Monetary policy, inflation and the outlook for the Norwegian economy
Address by Governor Svein Gjedrem to DnB Haugesund, 10 April 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. This was the result of weaker cyclical developments in the global economy, a sharp drop in interest rates internationally 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, enterprises, public entities, employees and employers can base decisions on the assumption that inflation in Norway will be 2½ per cent over time.
The inflation target is a vehicle for monetary policy's contribution to stabilising output and employment. This intention is also expressed in the Regulation on Monetary Policy. 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 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. 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. 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. 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, became highly attractive. 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. After edging down again since the beginning of February 2003, gold prices have shown a moderate rise since the start of the war in Iraq. The exchange rate for the Swiss franc has remained high.
Oil prices fell markedly after 11 September 2001, but have since risen. Fears of war and the war in Iraq have increased the uncertainty surrounding global oil supplies. The war premium on oil prices fell in the first days of the war in Iraq, reflecting expectations of a short and limited war. The oil market is unstable. Oil prices have fluctuated almost as widely as they did after 11 September 2001. Depending on developments in Iraq, oil prices may also vary considerably in the period ahead.
Oil prices will depend on the outcome of the war in Iraq. OPEC's ability to stabilise production will also have an impact. Futures prices now point towards an oil price of USD 24 per barrel at the end of 2003. However, prices for options contracts reflect considerable uncertainty.
Major economies such as the US, Germany and France are struggling with stagnation and fears of recession. Substantial tax relief and low interest rates are sustaining activity in the US. The Japanese economy has been in a deflationary recession for a long period. If oil prices rise again, this would have a dampening effect on activity in the global economy.
On the other hand, a weaker global economy may well push oil prices down when the war in Iraq is over. Weak developments in the global economy are often followed by a period of low oil prices.
Commercial stocks of crude oil and refined oil products are considerably lower than normal, especially US stocks. The strike in Venezuela and a cold winter in eastern parts of the US have contributed to the depletion of these stocks. The same picture applies to the entire OECD area. Levels of strategic oil reserves, however, are high.
OPEC countries probably have limited possibilities for increasing production. The International Energy Agency has estimated that capacity in OPEC, excluding Iraq and Venezuela, has now been fully utilised.
Nigeria's production has been reduced by between 700 000 and 800 000 barrels per day because of rioting. In recent years, Nigeria's production has been stable at around 2 million barrels per day. The fall in production has not had a substantial impact on oil prices, which have primarily been influenced by news from Iraq.
Revenues from exports of natural gas have risen sharply over the past few years, accounting for a quarter of the total export earnings from the petroleum sector last year.
Capacity in pipelines to continental Europe has not yet been fully utilised. As a result of gas sales contracts that have already been signed, gas exports will continue to increase in the years ahead, while oil production may have reached its peak.
In about ten years, Norway will probably export the same volume of gas as oil. A few years after that, the value of gas exports will equal the value of oil exports.
The price of gas is closely linked to the price of oil, albeit with a lag. The price of oil will therefore be an indicator of changes in the price of gas exported by Norway.
In the relatively near future, the UK may become an important market for Norwegian exports of natural gas. Coal-fired power plants were replaced by gas-powered plants in the UK in the 1990s. This resulted in a sharp rise in demand for gas.
The UK has so far been self-sufficient in natural gas, but production is likely to fall in a couple of years. The country may therefore quickly become a net importer of natural gas. Total demand in the UK is about twice as high as total Norwegian natural gas exports. The relatively short distance between the fields in the North Sea and the UK gives Norway an advantage. It may be necessary to lay more pipelines in order to expand capacity.
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 last year. 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, with its high interest rates, attractive. The krone appreciated at the same time as domestic and foreign stock markets fell. Bonds and other interest-bearing securities have been in demand.
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 mid-January, partly reflecting expectations of lower interest rates. Monetary policy has become less tight.
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.
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. Interest rates in the US have not been at such a low level since the 1960s. 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 through most of 2003. A similar picture is in evidence in Europe.
Global growth is still expected to rise gradually to a more normal level, but the recovery will come later than previously expected. However, we cannot rule out the possibility 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.
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 markets. Many companies have moved abroad or are planning to move all or parts of their production out of Norway.
The number of bankruptcies has increased sharply. The number of bankruptcy petitions has reached the highest level in nine years. If we disregard personal bankruptcies, the increase has been 19 per cent since the fourth quarter of 2001. The largest increase has been in the manufacturing and construction sectors. The number of bankruptcies increased compared with 2001 in all counties except Oppland. The counties of Vestfold, Rogaland and Nordland exhibited the sharpest increase, 67, 59 and 56 per cent respectively from 2001 to 2002. The number of bankruptcies in Oslo increased by 25 per cent from 2001 to 2002.
The number of new orders in manufacturing plunged in the third quarter last year, but edged up again in the fourth quarter. Incoming orders are not sufficient to sustain the order backlog.
In recent years, the shipbuilding and engineering industries have sustained the activity level in Norwegian manufacturing. Shipyards experienced a sharp increase in new orders before end-2000, when support to the shipbuilding industry in Norway and many European countries was eliminated. The level of new orders has since then been very low, and the order backlog is nearly exhausted.
Petroleum investment is somewhat higher this year than last year. The growth impulses from petroleum investment to the mainland economy may, however, be weaker than has been the case earlier. Construction and installations with a high import content will account for a large share of the increase. 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 shipbuilding and engineering industry.
Wages in Norwegian manufacturing rose 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 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 revisions of these statistics, supplementary information from other sources is useful.
The regional network provides updated information on 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 supplementary information about areas not covered by official statistical sources. We also learn which issues are of particular concern to enterprises.
Information from the February round in Region South-West indicates that developments in the petroleum sector are of particular concern. Internationally exposed enterprises are experiencing difficult times. The krone exchange rate and wage growth have squeezed operating margins for manufacturing. Manufacturing output for the domestic market is no longer expanding and export-oriented manufacturing is struggling with both output and prices. The number of supply contracts to the oil industry are on the decline due to a reduction in exploration activities, few new projects and loss of projects to foreign suppliers. The construction industry is exhibiting a moderate decline due to weaker demand for commercial buildings. Retail trade reports disappointing Christmas and January sales.
A less favourable period for export-oriented manufacturing, decline in parts of the petroleum sector and lower margins in business and industry may result in a rise in unemployment in the region. The supply of qualified labour is also reported to have improved.
As in the rest of the country, the public sector and parts of the private service sector are important to employment in the county of Rogaland, although the share of employment in these sectors is lower than the national average. The business sector and growth are stable in this part of the country.
Manufacturing and oil and gas extraction account for a larger share of employment in Rogaland county than in the rest of Norway. The internationally exposed sector is relatively large in the county. The engineering industry, shipbuilding and construction of oil platforms account for a substantial share of manufacturing employment in Rogaland county. Many are also employed in the food and beverage industry. Rogaland is also an important agricultural county. A large share of manufacturing production in Rogaland is export-oriented.
We must expect that unemployment will continue to edge up, especially 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 March, 3.8 per cent of the labour force in Rogaland was registered as unemployed. This is close to the national average.
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. The weakening of the krone since January has, however, led to an easing of monetary policy. Developments ahead will depend, among other things, on changes in the interest rate and the krone exchange rate. In the last 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, mainland GDP is projected to rise by 1¼ per cent in 2003 and 2 per cent in 2004. This is less than the expected long-term growth potential in the economy. In 2005, growth is projected at 2¼ per cent. In an alternative scenario, where monetary policy is eased in line with market expectations, there will gradually be prospects of stronger growth.
Consumer price inflation has been marked by a fairly wide gap between price inflation on imported consumer goods and domestically produced goods and services. The rise in prices for domestically produced goods and services reflects considerably higher wage growth in Norway relative to trading partners.
Wage growth moved up further last year, even in industries where profitability had been substantially eroded. The rise in prices for domestically produced goods and services remained at a high level mainly because of strong wage growth over the last few years. A slowing of inflation since last summer is related to lower airline prices (due to increased competition in the airline industry) and decreasing house rents. Price inflation for imported consumer goods has been pushed down by the strong krone exchange rate as well as by the shift in clothing imports from high-cost countries to low-cost countries such as Asia and Eastern Europe.
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 depend partly on global economic developments, 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 baseline scenario presented in the Inflation Report, where the interest rate was held constant at 5½ per cent and the krone exchange rate at the average for the past month, inflation was projected to remain below 2½ per cent for the entire forecast period. In the alternative scenario, where monetary policy was eased in line with market expectations, inflation might be somewhat higher than target at the two-year horizon.
On the basis of the analyses in the Inflation Report, Norges Bank reduced the sight deposit rate by 0.5 percentage points to 5.5 per cent at the meeting of the Executive Board on 5 March. At the press conference after the meeting, Deputy Central Bank Governor Jarle Bergo said, "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."