Norges Bank's submission on the Government's economic programme for 1998
The following document was submitted to the Ministry of Finance on Friday 3 November 1997
This document presents Norges Bank's views on the economic situation and developments and the present formulation of economic policy.
Pursuant to section 3 of the Act on Norges Bank, the central bank is under the obligation to "inform the Ministry when, in the opinion of the Bank, there is a need for measures to be taken by others than the Bank in the field of monetary, credit or foreign exchange policy". Norges Bank is of the view that the current situation is such that the Bank is obliged to inform the Ministry of Finance of its opinion pursuant to the provision cited above.
In earlier submissions to the Ministry of Finance in 1994 and 1996, Norges Bank stated that monetary policy can make an important contribution to sustainable economic growth and full employment when it is geared towards the operational target of exchange rate stability. In a letter dated 19 April 1994, Norges Bank clearly pointed out that "if the economy is affected by serious disturbances or long-term and wide cyclical fluctuations, the intermediate exchange rate target ought to be adapted to the long-term objective of monetary policy".
In the light of the strong pressures which now prevail in the Norwegian economy, which the Bank has indicated in its Inflation Reports, Norges Bank notes that the current economic situation places pressure on the monetary policy framework.
Norges Bank recommends a revision of the guidelines for monetary policy to provide for greater flexibility in the conduct of monetary policy, but that the operational target of a stable exchange rate is maintained. Norges Bank assumes that the other elements of monetary policy will be oriented in such a way that a conflict of objectives in monetary policy does not arise and that the existing division of responsibility for economic policy is maintained.
Executive Board member Gjelsvik is of the view that it is not necessary to raise the issue of guidelines for exchange rate policy in this submission, see end of letter for Gjelsvik's comments.
The revision of monetary policy in line with Norges Bank's recommendation does not require changes in the division of responsibility between the political authorities and the Bank, as provided for in legislation. The political authorities will continue to determine the overriding objectives of monetary policy, and operational responsibility for the use of instruments is vested with the central bank.
The Norwegian economy is now experiencing its fifth consecutive year of vigorous economic growth. So far there are few signs of a slowdown in demand and growth is high in the private and public sectors. Total municipal demand is now rising at a faster pace than mainland GDP. Investment growth is particularly high. Fiscal policy has been less tight than assumed in the National Budget for 1997, and considerably less contractionary than in the three previous years. In addition oil investment is generating substantial demand impetus to the mainland economy, in contrast to the early stages of this cyclical upturn.
A period of turbulence in the Norwegian foreign exchange market made it necessary to change the orientation of monetary and exchange rate policy instruments in order to stabilise the krone exchange rate, primarily through lower interest rates. This has amplified the rise in the interest- rate sensitive component of demand and is reflected in the strong growth in domestic credit. Gross domestic debt is now rising by over 9 per cent, and household sector gross debt is increasing by around 7 per cent. Growth in household credit has been more vigorous than growth in the rest of the economy in recent months.
Employment has risen by 180 000 over the last four years. The growth rate in employment has accelerated this year. In the first six months of the year, employment was nearly 65 000 higher than in the same period last year. Growth rates as high as those recorded in the past two years have not been seen since the mid-1980s.
The pronounced rise in employment has resulted in an increasingly tight labour market and a shortage of qualified labour in many sectors, particularly in health and care, the construction industry, IT and some manufacturing sectors. Capacity utilisation has increased sharply over the past year and there are many indications that the mainland economy is approaching capacity limits. Although further growth in demand can to some extent be met by higher imports, it must be assumed that continued robust growth in demand will steadily exert more pressure on production capacity in the economy.
Norges Bank projects that mainland GDP will rise by 3 1/2 per cent in the current year and 3 per cent in 1998. The projection for next year should be seen in the context of already high capacity utilisation, at the same time that underlying growth in total production capacity can, with some uncertainty, be projected at around 2-2 1/2 per cent. Norges Bank's projection therefore entails a further increase in capacity utilisation in 1997 and 1998.
In Norges Bank's Inflation Report for the third quarter, underlying price inflation is projected at 2 per cent this year and 2 1/2 per cent next year, whereas wage growth is projected to increase from 4 per cent in 1997 to 4 1/2 per cent in 1998. The projections in the Inflation Report imply that price and wage inflation in Norway will be somewhat higher than among our trading partners in the next couple of years. The projections in the Report also indicate that underlying inflation looks set to edge up in the period ahead.
Experience has shown that it takes time for pressures in the real economy to translate into higher price inflation. The time horizon in the Inflation Report is therefore too short to capture all the effects of the factors now generating price pressures in the Norwegian economy. According to the projections for economic developments underlying the Inflation Report, the labour market and asset markets in particular are now moving on a trend that cannot be sustained.
It is difficult to quantify with a high degree of accuracy the levels of employment and unemployment which are compatible with moderate price and wage inflation. It is questionable whether it is still possible to boost employment through higher labour force participation rates and the import of labour from other Nordic countries without enterprises having to offer higher wages as a result of labour shortages. Some labour market indicators, for example the rise in the number of vacancies and the fact that participation rates are now at record high levels, indicate that the labour market is already squeezed. Employment growth in line with the estimates for 1997 and 1998 entails a pronounced and growing risk that pressures in the labour market will gradually place substantial strains on incomes policy.
It is also difficult to assess the extent to which the fall in interest rates this year will affect the real economy in the period ahead. This depends on the impact on different asset prices and how the increase in asset prices will affect consumption and investment. Norges Bank's earlier projections indicate that a 1 percentage point reduction in interest rates in the current cyclical situation may, in isolation, contribute to a 1 per cent increase in demand after two years. Such a rise in demand could be countered by a fiscal tightening of around 3/4 per cent of mainland GDP, as measured by the non-oil, cyclically adjusted budget indicator net of interest payments. However, projections from other Norwegian institutions may indicate that the effects of a change in interest rates are less substantial than those presented above.
Although the extent of these effects is uncertain, it is clear that the fall in interest rates has, in isolation, contributed to intensifying pressures in the economy and the rise in asset prices. Recent movements in the equity market have illustrated that a sharp rise in asset prices may in turn result in fluctuating asset values. After bottoming out in 1993, house prices have risen by around 40 per cent in real terms, and by just over 13 per cent in the past two years. It must be assumed that the rise in this asset price component, which has been primarily generated by an expansionary monetary policy, is based on particular circumstances in the foreign exchange market and in international economic conditions which are not expected to persist.
Any substantial fall in asset values - particularly a fall in house prices - will have to be followed by financial consolidation in the private sector. There is reason to expect considerable fluctuations in the real economy as a result of such an adjustment. The risk of instability in the Norwegian economy is therefore not only linked to the prospects for higher price and wage inflation, but more generally to a demand trend that cannot be sustained over time.
Norges Bank would like to emphasise that the risk elements highlighted above also exist in the projections underlying Norges Bank's main scenario for economic developments in next few years. The Bank is of the view that this also applies to the projections underlying the formulation of the National Budget for 1998. For example, any further increase in asset prices may result in imbalances and fluctuations in the economy even in a situation with stable price and wage inflation.
Norges Bank would also like to point out that the projections for economic developments are based on a number of strict assumptions, among other things, linked to fiscal policy, monetary policy and incomes policy. If these assumptions change, pressures in the economy may quickly reach higher-than-projected levels.
In its latest Inflation Report, Norges Bank illustrated the potential effects of a change in some of these assumptions. Such calculations are by nature uncertain and schematic. However, taking this uncertainty into account, they show that price and wage inflation may easily become considerably higher than anticipated in the course of a two-year period and that the current economic situation implies that even minor changes in demand may over time trigger substantial changes in nominal trends. The reason for this is that the economy is already operating at near full capacity. In such a situation, even a minor increase in demand could generate considerable pressures on production resources, resulting in accelerating price and wage inflation.
One possible trigger could be a slightly more expansionary fiscal policy. However, Norges Bank would emphasise that developments in the foreign exchange market also represent a considerable risk.
The existing guidelines for monetary policy entail that strong, recurrent appreciation pressures can only be countered by a further relaxation of monetary policy. Norges Bank would underline that if pressures are not countered by a tighter fiscal policy, such an easing of monetary policy will, sooner or later, result in higher price inflation.
Based on the total risk outlook for economic trends in the period ahead, Norges Bank perceives the situation to be such that relatively small changes could result in imbalances in several parts of the economy, eg the labour market and property markets. Such imbalances will sooner or later translate into higher price and wage inflation and fluctuations in the real economy as a result of adjustments in the private sector. Norges Bank is of the view that this can be avoided by bringing demand growth down towards the underlying growth rate in production capacity, thereby preventing any further pressures on production resources. Growth is broad based, and there are pressures in several parts of the economy. This requires measures which influence growth in both private and public demand.
There is uncertainty attached to the assumptions regarding economic policy and the projections for future developments. It is also conceivable that the economy's capacity to adjust and long- term growth potential has been undervalued.
However, Norges Bank considers that such general uncertainty should not mean that no attempt is made to correct trends which involve a considerable risk of generating substantial costs in the future. Precisely because of this uncertainty it is necessary to analyse the risk elements which are now apparent. In this connection, Norges Bank emphasises that the ?safety margins' in the economy now appear to be small, and even minor departures from the projected trend may have serious consequences.
Experience has shown that the economy is best served in the long term by stable growth and that substantial deviations from such stable growth may result in imbalances which will take a long time to remedy. Based on the experience from the period of economic fluctuations between 1985 and 1993, Norges Bank would point out that a later correction will probably demand more substantial and time-consuming revisions than if corrections are made at an earlier stage, before the imbalances in the economy become excessive.
The central government budget proposal for 1998 entails a 3/4 per cent tightening of mainland GDP growth, as measured by the non-oil, cyclically adjusted central government budget surplus, net of interest payments. Underlying budget expenditure is estimated to increase by 1 per cent.
The proposed central government budget puts mainland GDP growth at 3 per cent for 1998. This is in line with Norges Bank's forecast and implies a further increase in capacity utilisation and growing pressures in the economy through 1998. In order to avoid increased pressure, growth in demand should be curbed fairly quickly so that production is adapted to the underlying growth in production capacity, which is not likely to exceed 2 1/2 per cent a year. Based on the proposed tightening, Norges Bank estimates that this would entail in isolation a fiscal tightening of a further 3/4 per cent and a total of close to 1 1/2 per cent of mainland GDP, as measured by the change in the non-oil, cyclically adjusted central government budget surplus, net of interest payments. This entails a further tightening of an estimated NOK 6 billion, compared with the proposed central government budget.
In spite of the element of uncertainty, these estimates illustrate the substantial challenges in terms of the division of responsibility between fiscal policy and monetary policy as regards fiscal policy's role in demand management. Norges Bank would also emphasise that further tightening of this scale would not necessarily be effective in terms of the situation in the foreign exchange market. Reference is made to the discussion of the division of responsibility for economic policy in the section on monetary and exchange rate policy.
Norges Bank would also point out that the situation in the foreign exchange market and the monetary policy guidelines involve a pronounced risk of the need to further ease monetary policy in order to counter any appreciation pressure on the krone. For purposes of stabilisation, it is natural to take account of this risk in formulating fiscal policy, ie that a relaxation of monetary policy has counteracted the effects of fiscal tightening over recent years. Norges Bank has estimated that a fiscal tightening in the order of 3/4 per cent of mainland GDP, as measured by the non-oil, cyclically adjusted budget surplus, net of interest payments, could be countered in terms of its effect on demand by a 1 percentage point decrease in interest rates over two years. Fiscal policy must be sufficiently flexible in order to ensure the responsiveness necessary to cope with such a situation should it arise.
The estimates above are based on a general assessment where the various effects on the pressure on domestic production resources of various public spending programmes are not taken into account.
A substantial share of the tightening in the budget proposal is achieved by increases in taxes and excise duties. Norges Bank would point out that higher taxes and excise duties under certain circumstances may trigger price and wage spirals in the economy. In view of the existing pressures in the labour market, such measures may generate demands for compensation at a central or local level which would undermine the effects of the tightening. This would indicate that tax increases may be an inappropriate instrument of stabilisation policy in the current economic situation. The need for stable framework conditions and general efficiency considerations indicate that the tax system should remain fairly stable during the business cycle. Naturally this does not preclude the possibility for a change in various taxes aimed at enhancing the overall efficiency of the economy and the need to avoid taxes which have adverse distortionary effects.
A reduction in public expenditure may appear to be a precise means of promoting stabilisation policy. In the light of the considerable challenges facing fiscal policy both in the short and long term, some increase in the tax level may nevertheless prove to be one of several necessary measures to reduce growth in private demand.
All in all, the authorities are confronted with difficult choices when formulating fiscal policy.
Stabilisation policy considerations point to the need for substantial fiscal tightening. Norges Bank is of the view that if fiscal policy alone is assigned responsibility for stabilising the economy, it is probably necessary - partly because the economy is already approaching full capacity utilisation - to pursue a considerably more contractionary fiscal policy than proposed in the budget. If the opposite case prevails, Norges Bank would underline the risk of the Norwegian economy moving onto an unstable path which may over time lead to wide fluctuations in the real economy.
Other factors provide an argument against substantial changes in public expenditure. Fiscal policy is also designed to promote an efficient public service sector, reasonably stable framework conditions for the business sector and a sound relationship between the public and private sector in the short and long term. From this perspective, it may be both difficult and inappropriate to rely solely on fiscal policy in short-term demand management.
Furthermore, Norges Bank would point out that a fairly substantial share of the burden which is now being placed on fiscal policy can be ascribed to the formulation of monetary policy.
Monetary and exchange rate policy
The existing monetary policy framework is set out in the Exchange Rate Regulation of 6 May 1994, with appurtenant guidelines in the documents presented by the Government to the Storting (Norwegian parliament).
Section 2 of the regulation reads:
"The monetary policy to be conducted by Norges Bank shall be aimed at maintaining a stable krone exchange rate against European currencies, based on the range of the exchange rate maintained since the krone was floated on 10 December 1992. In the event of significant changes in the exchange rate, monetary policy instruments will be oriented with a view to returning the exchange rate over time to its initial range. No fluctuation margins are established, nor is there an appurtenant obligation on Norges Bank to intervene in the foreign exchange market."
Pursuant to the guidelines adopted by the Government, monetary and exchange rate policy is geared to maintaining a stable exchange rate. This means that interest rates generally reflect conditions in the foreign exchange market.
The authorities have placed considerable emphasis on maintaining the structure of industry and competitiveness in the private business sector in order to avoid considerable restructuring problems when oil production starts to diminish, or if there should be another substantial drop in oil prices. The consideration of competitiveness is safeguarded through incomes policy which, combined with a stable exchange rate, shall secure the long-term basis for exposed industries. In addition, incomes policy is probably of importance to maintaining low unemployment. It has been stressed in the National Budget and by the social partners that a stable krone exchange rate is crucial to the implementation of incomes policy.
The objective of a stable exchange rate is consistent with Norges Bank's recommendation in a letter to the Ministry of Finance dated 19 April 1994, "Monetary and exchange rate policy under a floating exchange rate regime". In this letter Norges Bank placed considerable emphasis on Norway's longstanding tradition of a fixed exchange rate policy. In addition, the Bank pointed out the importance of the role of monetary policy and the exchange rate as a nominal anchor for wage settlements and the fiscal policy. Following an overall assessment, these factors led Norges Bank to recommend a stable exchange rate as the operational objective for monetary policy.
In its assessment in spring 1994, Norges Bank emphasised the experience gained since 1986. In the light of the difficult situation in the Norwegian economy at that time and the fact that the credibility of monetary and exchange rate policy had been clearly undermined, it was necessary to regain that credibility and to reduce price and wage inflation by linking the krone to currencies from countries with low inflation. Gradually through this policy, and with considerable help from fiscal policy and incomes policy, it was possible to bring down price and wage inflation and to restore the conditions for stable economic growth. With the exception of a depreciation of the krone in December 1992, it was also possible to stabilise expectations in the foreign exchange market and to once again build up confidence in monetary policy. As a result, Norwegian interest rates gradually converged with European rates. From this perspective, a fixed exchange rate policy seemed to provide an effective means of achieving the objectives of monetary and exchange rate policy.
Norges Bank considers that the present economic situation and the situation in the foreign exchange market are such that the monetary policy framework is under renewed pressure.
Furthermore, Norges Bank is of the view that this pressure, in addition to the current cyclical situation, appears to reflect more long-term and fundamental features of the Norwegian economy. In this connection, the Bank would like to highlight the following:
- Norway's cyclical situation has systematically differed from that of continental European countries since the mid-1980s, due to fundamental differences in the structure of business and industry and interest-rate sensitivity in the Norwegian economy and the economies of other European countries. In addition to the oil sector's obvious importance, the phases of the business cycle in large segments of mainland manufacturing industry are also out of step with continental European countries. Interest rates in those countries to which the krone is linked have therefore consistently been adapted to a different cyclical situation from that in Norway. Whereas towards the end of the 1980s it was clearly necessary to conduct a tight monetary policy in order to restore confidence in the krone and to reduce inflation, it is of concern that monetary policy has contributed to the upturn in recent years.
- In a world characterised by free capital movements and increasingly integrated financial markets, the possibilities of influencing the real krone exchange rate (ie cost competitiveness) over time through the formulation of monetary and exchange rate policy are limited. Norway's position as a minor currency outside a large foreign exchange area has, in periods, made the Norwegian krone an attractive currency in terms of investment and risk diversification. A sound balance of payments position and budget surpluses may have amplified these trends. Experience in recent years has shown that the scope for managing the nominal krone exchange rate while maintaining a monetary stance which over time is consistent with stable growth in demand, employment and competitiveness, has narrowed substantially.
- Recent experience indicates that it may be difficult for fiscal policy to provide a swift and sufficiently ample response to counter substantial changes in underlying demand conditions. For example, in Norges Bank's view, the reduction in interest rates the past year has to a large extent neutralised the effects of a tighter fiscal policy.
The effects of changes in interest rates in Norway appear to be more similar to the effects of interest-rate changes in Anglo-Saxon industrialised counties than in continental European countries. This is because loans to the household sector in particular largely have floating interest rates which are linked to trends in short-term money market rates. Interest rates on loans in most of Europe are long-term and closely linked to bond yields. As short-term interest rates normally show the widest fluctuations, changes in lending rates charged to the household sector will generally have a more marked effect in Norway than in most other European countries. In addition, changes in interest rates have a considerable impact on Norwegian household wealth as most dwellings in Norway are owner-occupied, and there is also a close relationship between changes in real interest rates and changes in house prices. In most other European countries, fewer dwellings are owner-occupied and changes in short-term interest rates therefore have less impact on household sector wealth. This is to some extent offset by higher household capital wealth in other European countries. Overall, it seems reasonable to assume that changes in short- term interest rates have a greater effect on wealth in Norway than in most other European countries.
In the long term movements in the real krone exchange rate and thereby cost competitiveness are determined by economic fundamentals, such as developments in total national income, performance in business and industry and the trend in total demand for Norwegian factor inputs. Real wages and cost competitiveness in Norway will, over time, have to be adjusted to these underlying conditions in order to avoid considerable imbalances in the labour market. Changes in the nominal exchange rate will therefore have little effect on competitiveness in the long term, as such changes will in turn and over time be countered by changes in price and wage inflation.
This does not mean that the authorities have no means of influencing competitiveness. In the long term, a fundamental prerequisite for maintaining cost competitiveness is that the exposed sector is given sufficient "room" in terms of the real economy - through access to real resources such as labour and capital - to maintain their share of total production in the economy. This in turn requires that over time, total domestic demand does not grow at a faster pace than the income base in the economy would indicate, if shortages of labour and other factors inputs which push up prices and wages are to be prevented. In this context, a successful incomes and labour market policy may provide a significant contribution, primarily by making it possible to maintain lower unemployment than would otherwise be the case - and thereby higher total employment - without a pick up in price and wage inflation.
The authorities can influence trends in total demand primarily through fiscal and monetary policy. The establishment and development of the Government Petroleum Fund, which has been designed primarily to channel government petroleum revenues to foreign investment, should be viewed in this connection. In addition, the authorities can also influence framework conditions for business and industry through other channels such as the tax system.
In the medium term, any appreciation expectations in the market tend to result in a real appreciation - either through a firming of the nominal krone exchange rate or by compelling a monetary policy shift which results in higher price and wage inflation. Pursuant to the existing monetary policy guidelines, persistent appreciation pressures can only be countered by an expansionary monetary policy.
When pressures in the foreign exchange market became acute in January, interest rates were reduced and Norges Bank allowed the exchange rate to be determined by market forces for a period. Key rates were reduced from an already low level by a total of 1 1/4 percentage points in the period from November 1996 to January 1997, which clearly entailed an expansionary monetary policy. This gave rise to a situation where market participants had to acknowledge the increased likelihood of a possible real appreciation of the krone through higher inflation in Norway in relation to other countries.
It is possible that any expectations of a continued appreciation in the exchange rate could also be reduced considerably if the fiscal policy conducted was so tight that there was always a sufficient supply of resources in the economy at the prices prevailing. This is because participants in the foreign exchange market would then see that the existing economic policy was compatible with a constant real exchange rate over time, see section on fiscal policy and the long-term trend in competitiveness above. Such a policy would thereby convince market participants that the Norwegian authorities would conduct an economic policy which would provide a constant supply of resources to the exposed sector at prevailing prices for labour and other factor inputs. However, this would probably require a tightening of fiscal policy considerably greater than that provided for in the budget proposal.
Norwegian financial markets have followed a general international trend towards globalisation and increasingly closer integration. As a small, open economy Norway has benefitted from this, among other things through substantial inflows of foreign capital and the opportunity to transfer parts of its oil wealth into financial wealth abroad. This has increased the room for manoeuvre in economic policy.
As a result of the deregulation of financial markets and the housing market, however, expectations in the financial markets have a stronger impact on economic developments. Expectations now have direct significance for interest rates and increased capital movements in connection with exchange rate expectations make it more difficult to manage the nominal exchange rate without substantial changes in monetary policy. Changes in interest rates will, at the same time, have a greater effect on private sector demand, in part through trends in the equity and housing markets.
In recent years, authorities in small, open economies have steadily addressed the implications of this trend. This has resulted in two major developments: the development of monetary union in Europe and the formulation of alternative monetary policy frameworks in countries outside the monetary union.
EU member states are seeking to establish monetary union (EMU), which entails that countries will have to relinquish their national currency in order to formulate a monetary policy for the entire union. This offers the advantage that such a large foreign exchange area is, to a greater extent, a closed economy. Fluctuations in the exchange rate against other currencies are therefore of less importance to business and industry in the area as a whole. The authorities in the union also relinquish the possibility of influencing relative prices through changes in the exchange rate.
In addition to those EU member states which for the time being are not likely to join EMU, most developed economies outside the EU conduct a monetary policy which is oriented towards a more or less direct inflation target. Countries which currently conduct such a policy are, among others, New Zealand, Australia, Canada, Sweden and the UK. Major economies such as the US, Japan and Germany conduct monetary policies which, in practice, scarcely differ from inflation targeting, but the guidelines for monetary policy in these countries allow a greater element of discretion, so that monetary policy has more scope for manoeuvre than would be the case with a quantified inflation target.
Norway and Iceland are the only two developed economies within the OECD area which currently have a unilaterally declared objective for the exchange rate. Countries participating in the ERM have set exchange rate targets based on wide fluctuation margins for exchange rates and a mutual intervention obligation. Furthermore, movements in the exchange rate in these countries already reflect the planned implementation of EMU in 1999.
Norway is not a member of the EU, and participation in EMU is therefore not an issue. The Norwegian authorities therefore have to base themselves on an independent, unilateral formulation of monetary and exchange rate policy in the foreseeable future. In this connection it is necessary to bear in mind that once EMU has been established, the Norwegian krone will be a minor currency outside a large foreign exchange area. Recent exchange rate unrest in relation to the major currencies may indicate that, in such a situation, the krone will be of increasing interest to international market participants for the purposes of investment and risk diversification, while monetary policy in EMU will continue to reflect economic trends in continental European countries. The problems associated with achieving the objective of a stable exchange rate, with little tolerance for exchange rate fluctuations, will be compounded in such a situation.
The section on monetary and exchange rate policy in the National Budget for 1998 states: "the division of responsibility between monetary and fiscal policy is well established and has provided positive results." It is also argued that amended guidelines for monetary policy could result in a deterioration in competitiveness through an appreciation of the krone and that such an orientation of policy would conflict with the wage moderation policy. The following is also stated:
"The most important instrument for ensuring balanced economic growth and for curbing pressures in the Norwegian economy is a tight fiscal policy, combined with income settlements that help to maintain low price and wage inflation... The objective of a stable krone exchange rate entails that Norwegian interest rates must generally shadow European interest rates. However, monetary policy nevertheless helps to stabilise the Norwegian economy in that a stable exchange rate underpins fiscal policy and the implementation of income settlements."
Norges Bank concurs that a tight fiscal policy is necessary in the current situation and that it is desirable that income settlements contribute to low and stable price and wage inflation. The question is, however, whether it is possible to implement this to the extent that a continuation of the existing monetary policy guidelines could be expected to provide positive results. In this context, Norges Bank would highlight the following:
- Norges Bank considers that fiscal policy as presented in the budget proposal is not such that it alone can be expected, with reasonable confidence, "to ensure balanced economic growth and to curb pressures in the Norwegian economy", particularly in the light of the risks outlined above. It may be questioned whether fiscal policy has the flexibility necessary to respond to the changes that may arise in monetary policy.
- In the light of increasing pressure in the labour market and the outlook for continued robust growth in employment and demand, Norges Bank is of the view that it cannot simply be concluded that the current orientation of incomes policy is sufficient to prevent a deterioration in competitiveness, resulting from a pick up in price and wage inflation.
- The current orientation of policy has small, if any safety margins in the event of continued appreciation pressures. The pro-cyclical effect of monetary policy means that it is questionable whether monetary policy contributes to stabilising the Norwegian economy, also in terms of underpinning fiscal policy and in the implementation of incomes policy.
Against this background, Norges Bank would underline that there are problems associated with the division of responsibility between fiscal and monetary policy, in that monetary policy has generally been productivity-cyclical and the possibility of recurrent appreciation pressures intensifies the risk of placing excessive strains on fiscal policy. In addition, Norges Bank is of the view that it is essential to bring economic growth down towards underlying growth in production capacity if the authorities want to reduce the risk of substantial imbalances in the economy.
In a letter to the Ministry of Finance dated 22 November 1996, Norges Bank raised the question of the basis for the monetary policy framework. Norges Bank wrote:
"It is Norges Bank's opinion that the existing guidelines for monetary and exchange rate policy are sufficient in terms of preventing monetary policy from contributing to economic instability, but Norges Bank will, if necessary, revert to the question of a possible revision of the monetary policy framework".
The overriding objectives of economic policy are low unemployment and sustainable economic growth. In addition, it is agreed that the necessary prerequisites for achieving these overriding objectives are low and stable price and wage inflation and stable economic growth, see section on monetary policy in the Revised National Budget 1994.
Norges Bank would point to the hierarchy of objectives the Bank presented in its letter to the Ministry in spring 1994, where it was underlined that monetary policy's most important contribution to stable economic growth is to maintain low price and wage inflation. Exchange rate stability was recommended as an operational intermediate objective. Norges Bank also pointed out that the operational intermediate objective of a stable exchange rate should be changed in certain situations:
"In Norges Bank's view the need for monetary policy guidelines robust enough for the economy to withstand serious disturbances calls for a clear declaration that low price and wage inflation will continue to be the long-term monetary policy objective. This would represent a continuation of the policy pursued both in the period of fixed and floating rates. The main economic policy objectives, as set out in the Long-Term Programme, are to secure a durable basis for sustainable economic growth and full employment, and to this end the best contribution monetary policy can make is to maintain low price and wage inflation in the long term. A stable exchange rate is a prerequisite for achieving this. However, if the economy is affected by serious disturbances or long-term and wide cyclical fluctuations, the intermediate exchange rate target ought to be adapted to the long-term objective of monetary policy".
In recent years, Norway has experienced a strong and persistent cyclical upturn which is now generating pressures in many parts of the economy. There are no clear signs of a slowdown in demand. Over time, it must be expected that this will translate into higher price and wage inflation, from an inflation rate that already exceeds that of our trading partners. The existing monetary policy framework may entail that instruments must be oriented in such a way that these problems become more pronounced.
Furthermore, it can be argued that the long-term considerations relating to the exposed sector cannot be safeguarded through a systematic pro-cyclical monetary policy and persistent pressure on production resources in the economy. Thus it is doubtful whether the consideration regarding the exposed sector can be safeguarded over time by maintaining a short-term objective of a stable nominal exchange rate with narrow fluctuation margins. This also indicates that the long-term consideration of cost competitiveness may be better safeguarded by an economic policy which secures a durable basis for stable growth in demand and the supply of resources over time.
Pursuant to section 3 of the Act on Norges Bank, the central bank shall "inform the ministry when, in the opinion of the Bank, there is a need for measures to be taken by others than the Bank in the field of monetary, credit or foreign exchange policy". In the light of this obligation and the discussion regarding economic developments and economic policy above, Norges Bank is of the view that the issue of revising the guidelines for monetary and exchange rate policy must now be addressed.
The issue relating to the degree of central bank independence in relation to the political authorities is raised periodically in the ongoing public debate regarding monetary policy. Norges Bank would like to point out that the desirable changes in monetary policy framework do not require changes in the division of responsibility between the political authorities and Norges Bank. The overriding objectives for monetary policy will continue to be determined by the political authorities, and operational responsibility for the use of instruments is vested with Norges Bank. Therefore no amendments to the Norges Bank Act are required in order to implement changes of the nature discussed below.
Possible changes in monetary and exchange rate policy
Norges Bank is of the view that it is necessary to consider changes in monetary policy which would make a greater contribution to a stable economic trend than has been the case hitherto, with a view to reducing the risk of severe economic disturbances. In the current situation, this implies less emphasis on the continual achievement of the operational goal of a stable exchange rate in favour of the fundamental objectives of full employment and sustainable economic growth based on the assumption of continued low price and wage inflation.
Furthermore, Norges Bank firmly advocates that monetary policy should not be permitted to have an expansionary effect as a result of shifting expectations in the foreign exchange market. The current guidelines take account of the need to accept short-term, substantial deviations from the exchange rate range, but the requirement that instruments shall be oriented with a view to returning the exchange rate to its initial range over time can hardly be interpreted, even in it its broadest sense, to mean that a change in the use of instruments in an expansionary direction would not have to be made relatively quickly and on a considerable scale in response to renewed pressure in the foreign exchange market.
A revision of the current exchange rate regulation providing greater flexibility in terms of short- term responses to such pressures, while retaining the objective of exchange rate stability, is one alternative. This would facilitate the task of avoiding the problems associated with a highly pro- cyclical monetary policy in situations with renewed pressure on the krone. This alternative would also permit a continuation of the present division of responsibility for economic policy, in particular as regards incomes policy as the exchange rate would continue to represent a nominal anchor.
This approach may give rise to periods of wider fluctuations in the exchange rate than have been commonly observed in the past. This raises the question of whether somewhat wider exchange rate fluctuations would in isolation have an influence on the framework conditions for the exposed sector.
One factor which limits the effects of short-term variations (up to one year) in the exchange rate is currency hedging on the part of businesses, either through positions in the foreign exchange market or by stipulating contractual prices in NOK. Norwegian kroner make up a substantial share of the settlement currencies used in imports and exports. This contributes to reducing the short-term effects of exchange rate swings although it is uncertain how far the contractual currency coincides with the settlement currency. Studies carried out by the Swedish central bank indicate that enterprises' foreign direct investments and transactions are hedged against currency fluctuations through loans in foreign currency or forward exchange contracts. A review of listed Norwegian companies' annual reports show that at least the large Norwegian enterprises hedge extensively against short-term changes in exchange rates.
Insofar as exchange rate variations constitute a problem for exposed businesses, this primarily applies to a medium-term period ranging from one to four years, ie the period following the currency hedging and up to the point when the exchange rate has had a pronounced impact on Norwegian prices and wages. What is essential to Norwegian business in this context is price changes measured in NOK. The changes depend both on the exchange rate and the prices measured in foreign currency. A large share of Norway's exports consist of raw materials and semi-finished goods which show wide price variations measured in foreign currency. The variations in prices will typically be wider than the fluctuations in the exchange rate, and are also reflected in widely fluctuating corporate operating results in sectors exposed to foreign competition. For most export industries price variations are thus of greater consequence than exchange rate fluctuations.
Developments in recent years have also shown that the krone exchange rate may show short-term variations also under the current monetary policy guidelines. In this context, one can also point to exchange rate developments under the fixed exchange rate system in Norway in the post-war period which resulted in periodic and substantial shifts in the exchange rate in situations where it was no longer possible to maintain the applicable exchange rate range. From an historical perspective, the objective of exchange rate stability has not in itself prevented movements in the exchange rate.
Norges Bank considers that there is no basis for assuming that somewhat wider fluctuations in the exchange rate will create any substantial problems for Norwegian business, particularly if the alternative is a varying, and in periods highly expansionary monetary policy stance.
Whether it is possible to confine a shift in monetary policy to a minor revision will depend on the market's perception of whether this shift is sufficiently clear and credible. Market credibility will partly depend on whether the other components of economic policy are considered over time to be consistent with the objective of exchange rate stability.
This will further be largely contingent upon an orientation of economic policy which does not generate expectations of a sustained real appreciation. If this is not the case, monetary policy is likely to come under renewed pressure even with a revision as outlined above, which may compel a review of the system, with a change in the exchange rate range or a more fundamental revision in favour of orienting monetary policy more directly towards the overriding objectives.
Such a shift in monetary policy - towards a goal oriented directly towards stable economic developments, anchored to the objective of low and stable price inflation (a so-called inflation target) - is an alternative to the prevailing system also in the current situation.
While a revision of the framework as described above will prevent an expansionary monetary policy response to pressures in the foreign exchange market, a policy geared directly towards the overriding objectives entails that monetary policy can be used more actively as a demand management instrument. Under an inflation targeting system, monetary policy would be tightened in response to high capacity utilisation and resource shortages in the economy, and eased in response to low capacity utilisation and a sufficient supply of resources in the economy. An inflation target would make it easier to use monetary policy to counter shocks to which the Norwegian economy is exposed in various phases of the business cycle. Under such a system, the exchange rate would shift status from being the operational goal to constituting an important monetary policy indicator.
Low and stable price inflation is a necessary condition for achieving the overriding objectives of economic policy. A shift to a monetary policy based on an inflation target may therefore be appropriate in a situation where expectations of a real appreciation would otherwise result in higher inflation and unstable economic trends.
It has been argued that gearing monetary policy directly towards low price and wage inflation may compound the task of implementing fiscal policy and incomes policy.
Accordingly, it is maintained that such a substantial shift in monetary policy may result in a lack of clarity of the role of fiscal policy, particularly in a situation with sizeable oil revenues, where the budget balance does not place any effective limits on fiscal policy in the short term.
Norges Bank would point out that the current economic conditions require a tight fiscal stance, irrespectively. Monetary policy cannot under any circumstances fully take over the role of fiscal policy as a demand management tool, particularly in a situation with wide cyclical fluctuations in the economy. Moreover, the authorities will have to take account of how the orientation of fiscal policy affects monetary policy, including the impact on real interest rates. The authorities must recognise that relying solely on monetary policy to stabilise the economy may place excessive strains on monetary policy to the same extent that the current guidelines may place a disproportionate onus on fiscal policy. With an inflation target, strong pressures in the economy would be countered by orienting both monetary and fiscal policy towards curbing domestic demand.
However, in a system where monetary policy is geared towards overriding goals, it is more natural for fiscal policy - over a business cycle - to be more oriented towards long-term objectives. The long-term challenges associated with, for instance, social security funding and the management of petroleum wealth may compel the authorities to focus more on long-term balance in state finances and the scope of the public sector. Stabilisation policy considerations may be incompatible with this and give rise to difficult challenges and heavy constraints on fiscal policy.
Another argument against an inflation target is that the social partners would no longer be able to establish a direct link between wage growth and competitiveness as this approach would mean that the nominal exchange rate would be less fixed than under the current system. As wage moderation has been linked to short-term developments in competitiveness in recent years, one may lose an anchor for incomes policy.
In principle, however, the policy of wage moderation can be re-formulated with an inflation target. The policy could be maintained by shifting the focus away from short-term developments in competitiveness, towards the relationship between real wage growth and employment.
On the other hand, it may seem difficult in the short term, based on what the social partners have asserted, to achieve incomes policy co-operation with a change in the division of responsibility for economic policy. The risk associated with this must be weighed against the risk that the current economic policy may lead to a severe economic setback.
A further argument against a shift away from a monetary policy aimed at exchange rate stability has been that this would lead to wider fluctuations in the exchange rate with the associated adverse implications for the exposed sector. As the Bank has pointed out previously, the real exchange rate and thereby competitiveness in the long term are not heavily influenced by movements in the nominal exchange rate. Moreover, short-term currency fluctuations do not in isolation influence the framework conditions of the exposed sector to any significant extent. It is less certain what the effects of fluctuations in the exchange rate over a period of one to four years are, particularly if the fluctuations are considerable. This may indicate that it would be appropriate to anchor expectations in the foreign exchange market to a longer-term credible exchange rate target or to an intermediate target which is consistent with the overriding objective of economic policy.
Irrespective of the approach adopted, monetary policy in Norway will have to place considerable emphasis on exchange rate movements. This is primarily due to the open nature of the Norwegian economy, which means that changes in the exchange rate have a considerable impact on price inflation in the short term.
Part of the problems associated with the current orientation of policy are the imbalances which build up in periods, which trigger a shift in expectations in the foreign exchange market. The experience of other countries and previous episodes of currency unrest in Norway indicate that it is difficult to correct such expectations relying solely on monetary policy. Stable developments in the real economy are therefore over time a prerequisite for exchange rate stability - irrespective of the monetary policy guidelines adopted.
It has also been argued that the Norwegian authorities should defer any revision of the guidelines for monetary policy until EMU has been established. As Norway is not a member of the EU, the establishment of EMU does not place any direct constraints on the choice of monetary policy regime in Norway. What must, in principle, be considered in terms of monetary policy is the emphasis to be placed on short-term exchange rate stability in relation to the overriding objective of full employment and long-term economic stability. This issue is largely independent of the establishment of EMU. Norges Bank would urge the authorities to address this issue before the time may come to consider possible forms of association with EMU.
Reference is made to economic developments, economic policy and the analysis of associated risks in this submission.
Pursuant to section 3 of the Act on Norges Bank, the central bank is under the obligation to "inform the Ministry when, in the opinion of the Bank, there is a need for measures to be taken by others than the Bank in the field of monetary, credit or foreign exchange policy". Norges Bank considers that the present situation obligates the Bank to inform the Ministry of Finance of its opinion pursuant to the provision cited above.
Norges Bank would underline that there are problems associated with the division of responsibility between fiscal and monetary policy. Monetary policy is under the present circumstances pro- cyclical, and the possibility of recurrent appreciation pressures intensifies the risk of placing excessive strains on fiscal policy.
The overriding objectives of economic policy are low employment and sustainable economic growth. Norges Bank is of the view that the risk of economic instability in the period ahead should prompt a revision of the applicable monetary policy guidelines with a view to enhancing monetary policy's contribution to achieving the overriding objectives of economic policy. A further relaxation of monetary policy may under the present circumstances have considerable adverse effects by amplifying the already strong pressures in the economy. There is a pronounced risk that the existing guidelines will necessitate such a relaxation.
Norges Bank strongly advises against relying on a system where one is compelled to orient monetary policy in a given situation so that it amplifies cyclical fluctuations and reduces the stability of the economy. This is of even greater consequence when there is uncertainty attached to the other components of economic policy, and particularly if fiscal policy is not sufficiently flexible to respond effectively to changes in monetary policy.
A system whereby monetary policy is oriented more directly to the goal of low and stable price inflation seems to provide an effective means of contributing to the attainment of the overriding objectives of full employment and sustainable economic growth. Such a goal may also prove to be an effective means of coping with a situation where expectations of a real appreciation would otherwise have resulted in higher price inflation and economic instability.
However, the effects of such a policy shift are uncertain, at least in the short term. This uncertainty is partly related to the formation of expectations in the foreign exchange market and partly to the effects of such a policy shift on the orientation of fiscal policy and incomes policy.
An element of uncertainty associated with a switch to an inflation target for monetary policy is how the effects of monetary policy are distributed between interest rates and the exchange rate. This may entail that a given monetary policy orientation may have varying effects on the exposed and sheltered sector over time. This element of uncertainty can be considered a cost associated with such a system.
With an inflation target, both monetary and fiscal policy could be oriented with a view to stabilising the economy. Over the business cycle, it would be natural for fiscal policy to be oriented towards long-term objectives to a somewhat greater extent.
In principle, the policy of wage moderation can be re-formulated with an inflation target for monetary policy. This could entail a shift away from the link between competitiveness and incomes policy, towards the relationship between real wages and employment in the overall economy.
However, a switch to an inflation target would nevertheless entail a risk for the implementation of fiscal policy and incomes policy partly because it would require a change in the division of responsibility for economic policy. It may be desirable to avert this risk. An alternative whereby the objective of a stable exchange rate is retained, but the exchange rate regulation is revised to provide for greater flexibility in the conduct of monetary policy, would make it easier than at present to avoid the problems associated with the risk of a highly pro-cyclical monetary stance. This would also permit the existing division of responsibility for economic policy to be maintained. Such a revision of the guidelines would, however, not solve the problems which would accompany substantial and recurrent appreciation pressures.
The decision regarding the guidelines for monetary policy will have to be based on evaluations of causes and effects which are shrouded with uncertainty and which will require an element of discretion. Norges Bank has carried out a professional assessment of the formulation of monetary policy in the light of the objectives of overall economic policy, including the relationship between monetary policy, fiscal policy and incomes policy.
Norges Bank places considerable emphasis on the elements of uncertainty associated with fiscal policy and incomes policy, and underlines that it cannot be ascertained with certainty that the existing pressure on monetary policy will necessarily persist. Based on an overall assessment, Norges Bank advises in favour of a revision of the monetary policy guidelines to provide for greater flexibility in the conduct of monetary policy while retaining the monetary policy objective of exchange rate stability.
The revision of the guidelines should aim to reduce the risk of monetary policy contributing to an unstable economy.
Greater flexibility in monetary policy, in order to avoid a considerable shift in the use of instruments in response to moderate variations in the exchange rate, can be achieved by various means. Norges Bank recommends that a broader exchange rate range towards which monetary policy is geared ("the initial range") be defined compared with the existing exchange rate regulation. The instruments should be oriented with a view to countering substantial deviations from this range.
When the krone is within the range, monetary policy could also be used somewhat more actively to stabilise the economy. Norges Bank points to the guidelines which have been drawn up previously, stating that "within the limits set by the operational goal of exchange rate stability, monetary policy will in the current cyclical phase be oriented to contribute to avoiding that excessive growth in domestic demand and activity trigger an acceleration in price and wage inflation".
Norges Bank assumes that the other components of economic policy will be consistent with the objectives of monetary policy, and that the existing division of responsibility for economic policy is maintained. This is a precondition if Norges Bank is to conduct a monetary policy which is consistent with overriding objectives of monetary policy in accordance with the stipulated objective of exchange rate stability.
Executive Board member Gjelsvik is of the opinion that it is not necessary to raise the question relating to monetary guidelines in the submission.
This member considers that the existing guidelines provide considerable flexibility in terms of the exchange rate in the short term, in that "it does not apply to fluctuation margins with the appurtenant obligation of Norges Bank to intervene in the foreign exchange market". Although developments in recent years have shown that the krone may come under pressure in periods, developments have also shown that Norges Bank has managed to return the krone to its initial range by orienting instruments as indicated in the regulation.
This member assumes that a majority of members of the Storting wish to retain the current division of responsibility for economic policy. This member does not consider that substantial changes have occurred in the economic situation or in the foreign exchange market of which one was unaware when the former Government presented the National Budget or when the political basis for the new Government was formulated at Voksenåsen.
This member concurs that the economic situation requires that the central government budget be at least as tight as proposed, and that any demand impetus beyond this increases the risks involved. On the basis of this situation, a somewhat tighter budget would facilitate the implementation of exchange rate policy, which Norges Bank is responsible for conducting, in particular with a view to growth and stability in the longer term.
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