Recent developments with weaker growth prospects for Europe and tendencies of a somewhat stronger krone might indicate that the interest rate should be increased at a later time. The Executive Board nevertheless concluded that it is now appropriate to raise the interest rate by 0.25 percentage point. The Executive Board weighed the objective of bringing inflation back to target and stabilising inflation expectations against the risk that output growth may eventually be too high. Looking ahead, the Executive Board nonetheless envisages a more moderate increase in the interest rate than in the March Inflation Report.

Assessments

The objective of bringing inflation back to the target of 2½ per cent and anchoring inflation expectations imply a continued expansionary monetary policy.

Oil futures prices have risen markedly. Market interest rate expectations in other countries have been lowered since the March Report. There may therefore be a risk of a stronger krone in the coming months. This might suggest that the interest rate be kept unchanged for a longer period.

On the other hand, output growth is high. As a result of the low interest rate, capacity utilisation and inflation are projected to rise further. The objective of stabilising developments in output and employment points in isolation to a higher interest rate. High capacity utilisation may lead to a higher rise in property prices and household borrowing. Such a development may be a source of instability in demand and output in the somewhat longer run.

The analyses and assessments in the Inflation Report imply that a path where the key rate gradually - in small, not too frequent steps - is brought up towards a more normal level provides a reasonable balance between the objective of stabilising inflation at the target and the objective of stabilising output and employment. In line with market expectations, Norges Bank's analyses are now based on a more moderate increase in the interest rate ahead than in the March Report. In the analysis, this counters the effect of a somewhat stronger krone and lower wage growth on inflation than expected in the March Inflation Report.

Outlook and risk factors

The projections in Inflation Report 2/05 are based on a baseline scenario where the key rate follows forward interest rates up to 2007, but rises somewhat faster thereafter. Forward rates imply expectations of an increase in the key rate to about 2¼ per cent towards the end of 2005 and up to 2¾ per cent at the end of 2006. Throughout the projection period the level of short-term nominal and real interest rates will be lower than what we consider to be neutral levels. Monetary policy will continue to be expansionary. The interest rate path is somewhat lower than in the March Inflation Report. The krone exchange rate is assumed to follow the forward exchange rate, which is broadly unchanged over the next three years. This implies an assumption that the krone remains somewhat stronger than assumed in the March Report.

Capacity utilisation in the Norwegian economy is expected to increase this year and next. Towards the end of this year the output level may be about 1 per cent higher than implied by output growth around trend. Inflation may rise gradually to close to 2 per cent in the first half of 2007. There are prospects that inflation will be around 2½ per cent three years ahead. A monetary policy that gradually becomes less expansionary will eventually stabilise the economy, curbing the rise in inflation and preventing it from overshooting the target.

The monetary policy strategy in Inflation Report 2/05 is that the sight deposit rate should be in the interval 1¾ - 2¾% in the period to the publication of the next Inflation Report on 2 November 2005, conditional on economic developments that are broadly in line with the projections.

The Executive Board has placed particular emphasis on the following uncertainties:

• The price-curbing effects of higher imports from low-cost countries in Asia and in central and eastern Europe may persist for a longer period than assumed. Moreover, higher inward labour migration and intensified competition in the labour market may have a dampening impact on wage growth. Weaker growth in the international economy may also curb the rise in prices for imported consumer goods. Such developments might imply less frequent interest rate increases than in the baseline scenario in the Inflation Report.
• Monetary policy is expansionary. So far, it does not seem that the effects are stronger than expected, but we have limited experience of such low interest rates. It is uncertain how rapidly prices and wages will react when growth in output and employment accelerates. There is also a risk that an interest rate that is kept low over a longer period may alone lead to expectations of persistently low interest rates. If there are prospects that the high level of capacity utilisation will persist and that inflation might eventually overshoot the target, interest rates may be increased more rapidly than in the baseline scenario.
• Developments in the krone exchange rate are highly uncertain. A markedly stronger krone exchange rate ahead than assumed in the baseline scenario may mean that it will take longer to reach the inflation target and for capacity utilisation to decline. In that case, the interest rate should be kept low for a longer period.

Economic developments

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

• Output growth in the US and Asia remains buoyant. On the other hand, output and employment growth is weak in the euro area. Growth has also slowed in the UK and particularly in Sweden. International long-term interest rates have declined. In spite of record-high oil prices, underlying inflationary pressures in the international economy are generally subdued.
• In this business cycle, our trading partners have increased their key rates by an average of ¼ percentage point. Financial market participants expect a continued gradual rise in US interest rates. Interest rates are also expected to be increased in Canada and Switzerland. The key rate in Iceland was increased further in the period. Interest rate expectations have been lowered markedly for the euro area, however, and many market participants see it as likely that the ECB will reduce its key rate in the course of the year. In Sweden, the key rate was lowered by 0.5 percentage point to 1.5 per cent. The key rate is also expected to be reduced in the UK.
• Oil prices have increased and have in periods been close to USD 60 per barrel. Oil futures prices 6-7 years ahead have also increased sharply.
• In Norway, inflation remains low, but has edged up over the past year. In May, the 12-month rate of increase in consumer prices adjusted for tax changes and excluding energy products was 1.1 per cent. Adjusted for the estimated direct effect of the interest rate decline on house rents, underlying inflation can be estimated at 1.3 per cent in May. Prices for domestically produced goods and services rose by 2.0 per cent, while prices for imported goods fell by 1.1 per cent over the past 12 months. There are more enterprises in our regional network that expect a higher rather than a lower rise in prices for their products, but the share expecting a higher rise in prices has decreased somewhat compared with earlier this year.
• The krone has recently been influenced by swings in market expectations concerning interest rates in Norway and other countries. The krone is now a good 1 per cent stronger, as measured by the import-weighted krone exchange rate, than around the previous monetary policy meeting on 25 May.
• Since the previous monetary policy meeting, market interest rate expectations for Norway have been lowered. The expected interest rate differential against trading partners has shown little change.
• According to preliminary quarterly national accounts figures, most mainland industries are recording strong growth. The upturn is particularly pronounced in many service sectors, retail trade and construction. Information from our regional network also indicates that the cyclical upturn in the Norwegian economy is continuing. The export industry reports high profitability, but somewhat lower growth.
• Employment rose by 3 800 between the fourth quarter of 2004 to the first quarter of this year (seasonally adjusted), according to preliminary quarterly national accounts figures. Registered unemployment exhibited a further fall in May. Statistics Norway's Labour Force Survey conveys a somewhat different picture. Statistics Norway has explained that the LFS figures are probably highly uncertain at present.
• The investment intentions survey for oil and gas activities in the second quarter confirms prospects of high investment growth this year. The survey points to continued buoyant investment activity in 2006.
• Household credit demand has remained high so far this year. House price inflation edged down in the first quarter, but moved up again in April and May. Total mainland corporate debt has increased somewhat over the past year. Monetary growth has increased markedly since the beginning of 2004. So far, the increase has been more pronounced for enterprises than for households.
• Banks' interest rate margins have narrowed recently. Several banks have reduced their mortgage rates.

 Charts - monetary policy meeting (854 Kb)
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