Address by Governor Øystein Olsen to foreign embassy representatives in Oslo, 10 April 2018.
Your excellencies, ladies and gentlemen.
Firsts of all, I would like to thank you for taking the time to attend this event, which provides me with an opportunity to present Norges Bank’s view of the economic situation and some of the challenges ahead.
The advanced economies have emerged from another challenging period. Ten years ago the world economy was hit by a shock and thrown into the deepest recession since the 1930s.
Chart: Economic growth following the financial crisis
The economic downturn that followed the financial crisis stands apart from earlier recessions. It was both deeper and longer. Potent measures were deployed to address the crisis, but it has still taken time to get the world economy back on its feet.
Monetary policy had to take on substantial responsibility. Without powerful economic policy measures, there was a risk of a self-reinforcing recession.
In the past few years, advanced-economy growth has steadily strengthened. Unemployment has fallen back, in Europe too. In parallel with this, longer-term structural developments have changed the economic landscape. A more closely integrated world economy and technological changes are transforming aspects of everyday life and also have consequences for economic policy.
Trade and technology
Chart: Global trade as share of GDP
Over the past fifty years, global trade has more than doubled as a share of global GDP. The scaling back of trade barriers has been an important driving force. In the past decades, lower transport costs and new technological solutions have fostered new ways of organising production and trade.
Global trade has generated substantial welfare gains. As consumers, we have gained access to cheaper and better products. More importantly, over one billion people have been lifted out of poverty. Many people would be negatively affected if the tendency is reversed towards higher trade barriers.
Chart: Productivity growth in Norway and abroad
Society is being transformed by advances in information and communication technology. We are living in an increasingly digital world. From the comfort of our sofas, we can now access an unprecedented array of music, film and literature. From a tablet or a mobile phone, we can order groceries or control the temperature in our holiday home.
Artificial intelligence and the increasing use of robots are also in focus. By managing processes using machine learning, work can be made more efficient. But even if technology appears to be advancing more rapidly than ever before, there is little visible effect on productivity growth for the economy as a whole. Both in Norway and among our trading partners, productivity growth has declined.
Productivity growth may be lagging because the diffusion of new technology into goods and services production takes time. Productivity growth will only increase once the use of information technology and digital solutions reduces the use of labour.
Chart: Productivity for frontier firms and other firms
Behind the average figures we also find an interesting pattern. In many sectors; the gap between the most productive firms and the rest has increased. The chart shows the gap within the service sector, but the same picture applies to other sectors. While productivity growth for frontier firms has remained robust, it has been substantially weaker in the rest of the economy. This may indicate that it is not the rate of innovation that has slowed, but rather the diffusion of new technology from frontier firms to laggard firms.
In the past decade, the fallout from the financial crisis has probably had a dampening impact on productivity growth. Weak economic growth and increased uncertainty have reduced businesses’ willingness to invest. In addition, banks in many countries held back on lending for a long period. This may have discouraged new entrants and slowed the replacement of outdated production equipment.
The legacies of the financial crisis are now fading. Investment is picking up across countries. This could lift productivity ahead.
But this will not materialise of its own accord. It is up to us to take advantage of the possibilities provided by technological innovation. In order to profit from new technology, work must become less labour-intensive. When labour flows into other profitable activities, we get more out of our resources. This is part of the restructuring needed to generate growth.
A flexible labour market, high education levels and a solid social safety net are preconditions for successful restructuring. In Norway, much of this is in place, but we too must be prepared to adapt to changing circumstances. In addition, we are lucky to be endowed with natural resources, which it will be important to build on, also in the years to come.
Low price and wage inflation
Not everyone benefits from a more closely integrated global economy and new technology. In many countries, the competition for low-skilled jobs has intensified, depressing wages for these workers. On the other hand, technological advances have pushed up demand for high-skilled labour for which there is a wage premium. The result is wider wage gaps.
Chart: Labour share
The income distribution between labour and capital has also changed. It had long been a widely-held view among economists that the labour share of income would remain fairly constant over time. Keynes described the stability of the labour share as “one of the most surprising, yet best-established, facts in the whole range of economic statistics”. Yet since 1980, corporate profits have risen faster than wages.
Technological advances have reduced the relative cost of capital goods. Tasks have been taken over by robots and other capital equipment. This probably explains some of the decline in the labour share.
Chart: World’s largest listed companies
The emergence of global technology companies is also reducing the labour share. With broad platforms and vast numbers of users, they dominate the market, which translates into both market power and substantial profits. The winner takes all. A few technology companies stand out by virtue of their size. Alphabet is one example. 80 percent of the world’s web searches are done through its Google search engine.
The decline in the labour share can primarily be explained by the fundamental transformation of the global labour market in recent decades. More countries are participating in global trade, labour mobility has increased, and offshoring production to low-cost countries has become easier. When China, India and Eastern Europe joined the global market economy, the labour force of countries participating in world trade doubled.
The result is that workers in advanced economies face competition from new groups, which pushes down wage growth and affects the income distribution between labour and capital. Lower unionisation levels have also weakened workers’ bargaining power.
Low wage growth puts downward pressure on prices for goods and services. Many firms also face competition from firms that have relocated production to lower-cost countries. The scope for passing on higher costs to prices is narrowing.
The tendency of lower global price and wage inflation has consequences for monetary policy. On the one hand, inflation is likely to show smaller fluctuations than earlier. But this also means that it may be more difficult to bring up inflation once it has fallen to a low level.
Chart: Unemployment and wages
The Phillips curve – the relationship between unemployment and wage and price inflation – may have changed. In many countries, wage growth has been fairly weak, even though unemployment has fallen. The reason for this, among other things, is the global driving forces I have just mentioned. But the relationship between wages and unemployment has not broken down. There are now signs in many countries that wage growth is again rising against the background of a broadening upturn and a tightening labour market.
Expansionary monetary policy in many countries
Chart: Global real interest rates
Never before have global interest rates been as low as today over such a long period. The interest rate level was moving down long before the 2008 crisis. The trend is explained by several structural changes. Diminished growth in advanced economies has dampened the willingness to invest. At the same time, groups and countries with a high saving rate account for a larger share of income growth. Both lower investment and higher saving have contributed to depressing real long-term interest rates.
When the financial crisis hit the global economy in 2008, central banks responded forcefully. Many central banks still found it difficult to provide a sufficiently accommodative monetary stance, and the room for further interest rate cuts was gradually exhausted. Central banks were led into unknown territory and implemented unconventional measures.
The strong medicine has worked. Unemployment in major economies is lower than before the financial crisis. Price and wage inflation is rising from low levels. The need for monetary accommodation is thus diminishing.
The global interest rate rise will probably be gradual. After a long period of very low rates, the effect of higher interest rates on the economy is uncertain. It is also uncertain how quickly wage and price inflation will rise as activity gains momentum.
As conditions normalise, interest rates will likely remain lower than they were a few decades ago. The structural conditions that have depressed the global neutral interest rate will not reverse overnight.
Monetary policy – lessons from the financial crisis
Ten years of historically low interest rates and large-scale asset purchases give cause for reflection. An important question is what responsibilities should rest with a central bank. A related theme is what is meant by the objective of low and stable inflation. Let me take a closer look at these questions.
The primary objective of monetary policy is to maintain monetary stability, as part of the central bank’s responsibility for the monetary system.
Inflation that is either too high or too low has undesired consequences, such as arbitrary wealth redistribution, underinvestment and resource misallocation. The result is lower activity and lower welfare.
Since 1990 an increasing number of countries have chosen to link monetary stability to a numerical inflation target. Since the financial crisis, all of these countries have maintained their inflation targeting regimes. This reflects the overall positive experience with this framework. It did not get in the way of a powerful response to the financial crisis.
Chart: Inflation in Norway
In Norway too, inflation targeting has functioned well. Inflation has remained low and stable since it came down in the early 1990s. Despite major shocks to the Norwegian economy, employment variability has been lower since 2001 than in previous periods.
Lessons have been learned along the way. Initially, central banks had high ambitions to steer inflation to target within a clearly defined time horizon. But experience with these regimes provided useful insight. When confronted with shocks, small open economies in particular experienced that a rapid return to the inflation target could have undesired consequences for the real economy. Norges Bank has addressed this concern by giving greater weight to output and employment. The inflation target horizon has been extended and monetary policy has gradually become more flexible.
A few weeks ago, on 2 March, the Norwegian Government adopted a new, modernised regulation on monetary policy. In Norges Bank’s assessment, the new regulation will not result in significant changes in the conduct of monetary policy. Let me elaborate somewhat on the implications of the new regulation.
“Monetary policy”, according to the new regulation, “shall maintain monetary stability by keeping inflation low and stable.”
The regulation thus clarifies the primary task of monetary policy. Price stability is the best contribution that monetary policy can make towards sound and stable economic developments over time.
According to the new regulation, “the operational target of monetary policy shall be annual consumer price inflation of close to 2 percent over time.”
It is not possible to quantify precisely an optimal inflation target for the Norwegian economy. A numerical target of 2 percent is, however, consistent with the inflation target of most of Norway’s trading partners.
In 2001, when inflation targeting was introduced, the Norwegian economy faced the prospect of gradually increasing oil revenue spending. It was widely expected that the phasing-in of revenues would entail an appreciation of the real exchange rate. At the time, the nominal target was set at 2.5 percent. An expected real appreciation could then occur partly in the form of wider price and cost differentials between Norway and its trading partners. The period of rising oil revenue spending now appears largely to be over. Thus, it is difficult to find compelling arguments for setting an inflation target in Norway today that differs from that of trading partners.
The new regulation underpins the Bank’s flexible approach to inflation targeting.
The regulation states that: “Inflation targeting shall be forward-looking and flexible so that it can contribute to high and stable output and employment and to counteract the build-up of financial imbalances.”
As long as there is confidence that inflation will remain low and stable, monetary policy can contribute to stabilising the economy. When the economy is exposed to shocks, the central bank can respond rapidly by adjusting the key policy rate, preventing downturns from becoming deep and protracted. This can reduce the risk of unemployment becoming entrenched at a high level following economic contractions. Nevertheless, monetary policy cannot assume primary responsibility for high output and employment. The level of output and employment over time depends on overall economic policy. Monetary policy is only one component of such an overall framework.
The importance of financial markets and financial stability was underestimated before the crisis - also by central banks. The financial crisis revealed how harmful financial imbalances can be. Monetary policy can in given situations take account of the risk of a build-up of financial imbalances. But monetary policy cannot take primary responsibility for heading off a gathering storm. Regulations and supervision of financial institutions are the primary means of addressing shocks to the financial system.
The build-up of financial imbalances has in recent years been given little weight in monetary policy by the major central banks. Their focus has been on counteracting a deeper and more prolonged downturn and on preventing deflation.
In countries that were less affected by the financial crisis, more attention has been devoted to financial stability considerations. In high-tech, global financial markets, capital moves rapidly between different currencies. A wide interest rate differential could have a substantial impact on the exchange rate, with repercussions on inflation, output and employment. This is why low interest rates in large economies that were severely hit by the financial crisis quickly led to lower rates in countries where the cyclical situation, in isolation, would have implied higher rates. This was the case in Norway until oil prices fell. Other small open economies have been in the same situation.
Chart: House prices
These countries have imported low interest rates and experienced rapidly rising house prices and debt. They have introduced measures to limit elevated debt in order to prevent imbalances from building up further. In Norway, stricter mortgage lending requirements have been imposed on banks. These measures have probably contributed to the recent correction in Norwegian house prices.
The exchange rate places a limit on how far Norwegian interest rates can deviate from foreign rates. But with a floating exchange rate, monetary policy can help to stabilise the economy when it is exposed to shocks. How Norges Bank will react to movements in the exchange rate will depend on how these fluctuations affect the outlook for inflation, output and employment.
A recent example is the monetary policy response to the negative oil price shock in 2014. The exchange rate served as a shock absorber. With confidence in the inflation target, monetary policy was able to underpin a weaker krone. The krone depreciation, combined with moderate wage settlements, contributed to a marked improvement in business profitability and competitiveness. At the same time, an expansionary fiscal policy and lower interest expenses have been important in sustaining domestic demand.
Chart: Mainland GDP
This brings me to the current situation. Two years after the cyclical trough was reached in Norway, growth has gained a firm footing. There are prospects for solid growth in business investment and consumption and renewed optimism in the petroleum industry. A number of large development projects will contribute to a rebound in oil investment in the coming years. The impetus from abroad has strengthened and exports are picking up. On the other hand, housing investment has fallen, and is likely to decline further.
While underlying inflation is still low, rising capacity utilisation will probably push up price and wage inflation further out.
Chart: The Executive Board’s assessment and interest rate forecast
At its monetary policy meeting in March, the Executive Board gave weight to the sustained upturn in both global and Norwegian economy. The Executive Board decided to keep the key policy rate unchanged at 0.5 percent. The Board’s current assessment is that the key policy rate will most likely be raised after summer this year. That would be the first increase in seven years – and should be taken as a good sign.
- Data are from Jordà, O., M. Schularick, and A. M. Taylor (2017): “Macrofinancial History and the New Business Cycle Facts” In: M. Eichenbaum and J. A. Parker. NBER Macroeconomics Annual 2016, volume 31. University of Chicago Press.
- Andrews, D., C. Criscuolo and P. N. Gal (2015): “Frontier firms, technology diffusion and public policy: micro evidence from OECD”, OECD Productivity Working Paper No. 2.
- Salvanes, K.G. (2017): “Omstillingsevnen i norsk økonomi under finanskrisen” [The adaptability of the Norwegian economy during the financial crisis], Arbeidsnotat 2017/7, Ministry of Finance (Norwegian only).
- Keynes, J.M (1939): "Relative Movements of Real Wages and Output", The Economic Journal 49 (193), pp 34-51.
- Hagelund, K., E. W. Nordbø and L. Sauvik (2017): “Lønnsandelen” [The labour share], Aktuell kommentar 9/2017, Norges Bank (Norwegian only).
- The figures are taken from Freeman (2008) “The new global labor market”. The most recent figures from ILO (2017) show that the global labour force in 2000 was 2.8 billion, while China (0.8), India (0.4) and Eastern Europe (0.2) together accounted for 1.3 billion (rounded).
- Rachel, L. and T. D. Smith (2015) “Secular drivers of the global real interest rate”, Bank of England Staff Working Paper No. 571.
- See for example Wheeler G. (2014): “Reflections on 25 years of Inflation Targeting”, Reserve Bank of New Zealand, speech delivered on 28 November 2014 and Norges Bank (2017): “Experience with the monetary policy framework in Norway since 2001”, Norges Bank Papers 1/2017.