The Covid-19 pandemic has led to a sharp downturn in the Norwegian economy. Low interest rates are helping to dampen the downturn, mitigating the risk of a more prolonged impact on output and employment. Since the monetary policy meeting in May, activity has picked up faster than expected, but there is still substantial uncertainty about developments ahead.

Norges Bank’s Monetary Policy and Financial Stability Committee reduced the policy rate from 1.5% to 0.25% in March, followed by a further reduction to 0% in May. At the monetary policy meeting on 17 June, the Committee decided to keep the policy rate unchanged. There are prospects that the policy rate will remain at the current level for some time ahead.

 

Sharp global downturn

The spread of Covid-19 and the extensive measures to contain it have thrown the global economy into a severe economic downturn. Unemployment has increased markedly. Most countries have implemented forceful fiscal measures and central banks have cut policy rates and provided liquidity to ameliorate the economic situation. Market-implied rates indicate very low interest rates among Norway’s trading partners for a long time ahead.

In recent weeks, many countries have embarked on a gradual reopening of society. Activity indicators have risen slightly from the very low levels observed in March and April, but the speed of the recovery is highly uncertain. There are prospects for low inflation in the years ahead.

 

Oil prices have risen since the sharp fall earlier this spring and are now around USD 40 per barrel. Oil futures prices have increased less, but still indicate somewhat higher oil prices in the coming years.

 

In the wake of the Covid-19 outbreak, there was considerable financial market turbulence, with a decline in equity indexes and an increase in risk premiums in money and bond markets. Like other central banks, Norges Bank has responded with a range of measures to improve market liquidity. Later in spring, financial market volatility abated. Equity indexes have advanced and money and bond market premiums have fallen. Since the monetary policy meeting in May, the money market premium has shown little change. Residential mortgage rates were reduced after the policy rate was lowered to 0%.

The krone exchange rate, as measured by the import-weighted index I-44, reached record-weak levels during the financial market turbulence in March. The krone has since appreciated and is now stronger than at the time of the monetary policy meeting in May, likely reflecting higher oil prices and reduced uncertainty in global financial markets.

 

Activity in the Norwegian economy on the rebound

After several years of solid growth, growth in the Norwegian economy passed a cyclical peak at the start of the year. Growth was already turning down when the Government introduced extensive measures to contain the spread of Covid-19 on 12 March. The measures led to production halts and lower activity across a range of businesses. Many employees were furloughed or made redundant.

The authorities have deployed forceful measures to dampen the economic fallout of Covid-19. The financial support measures are aimed at businesses and households that have suffered a loss of income, and at boosting activity as society is gradually reopened. Petroleum revenue spending now appears to be somewhat higher than assumed in the Monetary Policy Update published in May.

In the coming years, a decline in petroleum investment will put a drag on growth in the Norwegian economy. Oil companies have scaled back their investment plans in response to lower oil prices, but the latest investment intentions survey indicates that investment cuts may be smaller than envisaged in May. The sharp downturn among trading partners has led to a significant drop in demand oriented towards Norwegian export firms.

GDP for mainland Norway fell by 11.3% between February and April. The enterprises in Norges Bank’s Regional Network confirm the picture of a steep fall in production in recent months.

As the infection rate has declined and the authorities have eased the containment measures, economic activity has started to rebound. The upturn has been stronger than projected in May, particularly for household demand. The rise in house prices has been higher than expected and turnover in the housing market has increased again. Unemployment has moved down from the very high levels recorded in March and April. Mainland GDP is now projected to contract by 3.5% in 2020, less so than projected in May.

 

Temporary rise in price inflation

Lower energy prices have contributed to a markedly slower rise in the consumer price index (CPI) over the past year. At the same time, the underlying rise in prices measured by the CPI adjusted for tax changes and excluding energy products (CPI-ATE) has moved up. Twelve-month CPI inflation and CPI-ATE inflation stood at 1.3% and 3.0%, respectively, in May.

Twelve-month CPI-ATE inflation has shown a marked rise in spring, and has been higher than projected in May. The rise is primarily ascribable to a faster rise in prices for imported goods, which in turn reflects the krone depreciation through winter and spring.

Higher costs and lower productivity owing to Covid-19 may also push up prices for some goods and services ahead. In addition, disruptions in global supply chains may result in reduced supply of some goods and episodes of price increases.

Many businesses are facing lower profitability as a result of the containment measures. Combined with high unemployment and weaker prospects for oil-related business, pay increases are expected to be very modest in 2020. Government support measures are alleviating the situation for the business sector, but the capacity to pay wages appears to have decreased since the pandemic began. This year’s wage settlement has been postponed until August.

 

Low policy rate ahead

The operational target of monetary policy is annual consumer price inflation of close to 2% over time. Inflation targeting shall be forward-looking and flexible, so that it can contribute to high and stable output and employment and to countering the build-up of financial imbalances.

The Norwegian economy is now in the midst of a deep downturn. Since May, activity has rebounded faster than anticipated, and unemployment has fallen more than expected. Activity is nevertheless substantially lower than at the start of the year, and there is considerable uncertainty surrounding the path to recovery. Developments will depend on both the evolution of Covid-19 and how households and businesses respond. Activity will likely pick up slightly faster than envisaged earlier, but it will take time for production and employment to return to pre-pandemic levels.

In discussing the trade-offs facing monetary policy, the Committee placed weight on the contribution of low interest rates to speeding up the return to more normal output and employment levels. This reduces the risk of unemployment becoming entrenched at a high level and of inflation becoming too low further out. On the other hand, a long period of low interest rates could increase the risk of a build-up of financial imbalances.

In the Committee’s assessment, the overall outlook and the balance of risks imply a very expansionary monetary policy stance. The policy rate was reduced by 1.25 percentage points in March, and by a further 0.25 percentage point to 0% in May. The Committee does not envisage making further policy rate cuts.

 

The policy rate forecast implies a rate at the current level over the next couple of years, followed by a gradual rise as economic conditions normalise. With such a policy rate path, there are prospects that capacity utilisation will gradually increase and approach a normal level towards the end of the projection period. Unemployment is projected to edge lower, but to remain somewhat higher than prior to the pandemic. Underlying inflation is projected to lie above the inflation target over the next year, before gradually moving down to somewhat below 2%.

There is considerable uncertainty about developments ahead. If output and employment increase faster than projected, or there are signs of accumulating financial imbalances, a policy rate rise may occur earlier than indicated. If the downturn lasts longer than projected, for example, owing to a resurgence in infections, the policy rate may remain at the current level longer than implied by the rate path.

The Committee decided unanimously to keep the policy rate unchanged at 0%. In the Committee’s current assessment of the outlook and balance of risks, the policy rate will most likely remain at today’s level for some time ahead.

 

Øystein Olsen
Ida Wolden Bache
Jon Nicolaisen
Ingvild Almås
Jeanette Fjære-Lindkjenn

17 June 2020