Assessments

Output growth in Norway is high, and capacity utilisation is rising. It may appear that growth has become more self-driven. The low interest rate will probably contribute to an increase in the output gap and inflation ahead. The operational objective of monetary policy is inflation of close to 2.5 per cent over time. In the conduct of monetary policy, emphasis is also placed on curbing fluctuations in output and employment.

The objective of stabilising developments in output and employment implies, in isolation, a higher interest rate. This will reduce the risk that capacity utilisation in the Norwegian economy will become too high. High capacity utilisation could give rise to bottlenecks in some sectors of the economy and lead to a higher rise in property prices and household borrowing. This could be a source of instability in demand and output in the somewhat longer run.

The objective of bringing inflation back to target and anchoring inflation expectations nevertheless implies a continued expansionary monetary policy. International interest rates are rising, albeit slowly and from a low level. There are prospects of continued low inflation for a period ahead. Even if capacity utilisation in the Norwegian economy rises, there appears to be little risk that inflation will rapidly move up to a level that is too high. Inflation was unexpectedly low in the first months of this year, but in the light of our highly open economy we must perhaps expect somewhat wider variations in inflation than some other countries.

The Executive Board's assessment in Inflation Report 1/05 is that the interest rate can after a period, and then gradually, be brought to a more normal level. The sight deposit rate should be in the interval 1½ - 2½ per cent in the period to the publication of the next Inflation Report on 30 June 2005, conditional on economic developments that are broadly in line with the projections.

The unusually low interest rate and developments in output and inflation imply that further interest rate reductions are now less likely. The lower limit of the strategy interval has therefore been increased to 1½ per cent. The uncertainty surrounding economic developments implies that we should adhere to an interval of 1 percentage point for interest rate setting.

Outlook and risk factors

The analyses in Inflation Report 1/05 are based on financial market interest rate expectations. The krone exchange rate is assumed to follow the forward exchange rate and remain fairly stable at around the current level in the years ahead.

With such a path for the interest rate and the krone exchange rate, there are prospects that activity in the Norwegian economy will continue to rise at a fairly rapid pace this year and next. Strong growth in petroleum investment this year will have spillover effects on the mainland business sector.

As capacity utilisation in the economy gradually rises, profit margins in the business sector may increase further. Moreover, the decline in unemployment is likely to continue and wage growth may be somewhat higher. The extraordinary factors that have contributed to restraining the rise in prices for imported consumer goods are expected to have a diminishing impact in the years ahead. Inflation measured by the CPI-ATE may then rise from a little less than 1 per cent at present to almost 2 per cent in mid-2006. There are prospects that inflation will stabilise at around 2½ per cent three years ahead.

The Executive Board would place particular emphasis on the following factors:

• In recent years, the rise in prices for imported consumer goods has been curbed by a growing share of imports from low-cost countries. Moreover, intensified competition and strong productivity growth have reduced consumer price inflation. It is assumed that the contribution from these factors to inflation will gradually decline during the projection period. However, continued shifts in trading patterns, with higher imports from Asia and intensified competition in retail trade, may prolong the period of low inflation.
• Developments in the krone exchange rate are uncertain. The real krone exchange rate measured by relative labour costs is strong. Historically, the real krone exchange rate has tended to return to an average measured over a longer period. Should this occur in today's situation, through a depreciation of the nominal krone exchange rate, inflation will pick up somewhat faster than projected. If the krone appreciates, on the other hand, there is a risk that inflation will not move up as quickly as projected.
• There is uncertainty associated with developments in demand and output in the near term, partly because the interest rate has been low for a long period. Higher growth may trigger even stronger pressures in the economy.

Economic developments

The Executive Board also places particular emphasis on the following new information that has emerged since the previous monetary policy meeting on 2 February:

• In the US, economic growth has remained firm and capacity utilisation is rising. The Swedish economy has also shown fairly strong growth, but growth was lower in the fourth quarter. Growth in the euro area and Japan was weaker towards the end of 2004 than assumed in the previous report. In spite of slower growth and considerable excess capacity among trading partners as a whole, producer and export prices have been pushed up by higher prices for oil and other commodities.
• Many countries have increased their key rates in this cyclical upturn, also in several steps. On average, our trading partners have increased their key rates by a little more than ¼ percentage point. Since Norges Bank's previous monetary policy meeting, the US, Hong Kong, Iceland, Australia and New Zealand have raised their key rates. Market participants are now expecting a more pronounced rise in interest rates in the US and the UK than at the beginning of November. On the other hand, market participants expect interest rate increases in Sweden and the euro area to come at a later stage than assumed in November. Against the background of the prospect of low inflation for a period ahead, Norway has lagged behind other countries in adjusting the interest rate to a more normal level.
• Oil prices have risen. The price of Brent Blend oil is now well over USD 50 per barrel. Oil futures prices have also increased. Little idle production capacity in OPEC countries, combined with the prospect of lower production in non-OPEC countries, has probably influenced oil prices. At the same time, there are prospects of continued strong demand growth in important oil-importing countries, such as China and some other emerging economies.
• Consumer price inflation adjusted for tax changes and excluding energy products (CPI-ATE) picked up through autumn and winter. However, the year-on-year rise between December and January moved down from 1.0 to 0.7 per cent as a result of a fall in prices for some imported goods. In February, the rise in prices was unchanged at 0.7 per cent. Adjusted for the interest rate's direct effect on house rents, the year-on-year rise in the CPI-ATE is estimated at 0.9 per cent in February. Changes in indirect taxes from the beginning of the year, in particular VAT, make it more difficult than usual to interpret developments in inflation. The rise in prices for domestically produced goods and services has moved up gradually since late spring 2004.
• The krone is somewhat stronger, as measured by the import-weighted krone exchange rate, than at the time of the previous monetary policy meeting. Higher oil prices and an upward adjustment in interest rate expectations may have contributed to the appreciation of the krone.
• Information from our regional network indicates that the cyclical upturn is now broadly based. Whereas household demand was the main driving force behind output growth last year, demand in the business sector is now also picking up. Activity is particularly high in oil-related sectors. There is high activity in the building industry throughout the country.
• Among the enterprises in our regional network, the number that expects a higher rise in selling prices in the coming year is greater than the number that expects a slower rise in prices. TNS Gallup's survey shows a more neutral picture. Both surveys still indicate expectations of a higher rise in prices for service industries.
• Mainland GDP growth was 3.5 per cent in 2004. Even with a strong upturn in the economy, the increase in the number employed has been fairly modest. The increase in person-hours worked has been more pronounced. This must be seen in the light of three more working days in 2004 than in 2003 and a sharp fall in sickness absence partly due to changes in the National Insurance Act last summer.
• Preliminary figures from the Technical Reporting Committee on Income Settlements show that wage growth was 3¾ per cent for all groups as a whole in 2004. This is in line with the wage projection in the previous Inflation Report.
• House price inflation has moderated, but is still high. The twelve-month rate of increase was 9.2 per cent in February. Growth in household debt is high.
• Credit demand in the enterprise sector remains low. Commercial building starts rose through 2004. In addition, office vacancy rates have edged down from a high level. The decline in rental prices appears to have come to a halt.

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