Monetary policy and the outlook for the Norwegian economy
Address by Governor Svein Gjedrem, Stavanger, 21 March 2003
The address is based on the assessments presented at Norges Bank's press conference following the Executive Board's monetary policy meeting on 5 March and on previous speeches. Please note that the text below may differ slightly from the actual presentation.
The operational target of monetary policy as defined by the Government is inflation of close to 2½ per cent over time.
Norges Bank sets the interest rate so that future inflation will be equal to the inflation target of 2½ per cent. Interest rates were reduced this winter in response to the change in the inflation outlook. The inflation projection was revised downwards as a result of weaker cyclical developments in the global economy, a sharp decline in international interest rates and a strong krone. In addition, the Norwegian business sector is feeling the effects of the high Norwegian cost level. Moreover, growth in domestic demand has slowed. Household purchasing power has been reduced as a result of higher electricity prices. The weak prospects at home and abroad are in turn having an impact on the Norwegian labour market and the outlook for wage growth and inflation in the years ahead.
The inflation target provides economic agents with an anchor for their decisions concerning saving, investment, budgets and wages. Households, businesses, public entities, employees and employers can base decisions on the assumption that inflation in Norway will be 2½ per cent over time.
High demand for goods and services and labour shortages normally point to higher inflation in the future. When interest rates are increased, demand falls and inflation is kept at bay. When demand is low and unemployment rises, inflation will tend to slow. Interest rates will then be reduced. The inflation target is a vehicle for, not an obstacle to, monetary policy's contribution to stabilising output and employment. This intention is also expressed in the Regulation on Monetary Policy.
The krone exchange rate fluctuates. This is not surprising because other countries' currencies also fluctuate. The Swedish krona, sterling and the New Zealand dollar have fluctuated considerably in periods.
The krone exchange rate is the price of our currency measured in terms of a foreign currency. Developments in other countries are just as important for the krone as developments in the Norwegian economy. Capital flows freely and flows can change rapidly. This can spill over to exchange rates and interest rates as well as output and employment.
The inflation target of 2½ per cent is broadly in line with the inflation targets of our trading partners. It is also an anchor for developments in the krone exchange rate. The krone has been strong. As a result, prices for imported goods have fallen. This has led to low and stable inflation in spite of sharp wage growth.
Currency swings are driven by cross-border capital movements. Capital flows were heavily influenced by investor focus on stock market returns until the downturn began. In the US, equity prices almost trebled between 1995 and 2000. Stock markets in other countries followed suit. The decline was amplified after the downturn in the global economy deepened as a result of terror and fears of war. Investors sought to avert the risk in the stock market. Capital inflows into the stock market resulted in a strong dollar. However, expectations concerning corporate earnings were higher than later proved to be warranted. When expectations were lowered, equity prices fell. Demand for bonds increased, resulting in low long-term interest rates.
In response to heightened uncertainty and fears of war, traditional safe havens for capital, such as the Swiss franc and gold, have been attractive to investors. The Swiss franc appreciated after the terrorist attacks on 11 September 2001 and towards the end of last year. Gold prices moved up sharply after UN Security Council Resolution 1441 was adopted in November last year. Gold prices have edged down again since the beginning of February 2003, while the exchange rate for the Swiss franc has remained high.
Oil prices have risen again following a sharp fall after September 11 2001. The outlook for global oil supplies is uncertain due to fear of war in Iraq. Strategic oil reserves have risen, while private reserves are low. This has exerted upward pressure on oil prices. The extraordinary conditions in the oil market are not likely to persist. Following the announcement that the US and its allies would engage in war, oil prices fell sharply. The war premium on oil prices has been reduced. Market participants remember that oil prices fell by USD 10 the day after the liberation of Kuwait began in January 1991. At that time, strategic oil reserves in industrialised countries were used to maintain a sufficient supply of oil in the market. In addition, OPEC produces substantial quantities of oil and demand declines during spring.
The fall in oil prices reflects expectations of a short, limited war. The oil market is unstable. Oil prices are almost as volatile as they were in the wake of 11 September 2001. We expect oil prices to fluctuate considerably in the period ahead.
Major economies such as the US, Germany and France are struggling with stagnation and fears of recession. Substantial tax relief, high expenses on security and military operations and low interest rates are holding up activity in the US. The Japanese economy has been in a deflationary recession for a long period.
In recent years, the krone exchange rate has shadowed the difference between Norwegian and foreign short-term rates. This is why the krone has been strong. In addition, high oil prices appear to have had an influence.
The effect of the interest rate differential on the krone was intensified by conditions in capital markets. Investors have been favouring carry trades. Risk premiums in major currency markets have been low, which seems to indicate that investors have until recently been less prone to speculate in exchange rate fluctuations.
As equity prices fell, investors started seeking alternative vehicles. This made the krone market more attractive because of high interest rates in Norway. The krone appreciated at the same time as foreign stock markets and domestic equity prices fell. Bonds and other interest-bearing securities have been of particular interest.
The interest rate differential between Norway and trading partners has contributed to a strengthening of the krone. Norges Bank has reduced the sight deposit rate from 7 to 5.5 per cent since 11 December. The interest rate differential has narrowed. The krone has depreciated since the last half of January. Expectations of lower interest rates have probably been a contributing factor. Monetary policy has been relaxed.
Following the depreciation in the krone exchange rate since the last half of January, competitiveness in business and industry in mid-March was 10 per cent below the average for the last 30 years. Following substantial deviations, competitiveness has historically always returned to the average fairly rapidly. Market participants weigh the interest rate differential between Norway and other countries against the likelihood of a depreciation of the krone in the future. Cyclical divergence may cause the krone to overshoot its future level in the short term.
On 14 March, the krone was about 5 per cent stronger than in 1996. The rest of the deterioration in competitiveness is primarily due to the sharp rise in labour costs.
Wages in Norwegian manufacturing grew by close to 15 per cent more than wages among trading partners between January 1996 and end- January 2003. In the years around the millennium, the depreciation of the krone veiled the underlying deterioration in competitiveness. In May 2000, the krone exchange rate reached its lowest level in six years. The krone then appreciated up to the beginning of 2003, and the effect of high wage growth has gradually come into evidence in company accounts.
In the ten years following the banking and currency crisis in 1992, the economy featured a long period of balanced growth. However, towards the end of the upturn the economy was facing labour shortages, higher wage growth and a sharp increase in household consumption and debt. Interest rates had to be kept at a high level in Norway.
The turnaround abroad took place two years ago, but the Norwegian economy continued to show a high level of activity. This led to a widening of the interest rate differential against other countries. The main explanation for the wide interest rate differential is not that interest rates are high in Norway, but that interest rates are at a historic low abroad. Interest rates in the US have not been at such a low level since the 1960s.
The real interest rate, i.e. the interest rate adjusted for inflation, rose in 2000 and was thereafter somewhat higher than the average for the past 30 years. With the reductions in the key rate this winter, the real interest rate is no longer particularly high. The tight monetary stance is reflected in the strong krone.
A further jump in wages in 2002 amplified the imbalances in the economy and fuelled the rise in prices for goods and services produced in Norway. This is why monetary policy has been tight.
Over the autumn and winter, it has become clear that global growth is weaker than we and other observers had expected. Several central banks have responded by reducing interest rates further. Interest rates in the US, Europe and Japan are unusually low. Denmark, Sweden, the UK, Switzerland and Iceland have also reduced interest rates. Canada, on the other hand, has recently increased its key rate.
Weak developments are reflected in expectations of low interest rates in the period ahead. Interest rate expectations in the US have been lowered considerably since summer 2002. In the summer, market participants expected interest rates to rise fairly rapidly. In autumn 2002, expectations had been lowered to a gradual increase in interest rates. The key rate is now expected to remain below 1½ per cent throughout 2003.
The same picture applies to Europe.
Global growth is still expected to pick up gradually towards a more normal level, but the upturn may come at a later stage than previously assumed. However, we cannot rule out that the world economy is headed for a fairly long period of stagnation. Low interest rates in the US and Europe are a reflection of this risk.
Weak external developments have had negative spillover effects on the Norwegian economy through the appreciation of the krone, the fall in equity prices and lower demand for Norwegian exports. A larger share of Norwegian production is exposed to competition.
Unemployment has increased, primarily in service industries. The prospects for manufacturing industry are deteriorating. High wage growth is forcing many businesses and municipalities to cut costs and reduce their workforces.
In 2002, inflation was close to target at 2.3 per cent, but has been somewhat lower in recent months. The strong krone is the primary factor behind low inflation. The rise in prices for domestically produced goods and services is marked by the considerably higher wage growth in Norway relative to trading partners. Wage growth moved up further last year, even in industries where profitability had been sharply eroded.
A precondition for countering a possible downturn by means of monetary policy easing is slower growth in labour costs. Monetary policy cannot prevent an increase in unemployment that is caused by a significantly higher rate of growth in labour costs in Norway compared with other countries. Nor can this be achieved by means of fiscal policy.
Growth in real wages is far higher than the underlying growth in productivity in the Norwegian economy. If higher costs cannot be passed on to customers, earnings decline and the wage share increases. Many businesses will have to adjust their workforces to maintain profitability. This leads to a fall in employment and increased productivity. For some companies, this may be a prerequisite for maintaining operations in Norway. The alternative is to close down or relocate production to another country.
While the wage share has risen sharply in manufacturing, it has remained fairly stable in other industries. Import firms have increased their margins, suggesting that the appreciation of the krone has not fully benefited customers. We also know that employment in some service industries has fallen. Many companies in the service sector have adjusted their workforces to maintain profitability. To some extent, higher costs can also be passed on to customers through higher prices in this sector.
In the public sector, where employment growth has been strong the last few years, budgets will only allow a moderate increase in employment in 2003. Overall, employment is projected to fall by ½ per cent in 2003 and remain unchanged in 2004.
Employment followed a similar course in the early 1980s. At that time, unemployment rose markedly as a result of continued strong growth in the labour force.
Manufacturing employment is declining. Up to the end of 2002, manufacturing unemployment remained stable. However, it has risen considerably in the past few months. More lay-offs and lower expectations regarding manufacturing employment point to increased unemployment in the manufacturing sector ahead. In addition, statistics show a 40 per cent reduction in the number of advertised job vacancies in manufacturing in the last year.
Demand for labour, measured by advertised job vacancies, is also low in other industries. This indicates that unemployment may increase further in the period ahead. We must expect unemployment to continue to edge up, particularly in manufacturing.
Registered unemployment is projected to increase from 3¼ per cent in 2002 to 4 per cent in 2003 and up to 4¼ per cent in 2004. Unemployment is projected to stabilise at this level in 2005.
There are wide regional variations in unemployment. At the end of February, 4 per cent of the labour force in Rogaland county was registered as unemployed. This is close to the national average.
As in the rest of the country, the public sector and parts of the private service sector are important to employment in Rogaland, although the share of employment in these industries is lower than the national average. The business sector and growth are stable in this region.
Manufacturing and oil and gas extraction account for a larger share of employment in Rogaland county than in the rest of Norway. There is a relatively large proportion of internationally exposed manufacturing in the county. Manufacturing employment in Rogaland is mainly concentrated in the engineering and shipbuilding industries and in oil platform construction. The food and beverages industry is also a large employer. A large share of manufacturing in Rogaland is export-oriented. Rogaland is also an important agricultural county.
Setting the interest rate at an appropriate level requires knowledge of the economic situation. Economic statistics are useful, but they are published late and the figures are frequently revised.
In autumn 2002, Norges Bank established a regional network as a tool to gauge the level of activity in the Norwegian economy.
The network consists of enterprises, organisations and municipalities throughout Norway. In the two rounds of visits conducted in connection with Inflation Report 1/03, 440 contacts were interviewed. We will have six rounds of talks each year with business and community leaders concerning financial developments in their enterprises and industries, with about 200 visits in each round. The selection of contacts reflects the production side of the economy, both industry-wise and geographically.
In the course of 2003, the number of contacts associated with the network will rise to about 1000 persons, who will be contacted once or twice a year. Rogalandsforskning is responsible for the network and arranges contact meetings in Rogaland and Hordaland counties.
Our assessments will continue to be based primarily on official statistics, but because of the time lag involved and the revisions made of these statistics, supplementary information from other sources is useful.
The regional network provides us with updated information about the state of the Norwegian economy. Regular talks with local business and community leaders provide information that can supplement available official statistics. Moreover, we obtain more detailed knowledge about areas that are not covered by official statistical sources. We also gain insight into issues that are of particular interest to enterprises.
The information obtained in the February round for Region South-West concerning developments in the petroleum sector is of particular concern. Internationally exposed enterprises are struggling to maintain profitability. The krone exchange rate and wage growth have squeezed profit margins in manufacturing. Manufacturing output for the domestic market is no longer expanding and export industries are struggling with both output and prices. Supplies to the petroleum industry are falling as a result of a reduction in exploration activity, few new projects and a loss of projects to foreign suppliers. The construction industry is exhibiting a moderate decline due to weaker demand for commercial buildings. The new football stadium at Jåttå will counter this to some extent. Retail trade reports disappointing Christmas and January sales.
A less favourable period for export-oriented manufacturing, a decline in parts of the petroleum sector and lower margins in business and industry may result in higher unemployment in the region. The supply of qualified labour is also reported to have improved.
In spite of the interest rate cuts and a stimulatory central government budget, overall economic policy has been tight because the krone has been strong. Lower interest rates and a lower krone exchange rate have contributed to an easing of monetary policy. Competitiveness has nevertheless deteriorated due to high wage growth over a number of years. This will curb growth in the period ahead.
Statistics Norway's business tendency survey for manufacturing industry shows that manufacturing leaders' expectations concerning future developments are negative. Companies report a decline in production, employment and orders for both the export and domestic market. Many companies have moved abroad or are planning to move all or parts of their production out of Norway.
In recent years, the shipbuilding and engineering industries have sustained the activity level in Norwegian manufacturing. Shipyards experienced a sharp increase in new orders from end-2000 prior to the elimination of support to the shipbuilding industry in Norway and many European countries. The level of new orders has since then been very low, and the order backlog is nearly exhausted. A sharp increase in petroleum investment could provide positive growth impulses to the offshore-related industry.
The growth impetus to the mainland economy from petroleum investment will, however, be weaker than previously. Construction and installations with a high import content will account for a large share of the increase in investment from 2002 to 2003. Due to the high cost level in Norway, a growing number of contracts are also being awarded to foreign companies. At the same time, Norwegian shipyards are increasingly using foreign subcontractors in low-cost countries. This is having an adverse impact on the Norwegian engineering industry.
Strong growth in private consumption has contributed to sustaining activity in the Norwegian economy. Sharp wage growth, combined with reductions in direct and indirect taxes, resulted in close to 5 per cent growth in household real disposable income last year. Real income growth will be considerably lower in 2003 and probably lower than projected earlier. Imbalances in the Norwegian electricity market have resulted in a sharp increase in electricity prices. This implies a considerable reduction in household real income growth. Our projections indicate that, in isolation, electricity prices will contribute to a reduction in income growth of 1½ percentage points this year. The interest rate reductions this winter will have the opposite effect. In addition, developments in employment are expected to be weaker and wage growth somewhat lower this year than previously projected.
During the last six months, households have become less optimistic about the economic outlook. Increased uncertainty in the labour market and lower confidence point to heightened caution and increased saving in the household sector. Lower interest rates have the opposite effect. Household saving behaviour may also be affected by high electricity prices. On the whole, a moderate, temporary decline in household saving is expected in 2003. Next year, a normalisation of electricity prices will contribute to increasing real income growth compared with 2003. At the same time, we have assumed that a share of the increased use of petroleum revenues over the central government budget will entail increased transfers or tax cuts for households. These factors, combined with lower interest rates, may fuel relatively brisk growth in private consumption in the next few years.
In the last few months, house prices have risen at a slower pace than in previous years. Activity in the housing market has declined and it takes longer to sell a dwelling.
Household borrowing is still high. Weaker developments in house prices and reduced household optimism may restrain credit growth in the future.
In the last Inflation Report, we expected mainland GDP growth to be lower than trend growth, at 1¼ per cent this year and 2 per cent in 2004. In 2005, growth is projected at 2¼ per cent.
Norges Banks Executive Board assessed the interest rate at its monetary policy meeting on 5 March. It was decided to reduce the interest rate from 6 per cent to 5.5 per cent. Norges Bank judges that, with an interest rate of 5.5 per cent, the probability that inflation two years ahead will be lower than 2½ per cent is greater than the probability that it will be higher.
The underlying rise in prices in the coming year will be marked by the appreciation of the krone over the last two years. Despite high wage growth, the year-on-year rise in consumer prices adjusted for tax changes and excluding energy products (CPI-ATE) will most likely range between 1½ and 2 per cent until the summer. Developments after this will partly depend on the international economic situation, the effects of the high level of costs for business and industry, the krone exchange rate and how changes in the exchange rate feed through to consumer prices in Norway.
In the Inflation Report, we presented two alternative paths for the Norwegian economy. In the baseline scenario, where the interest rate is held constant at 5½ per cent and the krone exchange rate at the average for the past month, inflation is projected to remain below 2½ per cent over the forecast horizon. In an alternative scenario, where monetary policy is eased in line with market expectations, inflation may be somewhat above target at the two-year horizon.
There is uncertainty surrounding developments in many of the factors that will influence inflation ahead, among others the exchange rate. This implies a gradual approach to the conduct of monetary policy.
Thank you for your attention.