relating to indirect tax changes earlier in the year.

²Seasonally adjusted, three-month moving average converted to as an annual rate

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Charts - monetary policy meeting
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Charts - monetary policy meeting