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 for monetary policy 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
The Executive Board decided on 1 July 2004 to leave interest rates unchanged at 1.75 per cent. The interest rate was last changed on 11 March 2004, when it was reduced by 0.25 percentage point.

In Inflation Report 2/04, presented on 1 July, mainland GDP growth is projected to pick up markedly this year and remain relatively high next year. The output level will be slightly higher than implied by the trend level, i.e. the output gap is projected to be marginally positive in the period 2005-2007. Inflation, as measured by the CPI-ATE, is expected to rise towards the end of the year and to show a moderate increase in the period 2005-2007. In the baseline scenario in the report, inflation remains below target up to summer 2007.

The analyses in Inflation Report 2/04 are based on the 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. Norges Bank indicated, however, that monetary policy should be aimed at increasing inflation at a somewhat faster pace than projected and that a more expansionary monetary policy ahead than indicated by forward interest rates and the forward exchange rate may contribute to this.

The Executive Board's assessment was that the economic outlook implies a sight deposit rate in the interval 1¼ - 2¼ per cent at the beginning of November 2004.

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

• After rising sharply for several quarters, economic growth in the US declined in the second quarter and employment growth appears to have slowed this summer. Economic growth has picked up from a low level in the euro area. Economic growth has also picked up in Sweden and the UK. Inflation has edged up in both the US and the euro area, also when figures are adjusted for the effects of higher energy prices. In the US, the UK and New Zealand, the key rate has been raised by 0.25 percentage point. Financial market expectations indicate gradual interest rate increases in a number of countries, but expectations have been lowered recently. Equity prices in the US, Europe and Japan have fallen in July and so far in August.
• Oil prices have risen to approximately USD 42 per barrel. According to oil market expectations, oil prices are expected to remain high for a fairly long period, and even oil purchased for delivery in six to seven years is currently priced at close to USD 35 per barrel. Oil demand has risen sharply during this upturn, and there appears to be little excess production capacity. Periodic interruptions in oil deliveries from Iraq, fears of terror and uncertainty with regard to the Russian energy company Yukos are also affecting the oil market.
• Inflation remains low in Norway. The year-on-year rise in consumer prices adjusted for tax changes and excluding energy products (CPI-ATE) was 0.2 per cent in July 2004. Adjusted for some temporary factors, the rise over the past twelve months was 0.5 per cent.¹ Inflation, calculated over a shorter period, edged up early this spring but has since declined. Overall, prices have risen somewhat less in June and July than projected in the previous Inflation Report.
• The krone, as measured by a broad index (I-44), depreciated following the publication of the consumer price index for May and up to the beginning of July. After the previous monetary policy meeting, the krone was fairly stable for a long period, but has appreciated in the last few days and is now about 1½ per cent stronger than was the case prior to the previous monetary policy meeting.
• Market participants have revised down their expectations concerning interest rate developments in Norway. Market participants now seem to expect the key rate to remain unchanged up to the beginning of the second quarter of 2005.
• In Norway, retail trade developments have been affected by the transport workers' strike, but underlying growth in private consumption appears to have been fairly high in the second quarter. Imports of goods excluding ships and oil platforms rose sharply in the second quarter, while exports of the same goods fell slightly. Manufacturing output is picking up somewhat, and Statistics Norway's business tendency survey for the second quarter indicates that the positive trend will continue. Statistics Norway's latest LFS figures indicate that employment rose somewhat in the spring months.
• Activity in the housing market is high. Both housing starts and house prices are rising sharply. Commercial building starts have also increased in recent months, particularly in the retail trade sector.
• Growth in household borrowing increased further in June, while corporate debt continues to decline.

The outlook and risk factors
New information that has emerged since the previous monetary policy meeting has not led to any significant change in the assessments of developments in the real economy in Inflation Report 2/04.

The rise in prices over the past twelve months to July was somewhat lower than projected in Inflation Report 2/04. This is partly due to early summer sales of, for example, clothing and furniture. Inflationary impulses may also have been generally weaker than expected.

The effects of oil price developments on the Norwegian economy are mixed. Persistently higher oil prices may eventually contribute to higher petroleum investment and increased activity in sectors affected by petroleum activities. A sharp rise in oil prices, however, restrains global economic growth and affects demand for our other export products.

In some cases, a sharp rise in oil prices and unrest in the Middle East has boosted demand for the Norwegian krone. However, the extra revenues to the central government due to higher oil prices will be invested in foreign securities through the Petroleum Fund. Thus, higher foreign exchange revenues will not have a direct effect on the balance in the Norwegian foreign exchange market.

High oil prices are resulting in increased fuel and heating expenses for Norwegian firms and households. In addition, high oil prices are pushing up inflation abroad, with an attendant increase in domestic consumer prices via imports.

In addition to the effect of the rise in oil prices, important risks to the inflation outlook in the coming years are generally the same as indicated at the previous monetary policy meeting:

• If developments in the krone exchange rate differ from the assumptions in Inflation Report 2/04, the inflation outlook will be affected. The feed-through from the krone exchange rate to consumer prices is, however, 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. Labour shortages may arise more rapidly than assumed and as a result wage growth may be higher than projected. On the other hand, competitiveness in manufacturing industry and low inflation may be given greater emphasis in the wage negotiations. This may then result in wage growth that is lower than projected.
• Projections for developments in productivity and growth in potential output are uncertain.
• Inflation abroad may also rise more rapidly than projected if wage growth picks up or higher demand translates into higher profit margins. In that case, this might contribute to higher inflation in Norway. On the other hand, growth in China and other Asian countries may slow, resulting in lower commodity prices. It is also possible that the shift towards imports from low-cost countries will be broader than assumed by Norges Bank in the Inflation Report.

Assessment
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 one month to the next. Monetary policy also places emphasis on avoiding imbalances in the real economy. Uncertainty concerning the effects of previous monetary policy easing and the unusually low interest rate imply that we should exercise caution with regard to further interest rate reductions. With the prospect of continued low inflation for a period ahead, wide deviations from projected economic developments would be required before the interest rate should be increased. 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.

Low inflation in June and July is partly due to temporary factors. The coming months will confirm whether the unexpectedly low level of inflation is also due to the persistence of generally weaker price impulses, or whether inflation rises as projected by Norges Bank in the previous Inflation Report.

Growth in household borrowing increased further in June. The debt burden is high and households are thereby more vulnerable to economic disturbances. Corporate debt continues to decline.

New information that has emerged since the previous monetary policy meeting does not imply any significant change in the balance between the objective of reaching the inflation target and stability in the real economy in relation to the Inflation Report.

Summary
The Executive Board has come to the conclusion that it is appropriate to keep the key interest rate unchanged. 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 weighed the objective of bringing inflation back to target and of stable inflation expectations against the risk that output growth may eventually be too high. The Executive Board's assessment remains unchanged, i.e. that the inflation outlook may imply an unchanged interest rate for a longer period than assumed in the projections in the Inflation Report.

Charts - monetary policy meeting (757 kB)
(Store the file, call it up in PowerPoint, and then double-click on individual charts in order to gain access to the underlying data.)

Charts - monetary policy meeting (129 kB)