The operational target of monetary policy is annual consumer price inflation of 2½ per cent over time.

Consumer price inflation adjusted for tax changes and excluding energy products (CPI-ATE) has been low in the first eight months of 2003. In the period May-August, inflation has been below the target by more than 1 percentage point. This primarily reflects a decline in prices for imported consumer goods, which is pushing down overall price inflation.

In the years 1998-2002, the Norwegian economy was characterised by substantial labour shortages and a considerably higher rise in wage costs than among its trading partners. Wage growth in the economy is a result of an interplay between various factors and will vary from year to year. However, 2002 was the fifth consecutive year of very high annual growth. Several rounds of such strong wage increases might have led to a considerable decline in output and employment.

Monetary policy was therefore tightened by means of an interest rate increase last summer. At the one-year horizon, the strong krone would push down inflation to below 2½ per cent, but subsequently the effects of strong wage growth would dominate. Last year, Norges Bank's Executive Board struck a balance between the consideration of stable inflation in the short term and the consideration of stability in output and employment.

It was thus expected that inflation would be low this year. In the October 2002 Inflation Report, inflation was projected to fall to 1¾ per cent in summer 2003. Nevertheless, the deviation between the outcome and the projection was unusually large, reflecting that the economy has been exposed to considerable unforeseen disturbances.

Unexpectedly weak developments in the global economy resulted in lower interest rates abroad and a wider interest rate differential between Norway and other countries. Negative events such as the accounting scandals in large US companies, fears of terror and war in Iraq and the spread of SARS resulted in slow growth and low inflation in other countries. Developments in the global equity markets and the risk of higher oil prices also contributed to subdued international growth and at the same time strengthened the krone. In the Norwegian economy, reduced demand for some goods as a result of higher electricity bills have probably resulted in lower margins. Competition and rationalisation may also have contributed to a lower-than-expected impact of strong wage growth on prices.

The interest rate reductions this year will make a significant contribution to bringing inflation back to target. In the short term, the effects will primarily be channelled through a weaker krone. In the somewhat longer term, interest rate reductions will also lead to higher inflation through stronger demand in Norway.

Capacity utilisation in Norway has declined from a high level and is now on a par with the level prevailing in the years 1995-1997, before the rise in costs accelerated. The interest rate reductions from December 2002 must also be seen in connection with the stalling of growth in the Norwegian economy last winter. It now appears that growth in the Norwegian economy will gradually pick up again. Thus, conditions are now more conducive to stable developments in output and employment.

Norges Bank points out that the krone exchange rate will fluctuate as in other small economies with floating exchange rates. The appreciation of the krone may be reversed, but the loss of competitiveness and jobs caused by the high level of domestic wage growth is difficult to recoup. Competitiveness depends on developments in the labour market, productivity and aspects of wage formation and cannot be controlled over time by monetary policy.

The fiscal policy stance for 2003 has contributed to facilitating the marked reduction in the interest rate. Fiscal policy, together with lower wage growth, has thus resulted in a depreciation of the krone. The outlook for the internationally exposed sector is brighter today than a year ago because there are now prospects for a slower rise in costs.

When the monetary response pattern is known and consistent, the social partners can take into account potential effects on the interest rate and exchange rate when negotiating wages. The social partners can base their wage negotiations on the assumption that inflation over time will be 2½ per cent. It appears that wage growth in 2003 will be appreciably lower than in previous years. The interest rate was reduced and the krone depreciated. The prospect that wage growth will slow to a more sustainable level has been of considerable importance for the substantial easing of monetary policy.

Letter submitted to the Ministry of Finance 17 September 2003

Report on Monetary Policy 2003 - the first eight months (pdf)