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. Norges Bank operates a flexible inflation targeting regime, so that variability in both output and employment and inflation is given weight.

Previous assessments
On 28 January 2004, Norges Bank's Executive Board decided to reduce the sight deposit rate by 0.25 percentage point to 2.00 per cent. It was also stated that "with a sight deposit rate of 2.00 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 against the risk that output growth might eventually be too high.

Economic developments
Particular emphasis has been placed on the following:

• Underlying inflation is very low. The rise in consumer prices adjusted for tax changes and excluding energy products (CPI-ATE) has edged down since last summer. Annual CPI-ATE inflation was -0.1 per cent in February.
• After showing a tendency to appreciate in autumn 2003, the krone has weakened markedly since early December. The krone, as measured by a broad index, is now at the level prevailing at the beginning of 2002 and in line with the level in the mid-1990s.
• In recent months, market participants have lowered their interest rate expectations for most of the other countries, and interest rates have fallen somewhat in other countries. Market participants now expect that interest rates will be raised in the US well into the latter half of this year and in the euro area in the beginning of 2005. In Sweden, the official interest rate was reduced by 0.25 percentage point in February. In Canada, the interest rate was cut by 0.25 percentage point in March.
• The recovery in the US and Asia has gained a firmer footing, while growth is sill very moderate in the euro area. Growth is high in the UK. The Swedish economy is rebounding, but unemployment has nevertheless increased. The Danish economy stagnated last year, and unemployment rose.
• Oil prices are high. In the beginning of March, oil prices rose to more than USD34 per barrel, which is the highest level recorded since the war in Iraq. Measured in euros, however, oil prices are lower than one year earlier.
• Low inflation in December, January and February contributed to a fall in interest rate expectations in Norway. Participants in financial and foreign exchange markets seem to expect that the sight deposit rate will move down to 1½ per cent, or slightly lower, in the period to summer. From autumn and in the coming years, the key interest rate is expected to rise gradually, broadly in tandem with the expected increase in interest rates among our trading partners.
• Activity in the Norwegian economy is picking up. Current statistics indicate firm growth in mainland output in the latter half of 2003. Private consumption is showing clear growth in line with expectations. On the other hand, business investment is sluggish. Sentiment surveys suggest growing optimism in the business sector.
• Employment increased in autumn of last year, but has remained virtually unchanged in recent months. Unemployment, as measured by Statistics Norway's labour force survey, was 4.6 per cent in December.
• Equity prices have advanced sharply in Norway. House price inflation is high, but there is excess capacity in the commercial property market. Growth in total credit to the household sector and mainland enterprises fell marginally to 5.4 per cent in November 2003. Growth in household debt is high, but did not increase in December and January. Credit demand is still not rising in the enterprise sector.
• Norges Bank's regional network reports that activity is rising in most industries, and that the market outlook is favourable for the next six months. Developments in output and demand are positive for manufacturing, construction, distributive trades and services. However, few enterprises are planning an increase in investment. Many enterprises report that they can increase production to a fairly large extent without a substantial growth in employment. According to information from our regional network, the decline in manufacturing employment seems to have come to a halt, however, and enterprises report a moderate increase in employment in the construction industry and distributive trades.

The outlook and risk factors

• The analyses in Inflation Report 1/2004 are based on the assumption that the interest rate moves in line with forward interest rates observed at the beginning of March, i.e. a fall in the key interest rate towards 1½ per cent in the period to summer and thereafter a gradual increase. The krone exchange rate is assumed to follow forward exchange rates, which indicates that participants expect a fairly stable exchange rate ahead.
• Activity in the Norwegian economy is expected to pick up in the coming years. The past and ongoing rationalisation in the business sector may enable enterprises to increase production considerably in the short term without strong employment growth. This suggests that there is room for somewhat stronger growth in the economy without the emergence of pressures on real resources.
• Mainland GDP growth is projected to pick up markedly this year and remain relatively high in 2005 and 2006. The output level will be slightly higher than the trend level would imply. This means that the output gap, as estimated by Norges Bank, will be slightly negative this year and marginally positive in 2005 and 2006, and slightly negative this year. CPI-ATE inflation is projected to run somewhat below the inflation target next year. Two years ahead, there are prospects that inflation will move up to the inflation target of 2½ per cent.

The Executive Board has assessed the following important risk factors that may lead to lower growth and inflation than projected:

• Price developments for imported consumer goods are uncertain. Our projections are based on a gradual deceleration in the rate of decline of these prices measured in foreign currency. It is assumed that a large share of the gains associated with the shift in import patterns has been realised.
• Inflation among our trading partners may remain lower than projected in the period ahead. It is still uncertain how broad and sustainable the world economic recovery will be. The appreciation of the euro over the past six months may dampen the upturn in the euro area to a further extent than expected.
• The exchange rate has now reverted to the level prevailing before inflation started to decelerate. With the recent interest rate reductions, the Norwegian key interest rate is as low, as or lower than, the interest rate among trading partners. If interest rates continue to fall in other countries, the krone may appreciate. This will reduce the scope for reaching the inflation target.
• Several years of deteriorating competitiveness in Norwegian manufacturing has eroded profitability. If profitability in the manufacturing sector should be given greater weight in local and centralised wage negotiations than we have assumed, wage growth may turn out to be lower than projected. The unusually low rate of inflation may also push down wage growth.
• Intensified competition, with continued high productivity growth, may increase production capacity in the Norwegian economy to an even further extent and dampen inflation.

There are also factors that suggest that growth and inflation may over time be higher than projected:

• Monetary policy is now generating a fairly strong stimulus to the Norwegian economy. Our experience of such a considerable and rapid monetary policy easing is limited. It is possible we underestimate the effect of the stimulus on overall demand for goods and services.
• Labour shortages may emerge more rapidly than expected, which may lead to higher-than-projected wage growth.
• It cannot be ruled out that the krone depreciation since January 2003 may have a stronger and more rapid impact on inflation than assumed in the Inflation Report.

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

• It may take time before interest rates in other countries are raised to a considerable extent. Past experience shows that in periods the krone is heavily influenced by developments in the interest rate differential between Norway and other countries. This is given weight in interest-rate setting.
• A period of too low inflation may influence inflation expectations among economic agents. Low inflation may therefore be self-reinforcing.
• Sharp increases in asset prices and debt accumulation may pose a risk to economic stability. However, it is only in the household sector where debt accumulation is high at present. There is little borrowing activity in the enterprise sector. Overall credit growth is in line with long-term growth in the economy. There is still a risk that total credit will show marked growth in the medium term.
• The aim of monetary policy is higher inflation. It is appropriate to be particularly vigilant with regard to developments in consumer prices, but consumer prices may show random variations from one month to the next. Later this year, we will receive confirmation of whether consumer prices are rising in line with our projections. When inflation increases from a very low level, this will provide a basis for gradually moving towards a more normal short-term interest rate level in Norway. This may counter excessive credit growth and excessive pressures on domestic resources in the medium term. Interest rate developments in other countries may also have a considerable impact on the krone and hence on Norwegian interest rates.

Summary

• A path that is in line with the projections in Inflation Report 1/2004 provides a reasonable balance between the prospects for reaching the inflation target and stable developments in the real economy.
• As an alternative, the Executive Board has considered leaving the interest rate unchanged now and the possibility of keeping the interest rate low for a longer period. However, the Executive Board concluded that it is not appropriate - in the light of the decline in inflation - to deviate markedly from expectations in money and foreign exchange markets at present.
• 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 against the risk that output growth might eventually be too high. Furthermore, according to the Executive Board's assessment, with a sight deposit rate of 1.75 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
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Charts - monetary policy meeting