The objective of monetary policy
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.

Previous assessments
On 17 December 2003, Norges Bank's Executive Board decided to reduce the sight deposit rate by 0.25 percentage point to 2.25 per cent. It was also stated that "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." In reaching its decision, the Executive Board weighed the objective of bringing inflation back to target and stabilising inflation expectations on the one hand against the risk that output growth might gradually become too strong on the other.

In its last Inflation Report¹, Norges Bank projected that growth in mainland GDP² would pick up from ¾ per cent in 2003 to 3 per cent in 2004 and 2¾ per cent in 2005. The output gap, as calculated by Norges Bank, was expected to widen somewhat from marginally negative in 2003 to marginally positive this year and in 2005 and 2006. The mainland economy was thus expected to expand slightly more than trend. 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 in the summer of 2004 and to stabilise at target from autumn 2005.

Recent developments
Particular emphasis has been placed on the following new information since the previous monetary policy meeting:

• The year-on-year rise in the CPI-ATE fell to 0.4 per cent in December. The rise in prices was lower than projected in the October Inflation Report. Overall inflation is still being pushed down by the fall in prices for imported consumer goods, by a low rise in prices for domestically produced consumer goods that are influenced by prices on the global market and by services such as air travel, and telecom and hotel services. The rise in prices for services with wages as a dominant cost factor remains high.
• After having depreciated last winter and spring up to summer 2003, the krone appreciated through the autumn. This trend was reversed after Norges Bank reduced the key rate in December. The import-weighted krone exchange rate (I-44) has since depreciated by about 4½ per cent. The short-term interest rate differential between Norway and its trading partners is now approximately zero.
• The rise in equity prices in other countries and in Norway, which began in March 2003, continued towards the end of 2003 and into 2004.
• Exchange rates between the major currencies have varied considerably since mid-December. The effective exchange rate for the euro has appreciated by about ½ per cent, while the effective exchange rate for the US dollar has depreciated by about 1¾ per cent. All in all, the dollar has now depreciated by about 25 per cent since the beginning of 2002.
• The European Central Bank left its key rate unchanged at 2 per cent at its January meeting. The Bank of Canada reduced its interest rate. The Bank of Japan decided to supply additional liquidity to the banking sector.
• Market expectations concerning key rates have been adjusted downwards in a number of countries. Market participants appear to expect the interest rate in Sweden to be reduced at the beginning of February. It is now expected that the Federal Reserve in the US and the ECB will keep interest rates low for a longer period and not increase interest rates until the autumn or towards the end of the year. Market pricing points to expectations of an increase in interest rates in the UK as early as the first quarter of 2004. Bond yields in the US and Germany have fallen since December. Short-term money market rates in Norway are expected to be somewhat lower than the average for our trading partners up to autumn 2004.
• Economic growth in the US has been somewhat stronger than projected in the October Inflation Report, but employment growth in December was unexpectedly sluggish. Growth is high in the UK. So far, output growth in Japan and the euro area seems to be approximately as projected in the Inflation Report. Sweden has recorded moderate economic growth, but employment has declined. In Denmark, growth in total ouput is weak.
• There are no signs that global consumer price inflation is rising.
• Since mid-January, oil prices have hovered around USD 32 per barrel, the highest level since the outbreak of the war in Iraq. High oil prices partly reflect higher demand for oil in the US, where crude oil stocks fell to their lowest level in 28 years. Measured in euros, however, the price of oil is lower than one year earlier.
• In Norway, household consumption of goods was somewhat lower than expected in November. Traditional merchandise imports fell slightly in the fourth quarter. The decline was most pronounced for capital goods.
• After having fallen in the first half of the year, house prices rose through the autumn of 2003. On the other hand, prices in the commercial property market are influenced by the large number of vacant premises. Growth in total credit to households and the mainland business sector remains stable at about 6 per cent. Growth in household debt is edging up, while enterprises are not increasing their demand for credit.
• The number of persons employed has increased since May 2003. The number of man-weeks worked continued to fall until last summer, but the decline levelled off last autumn. Unemployment has been approximately unchanged in recent months.

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

• The depreciation of the krone in 2003 and into 2004 has not yet been reflected in consumer prices, but a higher rise in prices for imported consumer goods is expected to push up consumer price inflation over the next six months. The decline in prices for imported goods in recent months may indicate that the pass-through from the exchange rate to consumer prices takes longer than assumed earlier. The fall in prices may also be due to more pronounced shifts in trade patterns and weaker than assumed price developments, measured in foreign currency, for imported goods.
• 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 and the service sector 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. The increase in the number employed, which is somewhat higher than assumed earlier, may, in isolation, contribute to pushing up wage growth. It is conceivable, however, that profitability in internationally exposed industries will again play a more prominent role. Overall wage growth may then be lower than projected. The prospect of low inflation this year may also contribute to curbing wage growth. The year-on-year rise in the overall consumer price index fell from 1.4 per cent in November to 0.6 per cent in December.
• Developments in European economies have a stronger impact on output and employment in Norway than developments in the US economy. The appreciation of the euro may curb the moderate growth in continental Europe. This may contribute to extending the period of low interest rates in the euro area.
• Low interest rates in Norway may provide the basis for a rise in household debt and house prices which might have a negative impact on financial stability in the long term. On the other hand, growth in corporate demand for credit is very low, and at the moment there are few signs of increased investment activity in the business sector.

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

• 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 expected. The consumer price figure for December indicates that the unexpectedly low rise in prices in November was not incidental.
• Driven by interest rate expectations, the exchange rate for the Norwegian krone has depreciated since the last monetary policy meeting and has contributed, in isolation, to a more expansionary monetary policy. As with the exchange rates for the major currencies, the krone exchange rate has varied considerably since mid-December.
• Output in the mainland economy appears to be picking up approximately as expected. Private consumption and high petroleum investment are the most important driving forces. 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.
• Growth in total credit (domestic and foreign sources) has remained stable since last summer. Overall, the outlook for financial stability is considered to be satisfactory. The depreciation of the Norwegian krone has also strengthened the financial position of enterprises, but the current low level of interest rates may also increase the risk of a continued sharp rise in household debt and house prices.

Conclusion

• The Executive Board has come to the conclusion that it is appropriate to reduce the key rate now by 0.25 percentage point. 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. Furthermore, 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.

Footnotes

¹ Inflation Report 3/03 from October 2003

² Excluding the effect of the fall in electricity production