The objective of monetary policy
The Government has defined an inflation target for monetary policy in Norway. Norges Bank's operational conduct of monetary policy is oriented towards low and stable inflation. The operational objective is annual consumer price inflation of approximately 2.5 per cent over time.

Monetary policy influences the economy with long and variable lags. Norges Bank sets the interest rate with a view to stabilising inflation at the target within a reasonable time horizon, normally 1-3 years. The more precise horizon will depend on disturbances to which the economy is exposed and how they will affect the path for inflation and the real economy ahead.

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.

Previous assessments
Interest rates were left unchanged at Norges Bank's Executive Board meeting on 26 May 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". The interest rate was last changed on 11 March 2004, when it was reduced by 0.25 percentage point.

Economic developments
The Executive Board has placed particular emphasis on the following factors:

• The global cyclical upturn has gained a firmer footing. In recent months, growth has also picked up in several euro area countries. International inflation has edged up in recent months, primarily reflecting a sharp rise in prices for many commodities, particularly oil. However, the outlook for wage growth points to continued moderate inflation. Financial market expectations imply a gradual rise in interest rates in several countries in the period ahead.
• Inflation in Norway is low. The year-on-year rise in consumer prices adjusted for tax changes and excluding energy products (CPI-ATE) was 0.1 per cent in May 2004. The rise was 1.6 per cent¹ for the last three months, annualised. Developments in recent months have been broadly in line with the projections in the March Inflation Report.
• The krone exchange rate, measured by a broad index (I-44), appreciated markedly from mid-February to the beginning of May. The krone has varied somewhat and has depreciated by about 2½ per cent since the previous monetary policy meeting.
• Interest rate expectations in Norway increased during the spring. Market expectations seem to indicate an interest rate increase of ¼ percentage point towards the end of 2004. This implies a key rate of about 2 per cent at the end of the year.
• Growth in the Norwegian economy slowed in 2002 and was low in the first half of 2003. Activity has picked up since then. Growth in household borrowing is high. Housing investment has started to rise again. Low inflation has led to solid growth in real wages, in spite of relatively low nominal pay increases in this year's wage settlement. Private consumption is exhibiting brisk growth. There are some signs of a pick-up in mainland business investment. At the same time, the vacancy rate for office premises is high and enterprises are still reducing their debt. Norges Bank's regional network reports continued growth and rising activity levels in most industries. Market developments are positive.
• Unemployment seems to have levelled off after having risen through 2002 and 2003. Productivity growth in the mainland economy is probably fairly high. Employment is rising only moderately, despite solid output growth.

The outlook ahead and risk factors
The analyses in Inflation Report 2/04 are based on a technical assumption that interest rates will move in line with forward interest rates. The analyses are also based on the assumption that the krone exchange rate will shadow the path for the forward exchange rate as observed on 24 June. At that time, market pricing reflected expectations of a fairly stable exchange rate ahead.

Growth in mainland GDP is projected to pick up markedly in 2004 and remain relatively high next year. Growth is expected to be somewhat higher than the increase in production capacity. The output gap is estimated to be marginally positive in 2005 to 2007. Inflation, measured by the CPI-ATE, is projected to edge up towards the end of the year, mainly due to the depreciation of the krone in 2003. Inflation is expected to increase moderately in the period from 2005 to 2007. In the baseline scenario in Inflation Report 2/04, inflation remains below target up to summer 2007.

The Executive Board has assessed the following important risks to the inflation outlook over the coming years:

• The krone exchange rate has shown substantial changes since the March Inflation Report. Exchange rate expectations, as reflected in the forward exchange rate, have also varied considerably. A krone exchange rate path that deviates from the assumption in Inflation Report 2/04 will influence the inflation outlook. The feed-through from the krone exchange rate to consumer prices is uncertain.
• The key rate has been reduced from 7 per cent in December 2002 to 1.75 per cent in March 2004. We have little experience of such considerable and rapid monetary policy easing and such a low nominal interest rate level. If labour shortages arise more rapidly than we have assumed, wage growth may be higher than projected. On the other hand, competitiveness in manufacturing industry and low inflation may be given more emphasis in wage negotiations. This may then result in wage growth that is lower than projected.
• Projections for developments in productivity and potential output are uncertain.
• Global inflation may rise more rapidly than projected if wage growth moves up or prices for oil and other commodities continue to rise. This might contribute to higher inflation in Norway. On the other hand, growth in China and other Asian countries may slow and result in lower commodity prices. Oil prices have fallen in the past few days, partly as a result of higher oil stocks, and are unstable. It is also possible that the shift in Norway's imports towards low-cost countries is more substantial than we have assumed.

Assessments
The aim of monetary policy is higher inflation. The monetary policy stance is therefore expansionary. With the current low level of inflation, it is appropriate to be particularly vigilant as regards developments in consumer prices. However, consumer prices may show erratic variations from month to month. Several monthly observations show that the rise in prices since the March Inflation Report has been consistent with our projections. Over the next few months, we will receive further confirmation of whether consumer prices are rising in line with our projections. Monetary policy also places emphasis on avoiding imbalances in the real economy.

Credit developments are still giving ambiguous signals to our interest-rate setting. Growth in household borrowing is strong, while enterprises are reducing their debt. All in all, the financial stability outlook is satisfactory. However, high debt growth makes households more vulnerable to economic disturbances.

Given the assumptions underlying the projections in Inflation Report 2/04, inflation will remain somewhat lower than the inflation target up to autumn 2006. Capacity utilisation in the economy is increasing, and the output gap is expected to turn marginally positive during the projection period.

Monetary policy should be aimed at increasing inflation at a somewhat faster pace than projected in the Inflation Report. The most appropriate alternative now seems to be that the interest rate should be kept unchanged for a longer period than indicated by market expectations. The prospect of continued low inflation in Norway also implies that Norway should not be the frontrunner when interest rates are increased in other countries.

The Executive Board's assessment is that the economic projections imply a sight deposit rate in the interval 1¼ - 2¼% at the beginning of November 2004. If the krone appreciates substantially, this may provide a basis for considering an interest rate at the lower end of, or below, the interval. The unusually low interest rate and uncertainty concerning the effects of previous monetary policy easing imply that we should exercise caution with regard to further interest rate reductions. On the other hand, given the prospect of low inflation ahead, wide deviations from projected economic developments would be required before it would be appropriate to increase the interest rate in the period to the beginning of November 2004.

Summary
The Executive Board has come to the conclusion that it is appropriate to keep the key interest rate unchanged at this time. The Executive Board did not find any clear alternative to an unchanged interest rate at this monetary policy meeting. 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, the inflation outlook may imply an unchanged interest rate for a longer period than implied by the interest rate assumptions in Inflation Report 2/04.

Charts - monetary policy meeting (762 kB)
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Charts - monetary policy meeting (141 kB)