Discussed at the meeting of the Executive Board on 25 February 2004 and approved by the Executive Board at its meeting on 11 March 2004.

1. Introduction

Norges Bank's operational conduct of monetary policy shall be oriented towards low and stable inflation. Norges Bank operates a flexible inflation targeting regime, so that variability in output and employment and in inflation is given weight. Inflation shall be 2½% over time. Monetary policy influences the economy with long and variable lags, and the Bank must therefore be forward-looking in interest-rate setting. In the operational conduct of monetary policy in Norway, the path of inflation and the real economy in the period ahead will be taken into account. At the same time, considerable emphasis will be placed on confidence, predictability and transparency. Normally, the interest rate is set with a view to achieving inflation of 2½% at the two-year horizon. This time horizon usually provides a reasonable balance between stabilising inflation on the one hand and smoothing fluctuations in output and employment on the other.

In the monetary policy discussion in October 2003, the Executive Board deemed that a sight deposit rate in the interval 2-3% would be appropriate at the beginning of March 2004. The interval was conditional on developments in the krone and economic projections. The sight deposit rate was reduced by ¼ percentage point at the monetary policy meeting on 17 December and by ¼ percentage point at the monetary policy meeting on 28 January this year. The press release issued following the monetary policy meeting on 28 January stated: "According to Norges Bank's assessment, with a sight deposit rate of 2 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."

Short-term interest rates are now closely in line with those of our main trading partners. The interest rate reductions since December 2002 have contributed to weakening the krone. The krone, as measured by the I-44, has depreciated by about 15% since the beginning of 2003, and has returned to the level prevailing in summer 2001, in line with the average for the 1990s. The real exchange rate, as measured by relative labour costs, is still about 7% stronger than in the period 1996-1997, before cost inflation started to rise. Real interest rates after tax are low (see Chart 1).

2. Economic developments and prospects

Activity in the Norwegian economy has picked up over the past year. The recovery is being fuelled by private consumption and public purchases of goods and services. Investment has continued to decline. Employment is rising again, and unemployment appears to have stabilised. Household confidence is rising. The value of companies listed on the Oslo Stock Exchange has doubled over the past year.

Inflation is very low. Prices for imported consumer goods are falling. This most likely reflects a shift in import patterns in favour of low-cost countries, a general price fall for some internationally traded goods and the lagged effects of the marked appreciation of the krone up to 2003. Clothing and audiovisual prices have shown the steepest decline. The rise in prices for domestically produced goods and services has also slowed, partly reflecting intensified competition in many markets. Intensified competition may have led to lower margins and higher productivity.

Growth in household borrowing is high, but enterprises are reducing debt. Total credit is expanding broadly in line with trend GDP growth. Developments in credit to enterprises shadow developments in their investments. Low credit growth indicates that mainland business investment has not yet picked up. Household credit demand is closely linked to developments in the housing market. House prices have risen by an average of around 9% over the past 10 years.

There are prospects that overall growth among our trading partners will pick up this year, which will provide positive growth impulses to the Norwegian economy. At the same time, low interest rates, combined with high real wage growth, will contribute to strong growth in private consumption. However, it may take some time for business investment to pick up. Several corporate service industries are still marked by excess capacity. Manufacturing is struggling as a result of a high relative cost level due to strong wage growth over several years. Moreover, excess capacity in the commercial property market, particularly in some of the large cities, has reduced investment demand. In 2004, investment is being held up by large public investment projects and housing investment.

The projections for the period up to 2006 are based on the technical assumption that the interest rate will move in line with the forward interest rate. The assumption implies that the interest rate will be reduced somewhat in the coming months and rise gradually from autumn (see Chart 2a).¹ The forward exchange rate will remain virtually unchanged at today's level.

Under these assumptions, monetary policy will stimulate growth in demand this year, primarily via private consumption. Growth in the Norwegian economy will probably be somewhat higher than projected in the October Inflation Report. Moreover, there are signs of fairly high productivity growth so that companies can produce more with the same workforce. Productivity growth has been adjusted upwards by ½ percentage point compared with the October Inflation Report. As demand edges up, corporate profitability will improve. At the same time, enterprises may face capacity constraints. Against this background, there are prospects that investment will pick up gradually and become a more important driving force behind the upturn.

Inflation is expected to accelerate from autumn 2004. The krone appreciation in 2002 has now been fully reversed. In isolation, this will contribute to a renewed rise in inflation. On the other hand, the rise in prices for imported consumer goods will be restrained by a continued fall in prices for imported goods measured in foreign currency. Domestic inflation, which normally accelerates when output and employment growth pick up, will be curbed by increased competition and high productivity growth in a number of industries. On the assumption that the exchange rate follows the forward exchange rate, our projections imply that inflation will move up to around 2½% in the spring of 2006. It seems that the output gap will be negative again this year, but the projections indicate strong growth in the real economy through the year. The output gap is expected to widen up to 2006 and be marginally positive from next year.

An alternative interest rate assumption is that the key rate is left unchanged up to the summer of 2005 and then gradually rises up to the forward rate curve. Under this assumption, the interest rate will be higher than the forward interest rate to the end of the year and thereafter remain lower for a period. This assumption also implies a virtually constant krone exchange rate. Under these assumptions, inflation and the output gap will be more or less in line with the baseline scenario.

However, money market and exchange market expectations imply a reduction in the key interest rate to below 2% in the strategy period. If these expectations do not materialise, the krone may appreciate. Monetary policy will then be tighter. On the other hand, any signals that the interest rate will remain at the current low level over a long period may have a more expansionary effect on household credit demand than the interest rate path implied by forward rates.

Assessment of the inflation outlook and the balance of risks
The expected rise in inflation has still not occurred. On the contrary, the twelve-month rise in the CPI-ATE has continued to fall, down to -0.1% in February. There appears to be three factors underlying low inflation:

The strong krone exchange rate in 2001/2002 has been an important reason behind low imported consumer price inflation. The krone exchange rate has depreciated markedly since January 2003, and has reverted to the level prevailing in mid-2001 when inflation was around 2½%. The depreciation will lead to higher inflation. Analyses based on the exchange rate feed-through to imported price inflation may, however, indicate that there is a somewhat longer lag than previously assumed. Hence, we cannot expect the exchange rate to exert marked upward pressures on consumer prices until the end of 2004. The deviation from the inflation target is likely to continue to the end of this year. However, it cannot be ruled out that the depreciation of the krone exchange rate may have a stronger and swifter impact on inflation than indicated in the analysis of the exchange rate feed-through. Should imported inflation accelerate rapidly through the spring, the feed-through from the exchange rate may be stronger than our current assumption.

An extraordinary price fall for some imported goods appears to be another factor underlying low inflation. A fall in prices for audiovisual equipment has taken place in many countries and appears to be a permanent structural feature as a result of rapid technological development for these goods. The fall in clothing and footwear prices must be seen in connection with a shift in import patterns in favour of low-cost countries in Asia, primarily China. Early liberalisation in Norway as a result of the WTO agreement is a possible explanation of why Norway seems to have experienced a steeper price fall for these goods than other countries. A continued shift in trade, not only towards low-cost countries, but also between regions in these countries, is likely to continue. On the other hand, some Asian currencies may come under mounting appreciation pressures both as a result of strong domestic growth and because these currencies have been linked to a weaker dollar for some time. An appreciation of these currencies may generate inflationary impulses to the Norwegian economy more rapidly.

A third factor that may contribute to explaining consumer price developments is intensified competition in goods and services markets. Margins for producers and retailers may have fallen in some industries. Productivity may have increased. Low domestic inflation in spite of high wage growth is an indication of this. For example, increased competition has led to lower air fares, telecom services and some grocery prices. However, it is uncertain how long-lasting the decline will be. A relatively high price level in Norway compared with neighbouring countries, combined with more closely integrated European economies and increased globalisation, will probably maintain some downward pressure on goods and service prices that are directly or indirectly exposed to competition. Structural changes in the grocery trade this year may support this.

With lower inflation expectations in the longer term, it may become more demanding to achieve higher inflation. There is no evidence indicating that inflation expectations are now deviating from the inflation target in the long term. Table 1 shows that economic agents expect inflation to be around target five years ahead. The reason why expectations have remained fairly well anchored around the inflation target even though inflation has shown a considerable decline may be the strong monetary policy response.

Table 1. Projected inflation 2 years ahead and 5 years ahead. 1st quarter 2004.
Annual rise. Per cent

	2 years	5 years
Experts2	2,2	2,4
Employees' organisations	2,1	2,5
Employers' organisations	1,9	2,5
Business leaders	2,3	-

On balance, inflation is expected to remain near zero during the strategy period and to rise gradually from summer. Measured as the average increase from the penultimate three-month period to the previous three months, rising inflation will come into evidence at an earlier stage (see Chart 3).

Developments in recent months imply a considerable risk that annual inflation, as measured by the CPI-ATE, will fall. There is reason to assume that inflation will remain very low in the coming months. The rise in inflation will partly reflect a weaker krone. Should the period of low inflation have an impact on inflation expectations, the rise in inflation may be smaller, and it may take longer for inflation to return to target.

Developments in capacity utilisation (the output gap) depend to a large extent on the assessment of capacity utilisation today and assumptions concerning the economy's potential growth ahead. Both variables are shrouded in uncertainty. Low inflation may indicate that the output gap is currently more negative than previously assumed. This will be the case if productivity growth has increased without fuelling demand. The economy may in that case expand at a faster pace for a period ahead without feeding through to inflation as rapidly as earlier.

On the basis of the analysis above, the output gap in 2003 and 2004 is now assessed to be more negative than in the previous Inflation Report. According to our projections, the output gap will close and gradually turn positive, but it is assumed that temporary high productivity growth will increase the economy's potential growth. Economic growth is nevertheless projected to be so strong that the output gap increases to about ½% in 2006. Should increased competition and higher productivity growth prevail also in 2005 and 2006, the output gap may remain close to zero.

3. Monetary policy assessments and strategy

Norges Bank's operational conduct of monetary policy shall be oriented towards low and stable inflation. Norges Bank operates a flexible inflation targeting regime, so that weight is given to variability in output and employment and inflation. Inflation shall be 2½% over time.

In the past year, inflation has been lower than target and there have been prospects of low inflation ahead. The aim of monetary policy is higher inflation. Against this background, the key interest rate has been reduced to 2%.

The path for forward interest rates implies that the key rate will move down towards 1½% during the strategy period. In practice, the path for the key rate will be more uneven than indicated directly by the path for forward rates as the key rate is not changed continuously.

With an interest rate path ahead in line with forward rates and a virtually constant krone exchange rate, inflation is likely to rise gradually to reach 2½% in the spring of 2006. Inflation will be very low in the coming months.

An expansionary monetary policy aimed at bringing inflation back to target will also stimulate output and employment. Growth in the production of goods and services is expected to pick up. Chart 2b shows the projections for inflation and the output gap. Growth in mainland output is projected to be higher than growth in potential output in the period to 2006, which implies a widening of the output gap.

A monetary policy stance that results in below-target inflation and low capacity utilisation in the economy (negative output gap) will normally be too tight. Similarly, a monetary policy stance that results in above-target inflation and high capacity utilisation in the economy (positive output gap) will normally be too expansionary. A monetary policy that results in a path over the next three years as indicated in Chart 2b, where inflation remains below target for a period and the output gap is positive, will not be contrary to the requirements as to an optimal monetary policy.

With an interest rate in line with forward rates, the projections show that inflation will move up to target. In the coming quarters, the deviation from the inflation target is considerable. At the same time, growth in output and employment is projected to be higher than the long-term sustainable growth rate. On balance, this may provide a reasonable trade-off between the objective of reaching the inflation target and the objective of stable growth in output and employment. Nevertheless, there seems to be a greater risk of a sustained and marked negative deviation from the inflation target.

The following factors that may delay a rise in inflation should be given particular weight:

• After a period of low inflation and prospects of continued low inflation, inflation expectations may be lowered. This alone increases the risk of persistent low inflation and supports an expansionary monetary policy. There is particular uncertainty associated with the rise in prices for imported consumer goods. A more expansionary monetary stance than that underlying our projections would be appropriate if inflation is clearly lower than projected.
• The exchange rate has now reverted to the level prevailing before inflation started to decelerate. A renewed appreciation of the krone will reduce the scope for reaching the inflation target.
• Our projections are based on the assumption that developments in the overall labour market will continue to play an important role in wage determination. If wage growth in manufacturing regains a more prominent role, or wage negotiations and developments in wage growth are marked by the abnormally low rate of inflation, wage growth may be lower than projected and may warrant a lower interest rate path.
• If increased competition and higher productivity growth are sustained in 2005 and 2006, the output gap may remain close to zero. This will curb inflation.

The projections also imply an increasingly positive output gap. There are also some factors that support a tighter monetary policy:

• Growth in credit to the household sector is high and rising, and house prices are on the increase. Sharp increases in asset prices and debt accumulation may pose a risk to economic stability. With a view to mitigating this risk, it will be appropriate in some situations to increase the interest rate or apply a somewhat longer-than-normal time horizon than two years to attain the inflation target. At present, however, debt accumulation is high only in the household sector. There is little borrowing activity in the enterprise sector. The interest rate can be used to reduce credit demand. At present - with low interest rates abroad and a close link between domestic interest rates and the krone - a tighter monetary policy would restrain credit demand primarily because job security would be reduced. On the one hand, the signal effects of a somewhat tighter monetary policy through expectations formation may restrain household credit demand to a further degree than an interest rate increase may imply in isolation.
• Unemployment will fall to 4% in 2006, and employment is expected to show fairly strong growth, particularly in 2005. Bottlenecks may arise and wage costs may rise faster in 2006 than implied by the projections in the Inflation Report. The risk of a marked rise in inflation from 2006 will increase if productivity growth also turns out to be weaker than projected.

Given the assumptions underlying the analyses in this paper, with normal uncertainty, the analysis indicates that a key rate in the interval 1¼ - 2½% would be appropriate at the end of the strategy period.

Chart 5 illustrates that Norwegian money market rates and interest rate expectations for the coming months are at about the same level as in the euro area. The krone has depreciated markedly, partly reflecting a decline in interest rates in Norway from a level that was higher than the average for our trading partners to a level that is now lower. A lower interest rate path than that underlying our projections would be appropriate if other central banks reduce interest rates.

Chart 6 shows the interest rate that follows from the Taylor rule.³ In the coming months, the Taylor rate is closely in line with forward interest rates. According to the rule, the interest rate should be increased this summer because both inflation and output growth are expected to pick up in the course of the year. According to the rule, the nominal interest rate should be increased so that the real interest rate also increases gradually as inflation rises. However, the Taylor rule does not take into account relationship between the interest rate differential against other countries and the exchange rate. With a marked increase in interest rates this summer in line with the Taylor rule, the probability of a substantial appreciation of the krone and hence persistently low inflation will increase.

If international interest rates rise at an earlier stage than assumed in the analysis in this paper, the key rate can also be increased within the strategy period without an attendant appreciation of the krone exchange rate.

If developments over the next four months deviate considerably from the projections and the assumptions underlying the analysis, it may be appropriate to deviate from the approved interval for the sight deposit rate.

Approved strategy

• Norges Bank's operational conduct of monetary policy shall be oriented towards low and stable inflation. The inflation target is set at 2½%.
• Inflation targeting should be flexible so that variability in both output and employment and in inflation is given weight.
• In the operational conduct of monetary policy in Norway, the path of inflation and the real economy in the period ahead will be taken into account. At the same time, considerable emphasis will be placed on confidence, predictability and transparency.
• The interest rate is normally set with a view to achieving an inflation rate of 2½% two years ahead. This time horizon usually provides a reasonable balance between stabilising inflation on the one hand and smoothing fluctuations in output and employment on the other.
• The key rate will normally be changed gradually so that we can assess the effects of an interest rate change and other new information about economic developments.
• Financial market confidence in the inflation target provides Norges Bank with greater scope for promoting stability in the real economy. This scope will increase as the inflation target is incorporated as an anchor for wage formation.
• Our projections for economic developments and assessment of the balance of risks imply a sight deposit rate in the interval 1¼ -2½% at the end of June 2004.
• Developments in the krone exchange rate and the effects of the appreciation of the krone on inflation and output are uncertain. If the krone appreciates markedly, it may be appropriate to reduce the interest rate to the lower range of the interval or below the interval. If the krone depreciates sharply it may be appropriate with an interest rate in the upper range of the interval or higher than the interval. Any interest rate reaction must be based on an analysis of exchange rate movements and an assessment of the duration of the change in the exchange rate.

Charts in pdf-format

Footnotes

¹ Forward interest rates are interest rates that span two future points in time. Forward interest rates reflect market expectations as to future market interest rates. The expected sight deposit rate is somewhat lower. The forward exchange rate is the exchange rate that clears exchange market for given forward interest rates in Norway and abroad.

²Financial analysts and university economists

³ In the Taylor rule, the interest rate is set to keep inflation around a specific target over time, at the same that interest rate stabilises output. The Taylor rule has provided a fairly accurate description of interest-rate setting by many central banks. At the same time, more recent research shows that the Taylor rule results in relatively low variability in output and inflation in many theoretical analyses and when using many different models.