The objective of monetary policy

The operational objective of monetary policy is low and stable inflation, with annual consumer price inflation of approximately 2.5 per cent over time.

Monetary policy influences the economy with long and variable lags. Norges Bank sets the interest rate with a view to stabilising inflation at the target within a reasonable time horizon, normally 1-3 years. The more precise horizon will depend on disturbances to which the economy is exposed and how they will affect the path for inflation and the real economy ahead.

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.

Previous assessments

On 22 September 2004, the Executive Board decided to keep Norges Bank's key rate unchanged at 1.75 per cent. The Executive Board indicated that low price inflation, in isolation, pointed to a lower interest rate. Moreover, it was emphasised that monetary policy must give weight to avoiding imbalances in the real economy and that developments in aggregate demand warranted caution with regard to further interest rate cuts. The interest rate was last changed on 11 March 2004, when it was reduced by 0.25 percentage point.

Economic developments

The Executive Board places particular emphasis on the following:

• Growth in the world economy has been strong. High growth in private consumption in the US and brisk investment growth in China have been the main driving forces, but the recovery has gradually broadened to other countries. However, the growth peak seems to have been passed, and there are prospects that growth among our trading partners will moderate. This is reflected in a decline in long-term interest rates since the previous monetary policy meeting.
• After accelerating in the US, the euro area and the UK in the second quarter, consumer price inflation has moderated again. Thus far, there are few signs that the sharp rise in oil prices has had an inflationary effect. Underlying inflation remains moderate. The market now expects a less pronounced interest rate increase in the US and the euro area than at the time of the publication of Inflation Report 2/04 on 1 July.
• The effective US dollar exchange rate has depreciated by about 4 per cent since the previous monetary policy meeting.
• Even after falling this week, oil prices are high. Since July, the price of Brent Blend has varied between USD 42 and 52 per barrel. Futures prices have also risen in recent months. Oil prices measured in krone terms have not risen to the same extent, owing to the depreciation of the US dollar. Strong global demand for oil products, combined with very low spare production capacity in OPEC, has driven up oil prices. Oil prices also reflect temporary production disruptions in Iraq, unrest in Nigeria and hurricanes in the Gulf of Mexico.
• Inflation measured by the CPI-ATE was lower during the summer than projected in the previous report. In September, the year-on-year rate of increase in prices moved up to 0.5 per cent, approximately in line with the projections in the previous report. The introduction of maximum rates for day-care places, which has a one-off effect on consumer price inflation, and the effects of interest rates on house rents are expected to push down inflation by ¼ percentage point on an annual basis. If the CPI-ATE is adjusted for these two factors, inflation was about ¾ per cent in September.
• The Norwegian krone has appreciated since the previous monetary policy meeting. Expectations that the interest rate has reached a trough, in conjunction with high spot and futures prices for oil, have probably supported the krone.
• Output growth is high in Norway. Reports from Norges Bank's regional network point to continued growth and rising activity levels in most industries. As a result of high commodity prices and strong international demand, the conditions for the metal and processing industry have been favourable. Growth in manufacturing sectors supplying the domestic market is rising and is at its strongest level since the network was established.
• The output gap, as assessed by Norges Bank, is turning positive. Low interest rates, higher petroleum investment and the international recovery are fuelling demand. However, demand has largely been concentrated on imports of goods and services. As a result of a strong real krone exchange rate, the business sector is losing market shares both at home and abroad.
• In spite of high output growth, employment growth has been moderate thus far. This reflects rationalisation in the business sector. Reports from the regional network suggest that employment will increase in the construction industry, retail trade and other service industries in the near term.
• In the government budget proposal for 2005, underlying nominal spending growth is estimated at close to 11 per cent between 2003 and 2005. Local government nominal revenues are estimated to rise by a little more than 11 per cent in these two years. This is somewhat higher than nominal mainland GDP growth in the same period.
• Growth in total household demand remains buoyant. House price inflation is high, but has slowed somewhat since August. Housing starts have increased markedly. Growth in household debt is about 11 per cent.
• Information from the regional network indicates a moderate rise in investment in the private sector. In manufacturing, investment is concentrated on production automation. In response to higher demand, the retail industry is upgrading and expanding existing premises. Service industries are investing in IT equipment. After falling between 2001 and 2003, prices for office and commercial property have shown a clear increase, rising by 9 per cent in the year to end-June 2004. Credit demand in the enterprise sector is low, but has recently increased.

Outlook and risk factors

The analyses in Inflation Report 3/04 are based on the technical assumption that the interest rate will move in line with forward interest rates. The krone is assumed to follow the forward exchange rate as observed on 28 October. Under this assumption, the krone will be fairly stable in the period ahead. Market participants expect a less pronounced rise in interest rates in Norway than in June.

Growth in the Norwegian economy has picked up markedly. It is also assumed that potential output in the Norwegian economy will show a considerable increase. Nevertheless, our projections indicate that growth is higher than growth in potential output, and that capacity utilisation in the Norwegian economy is approaching a normal level. Capacity utilisation is expected to increase further over the next two years, before edging down again.

Inflation, as measured by the CPI-ATE, is projected to pick up in the course of 2005. The depreciation of the krone through 2003 will continue to exert upward pressure on prices for imported consumer goods up to autumn 2005. From 2006, inflation will be gradually pushed up by higher resource utilisation in the Norwegian economy. This will contribute to somewhat higher wage growth and make it possible for enterprises to increase their margins. Inflation is projected to reach 2 per cent in the beginning of 2007. According to the projections, the inflation target will be reached three years ahead.

Furthermore, the Executive Board would place particular emphasis on the following factors:

• In the short term, high oil prices probably constitute the greatest risk to the outlook for the global economy. High oil prices may lead to a more pronounced slowdown in global growth than projected. This could in turn result in lower demand and lower commodity prices.
• The effects of high oil prices on the Norwegian economy are mixed. Lower external demand will have a negative impact on some Norwegian manufacturing sectors. At the same time, domestic demand is normally stimulated by higher petroleum investment. The allocations to the Government Petroleum Fund will be higher. The additional central government foreign exchange revenues as a result of high oil prices will be invested in foreign securities through the Government Petroleum Fund. As a result, they will not have a direct impact on the balance in the Norwegian foreign exchange market. Moreover, oil companies probably hold a large share of their cash surplus in foreign currency. In addition, high import growth will contribute to reducing the current account surplus.
• The projections for potential output are uncertain. We have assumed that potential output will show stronger-than-normal growth this year. If productivity growth remains high for a longer period than projected, this may contribute to keeping down inflation.

Assessment

The objective of monetary policy is inflation of 2½ per cent over time. At present, inflation is considerably lower than this. The key rate is therefore low. Particular weight must be given to factors that may delay an increase in inflation.

In the conduct of monetary policy emphasis is also placed on avoiding imbalances in the real economy. Growth in the Norwegian economy is now high and household demand is rising sharply. Housing investment is rising at a faster pace than projected earlier.

Developments in credit have given ambiguous signals to interest rate setting. Enterprises have reduced their debt over a period, but this trend now seems to have been reversed. Growth in household borrowing is strong.

It is the assessment of the Executive Board that the projections for economic developments imply a sight deposit rate in the interval 1¼ -2¼ per cent in mid-March 2005. Uncertainty as to the effects of previous monetary policy easing and the unusually low interest rate level imply, on the one hand, that we should exercise caution with regard to further interest rate reductions. On the other hand, the prospect of continued low inflation for a period ahead implies that wide deviations from projected economic developments would be required before interest rates should be increased. The prospect of continued low inflation in Norway also implies that we should lag behind other countries in setting interest rates at a more normal level.

Summary

The Executive Board did not see any clear alternatives to leaving the interest rate unchanged. The Executive Board has weighed the objective of bringing inflation back to target and stabilising inflation expectations against the risk that output growth may eventually be too high.

Charts - monetary policy meeting (1007 kB)
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Charts - monetary policy meeting (169 kB)