The Government has defined an inflation target for monetary policy in Norway. The operational objective is a rise in consumer prices of 2½ per cent over time. In general, the direct effects on consumer prices resulting from changes in interest rates, taxes, excise duties and extraordinary temporary disturbances are not taken into account. Norges Bank places particular emphasis on CPI inflation adjusted for tax changes and excluding energy products (CPI-ATE) when assessing underlying inflation.

Normally, Norges Bank sets the interest rate with a view to achieving an inflation rate of 2½ per cent two years ahead. It would in general have been possible to achieve the inflation target at a horizon shorter than two years by changing the interest rate more rapidly and more markedly. This might, however, have a greater impact on output and employment. Norges Bank has based its monetary policy on flexible inflation targeting, where variability in both output and inflation are given weight.

At the meeting of the Executive Board of 29 October, the sight deposit rate was left unchanged, at 2.5 per cent. It was also stated that according to Norges Bank's assessment, with a sight deposit rate of 2.5 per cent at present, the probability that inflation two years ahead would be higher than 2½ per cent was the same as the probability that it would be lower. The press release following the meeting of 29 October stated that after a period of very low inflation as we have now witnessed, it is appropriate to be particularly vigilant in monetary policy in the event that inflation does not increase as projected.

In Inflation Report 3/03, Norges Bank projected that growth in mainland GDP would pick up from ¾ per cent this year to 3 per cent in 2004 and 2¾ per cent in 2005. The output gap, as calculated by Norges Bank, was expected to be marginally positive next year and in 2005 and 2006. This means that output in the mainland economy is expected to be slightly higher than the level indicated by trend growth. The year-on-year rise in consumer prices adjusted for tax changes and excluding energy products (CPI-ATE) was projected to increase to about 2¼ per cent next summer and to stabilise at target from autumn 2005. The analyses in the Inflation Report were based on a technical assumption that the interest rate would move in line with forward rates in the money market as observed on 23 October. This implied that the interest rate would remain approximately unchanged up to summer 2004 and thereafter increase gradually in step with foreign rates. Furthermore, the analyses were based on the assumption that the exchange rate would depreciate by close to 2 per cent over the next few years. This assumption was based on expectations in the foreign exchange market as reflected in the forward exchange rate for NOK on 23 October.

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

• Inflation has been lower than expected. The year-on-year rise in the CPI-ATE fell to 0.5 per cent in November. For example, prices for air travel, telecom services, beverages and imported goods such as footwear and audiovisual equipment showed a decline. The rise in prices for imported consumer goods was lower than expected in both October and November. Developments in prices for services with wages as a dominant cost factor and house rents have been broadly in line with expectations.
• The import-weighted krone exchange rate (I-44) has appreciated by about 1½ per cent since the last monetary policy meeting. Interest rate expectations in Norway and among trading partners are now about the same one year ahead.
• Economic growth in the US has been somewhat stronger than expected, while developments in Japan and the euro area appear to be approximately as projected. The rise in prices for Norwegian imported goods, measured in foreign currency, remains low.
• The Federal Reserve kept its key rate unchanged at 1 per cent at its meeting of 9 December, but stated that the "probability of an unwelcome fall in inflation has diminished in recent months and now appears almost equal to that of a rise in inflation. However, with inflation quite low and resource use slack, the [Federal Open Market] Committee believes that policy accommodation can be maintained for a considerable period". The European Central Bank has kept its key rate unchanged at 2 per cent, while the central banks in the UK and Australia have raised their key rates.
• After recording a new peak in mid-November, oil prices have remained above USD 28 per barrel in recent weeks. Unrest in the Middle East and oil stocks in the US that are lower than normal for this time of year are holding up oil prices.
• Petroleum investment will be high in both 2004 and 2005. More petroleum industry contracts are being awarded to Norwegian enterprises.
• According to preliminary figures from Statistics Norway, mainland GDP growth was fairly high in the third quarter of 2003 and figures for the first half of the year have been revised upwards slightly. Employment increased again during the summer and autumn months. Unemployment has been approximately unchanged in recent months.
• House prices have risen since last summer, while there is still excess capacity in commercial property. Growth in credit to households has risen, while corporate demand for credit is still very low.
• Following the final budget bill for this year and the budget resolution for next year, it appears that fiscal policy is somewhat more expansionary. The effects on inflation ahead are considered to be small.
• Norges Bank's regional network reports that many enterprises have reduced their workforce and cut costs as planned. Household demand for retail goods and for services is rising. Growth in demand and output is more moderate in manufacturing and the corporate service sector, and enterprises are uncertain about the sustainability of the recovery. Profitability in the business sector is improving, also as a result of higher earnings. Even though they are cautious, the number of enterprises reporting specific plans for expanding their workforce has increased. Reports from the regional network do not point to any substantial increase in investment next year.

The Executive Board has assessed the outlook and the following important risk factors:

• The depreciation of the krone in 2003 has not yet been reflected in consumer prices, but a higher rise in prices for imported consumer goods is expected to push up the rise in the consumer price index over the next six months. The decline in prices in November may be random and be reversed, but uncertainty as to when inflation will start to rise has increased. Krone exchange rate movements are also having a dampening effect on the inflation outlook.
• As discussed in Inflation Report 3/03, it may take longer for inflation to pick up if productivity growth is stronger than assumed by Norges Bank. Changes in the competitive situation in retail trade may influence productivity developments and prices to a greater extent than assumed earlier.
• The Inflation Report was based on the assumption that wage growth is primarily determined by overall conditions in the labour market. It is conceivable, however, that profitability in internationally exposed industries will play a more prominent role. Overall wage growth may then be lower than projected and lay the basis for an easing of monetary policy. Developments in recent months, however, may indicate that the labour market will stabilise more quickly than previously expected.
• Developments in European economies have a stronger impact on output and employment in Norway than developments in the US economy. Moderate growth in continental Europe is primarily being fuelled by higher net exports and is vulnerable to a strong euro.

Against the background of the above factors, the Executive Board has made the following assessment:

• Inflation is lower than expected. The aim of monetary policy is higher inflation. After a period of very low inflation as we have now witnessed, it is appropriate to be particularly vigilant in monetary policy when inflation does not increase as projected.
• The krone has appreciated after the last monetary policy meeting and has, in isolation, contributed to a tighter monetary policy stance.
• Output in the mainland economy has picked up during the autumn, and the outlook seems to be better than earlier. At the same time, the business sector is still feeling the effects of the very sharp rise in labour costs over several years. The cost level may hamper growth in output and employment.
• Total credit (domestic and foreign sources) has remained stable since last summer. Growth in credit to households has risen, while corporate demand for credit is still very low. Overall, the outlook for financial stability is considered to be satisfactory.

The Executive Board has come to the conclusion that it is appropriate to reduce the key rate now. In reaching its decision, the Executive Board has weighed the objective of bringing inflation back to target and stabilising inflation expectations on the one hand against the risk that output growth may gradually become too strong on the other. However, we are taking a smaller step and are reducing the sight deposit rate by 0.25 percentage point to 2.25 per cent. Furthermore, according to Norges Bank's assessment, with a sight deposit rate of 2.25 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.

Charts - monetary policy meeting