Norwegian monetary policy in the age of the euro
Central Bank Governor Svein Gjedrem
Speech at the conference on EMU and the euro hosted by The European Commission, Euro-Info Centre and NHO (Confederation of Norwegian Business and Industry)
Oslo, 30 October 2001
Please note that the text may differ slightly from the actual presentation
Introduction
Welfare and prosperity in Norway rely on the free movement of goods, services, capital and knowledge. The
EU accounts for about 80 per cent of Norway's foreign trade. By virtue of the
EEA Agreement, Norway is part of the internal market. The Norwegian economy is
interwoven with European economies. This has also been reflected in Norway's
monetary policy throughout much of the post-war era.
Chart1.Monetary policy's most
important task is to provide a nominal anchor for the economy. Since the Second
World War, there have been several monetary policy reforms in Norway. In the
period between 1972 and 1986, monetary policy was to a limited extent
focused on curbing the effects of cost shocks on prices.
Chart2.During this period,
inflation was high and variable. Consumer prices rose almost twice as
much as in Germany. At the same time, the krone's value against
the German mark was almost halved.
From 1986 to 1992, Norway
operated a fixed exchange rate regime. The fixed exchange rate was the anchor
for inflation in Norway. The difference between inflation in Norway and Germany
narrowed substantially.
Chart3.From 1986 to 1990, monetary
policy was oriented towards maintaining a fixed exchange rate against a
trade-weighted basket of currencies. In 1990, the krone was pegged to the
European currency unit, the ECU. The peg was abandoned in December 1992 when
international currency turbulence compelled Norway and several other countries
to discontinue the fixed exchange rate system against the ECU. However,
monetary policy was still geared towards maintaining a stable krone exchange
rate against European currencies. The ECU was used as the main reference for
European currencies. The euro took over this role when it was introduced on 1
January 1999.
Developments since the
beginning of 1997 indicated that the exchange rate was no longer an appropriate
operational target of monetary policy. Norges Bank therefore placed increasing
emphasis on low and stable inflation as a precondition for exchange rate stability. In our opinion, the
best contribution monetary policy could make to a stable krone exchange rate
against the euro was low and stable inflation in line with inflation in the
euro area. Monetary policy was therefore oriented towards bringing inflation
over time into line with that aimed at by the European
Central Bank.
Guidelines for economic policy in Norway
Chart4.On 29 March, the Government
issued new guidelines for monetary policy. Monetary policy shall now be
oriented towards low and stable inflation. The
operational target of monetary policy is consumer price inflation of 2½ per
cent. At the same time, new guidelines for fiscal policy were drawn up,
providing for the use of petroleum revenues over the central government budget
equivalent to the expected real return on the Government Petroleum Fund.
The new guidelines for
monetary policy did not entail any significant change in the conduct of monetary
policy. Quantifying an inflation target, in line with international practice,
has made it easier to explain and understand Norwegian monetary policy.
The implementation of monetary policy
Monetary policy influences the economy with considerable and variable lags. Our
analyses indicate that a substantial share of the effects of an interest rate
change occurs within two years. Two years
is thus a reasonable time horizon for achieving the inflation target of 2½ per
cent.
The
effects of interest rate changes are uncertain. In addition, it may be difficult to assess the
current situation. Different indicators may point in various directions and
economic statistics are normally published with a lag. This suggests
that a gradualist approach to setting interest rates is appropriate. We will then acquire new
knowledge and can adjust interest rates underway.
If evidence suggests that inflation will be higher than 2½ per cent with unchanged
interest rates, the interest rate will be increased. If it appears that inflation
will be lower than 2½ per cent with unchanged interest rates, the interest rate
will be reduced. There
is symmetry here. It is just as important to
avoid an inflation rate that is too low, as it is to avoid an inflation rate
that is too high.
Economic
policy in the euro area
The introduction of the euro
on 1 January 1999 also meant the introduction of a single monetary policy in the
eleven member countries. Greece joined as the
twelfth country on 1 January 2001. The population of the euro area is a little
more than 300 million and the euro area economy accounted for about 16 per cent
of world GDP last year.1 Price
stability is the primary objective of the single monetary
policy in the euro area. The Governing Council of the European
Central Bank has defined price stability as a year-on-year increase
in the Harmonised Index of Consumer Prices (HICP) for the euro area of
below 2 per cent. The project will be completed in January and February
2002. On 1 January, euro banknotes and coins will be put into circulation.
During a changeover period, national currencies
can be used as a means of payment alongside the euro. This
period is no longer than two months in any of the member
countries. As from the beginning of March, the euro will be the
only legal tender in all euro area countries, and all prices will
be in euros.
The objective of monetary
policy in the euro area is price stability in the euro area as a whole. If asymmetric
shocks across euro area countries occur, the national authorities
can use fiscal policy to stabilise economic developments. While adhering to the
Stability and Growth Pact,
fiscal policy could become more
effective in the small and medium-sized
economies since
the exchange rate and interest rates will not in principle be affected. In
addition, local wage determination and investment flows will over time
contribute to reducing differences in profitability and production costs.
The responsibility for
fiscal policy rests with the national government of each euro area country.
Fiscal policy can be adapted to the economic situation, provided the provisions of the Stability and Growth Pact
are adhered to. Under the Pact, Member States are committed to pursuing the
medium-term objective of budgetary positions
close to balance or in surplus. Fiscal policy can be used to deal with cyclical fluctuations, but
the budget deficit must not exceed 3 per cent of GDP unless it is deemed to
result from an unusual event or severe economic
downturn.
In Norway, fiscal policy
also has a long-term anchor, and monetary policy is oriented towards low and
stable inflation. The guidelines for the use of petroleum revenues set limits
on the structural budget deficit. Like the Stability and Growth Pact in the EU,
these guidelines will contribute to economic stability.
Chart5.The economic situation and the monetary policy stance
Growth forecasts for the
global economy have been revised downwards markedly in recent months. Since
December 2000, growth forecasts for our trading partners have been halved for
2001. The tragic events of 11 September will have a further dampening effect on
activity in the US, Asia and European economies.
In the euro
area, high oil prices, livestock diseases, the decline in the ICT sector and
reduced demand in the US have had a negative impact on economic developments.
GDP growth has also slowed considerably over the last year. Unemployment has
shown a substantial decline in recent years and is low in many of the smaller
countries. Unemployment is high in the large countries. Particular structural
features, such as wide regional disparities, are contributing to the high level
of overall unemployment. The terrorist attacks of 11 September have reduced
demand in the aviation and travel industries. The European Central Bank has cut
its key rates by 1 percentage point
so far this year.
Until the autumn, the
Norwegian economy had remained relatively insulated from the world economic
slowdown. It now appears clear that Norway will also be affected by the slowdown. A
number of Norwegian enterprises in export industries and the travel industry
have felt the effects of growing caution among households and businesses
worldwide. Investment in mainland
enterprises will probably also decline.
However, the economic
situation in Norway is different from that of the euro area. The Norwegian
economy is still characterised by high capacity utilisation with a limited
supply of labour. Registered unemployment has been low and stable since the
autumn of 1998. Employment is growing sharply in the public sector and the
construction industry.
In recent years, consumer
price inflation has been higher in Norway than among our trading partners. The
year-on-year rise in prices was 2.4 per cent in September. Stable prices for
imported consumer goods is contributing to containing inflation in Norway. The
rate of increase in prices that is primarily influenced by domestic costs is
high.
Chart6.It is not a new
phenomenon that Norway is at a different stage of the business
cycle than the euro area countries. One reason
for this is that changes in the external environment often have a different
impact on the Norwegian economy than other European economies. For example, a
sharp rise in oil prices has a dampening impact on purchasing power and the
activity level in the euro area. In contrast, this tends to boost
petroleum investment and household confidence in Norway. The development of a
national oil industry and restructuring in the 1980s and 1990s have also
contributed to a cyclical path that is specific to Norway. For example,
petroleum investment was probably one of the main driving forces behind the
booms in the mid-1980s and in 1997-1998.
Chart7.Norwegian labour costs have
risen by 5-6 per cent annually in recent years, while labour costs in the euro
area countries have increased by less than 3 per cent annually. When cyclical
developments are not synchronised and labour costs are at different levels,
interest rates will also vary.
Chart8.In the current situation,
Norwegian interest rates on a par with interest rates in the euro area would
lead to instability. If monetary policy had not contributed to curbing demand,
the pressure on economic resources would have led
to accelerating inflation.
Countries participating in
EMU have gained access to a large, liquid financial market in their own
currency, with low transaction costs. The risk
of exchange rate losses associated with cross-border investment and borrowing
in the euro area has been eliminated. This can result in substantial gains, not
least for some of the smaller countries. The business sector in the euro area
is taking advantage of this. The volume of bonds issued by non-financial corporations
has increased substantially each year since the introduction of the common
currency in January 1999.
Chart9.Financial markets are small
and fairly illiquid in Norway compared with the euro area. Combined with the
uncertainty associated with exchange rate developments, this can add a
premium on the required rate of return on investments in NOK. This
can in turn contribute to a higher long-term interest rate in Norway than in
the euro area countries over time. In the long term, financial market
participants expect Norwegian interest rates to be close to 1 percentage point
higher than in the euro area.
Exchange
rate developments after the introduction of the euro
Before the introduction of
the euro on 1 January 1999, it was assumed that the establishment of a large
currency area in Europe could result in more substantial exchange rate
fluctuations than earlier. Foreign trade for EMU as a whole accounts for a
smaller portion of the economy than for Germany, for example. The focus on
exchange rate changes could thus be expected
to fade. The Norwegian krone would also be affected by such increased
fluctuations.
Chart10.For Norway and other
countries on the rim of the euro area, exchange rate fluctuations have not
increased since the introduction of the euro. To the contrary, the effective
exchange rates for pound sterling, the Swiss franc, the Swedish krona and the
Norwegian krone have varied somewhat less than in the period 1996-1999. These
currencies have also fluctuated somewhat less against the euro than they did
against the German mark the last few years before 1999.
Chart11.Market participants also
seem to assess the risk of future short-term fluctuations in the
krone exchange rate against the euro as fairly moderate. This uncertainty,
which is indicated by the costs of hedging
against future exchange rate fluctuations in the short term, is now relatively
limited for the Norwegian krone compared with other currencies on the rim of
the euro area.
Chart12.Changes in the terms of
trade are an important source of exchange rate fluctuations. The terms of trade
measure the prices for goods and services that we export in relation to the
prices for those we import. Commodities account for a substantial share of
Norwegian exports. Commodity prices are subject to wide variations. Experience
shows that a deterioration in the terms of trade results in a depreciation,
whereas an improvement leads to an appreciation. The exchange rate thus
acts as a stabiliser, a buffer that partly curbs the effects of
changes in the terms of trade on economic activity. Developments in the krone
exchange rate can also contribute to restraining the effects on prices of
higher wage growth and other domestic cost disturbances when there is
confidence that inflation will be stable over time.
Oil and gas are the
commodities that account for the largest share of Norwegian exports. A
substantial portion of the revenues from the sale of oil and gas is invested in
foreign equities and bonds through the Government Petroleum Fund. The Fund has thus
diminished the impact of short-term fluctuations in oil prices on
the domestic use of petroleum revenues. In the last 20 years, fluctuations in
the terms of trade have been three to four times greater for the Norwegian
economy including the petroleum sector than for the mainland economy. The Petroleum
Fund thus relieves pressure on the krone exchange rate. The relatively low
level of uncertainty that market participants seem to attach to krone exchange
rate developments may be a reflection of this.
Introduction
of euro banknotes and coins
The introduction of euro
banknotes and coins from 1 January 2002 has no direct consequence for Norwegian
monetary policy. For households and businesses in the euro area, the new
currency will become a physical reality, not just an
accounting currency. The practical advantages of the common
currency will become more apparent. The euro may be used in twelve countries.
The costs connected with currency exchange between the twelve countries
disappear. When the national currencies are withdrawn, price differences between
the euro area countries will become more apparent. The result may be increased
competition and lower interest rates over time. Euro area citizens will develop
a more positive attitude to the euro as their money. They
will experience that the euro is stable, as it will be
reflected in a stable level of retail prices.
The changeover period, from the introduction of euro banknotes and coins until the national currencies
cease to have legal tender status, is short.
Norwegian enterprises and households will also have to exchange their cash in
euro area countries' national currencies. There seems to be a perception that
exchange between two foreign currencies in Norwegian banks must be made via
Norwegian krone, so that two exchange transactions are actually made, with fees
being charged twice. I would like to use this opportunity to point out that
there is no rule that stipulates that, for example,
German banknotes are to be exchanged into Norwegian banknotes before being
exchanged into euro banknotes.
The UK, Sweden and Denmark
have so far chosen to remain outside EMU.
Sweden and the UK have inflation targets and floating exchange rates, while
Denmark's monetary policy is oriented towards a fixed exchange rate against the
euro. These three countries are important to Norway, both because of their
geographical proximity and because they account for close to 40 per cent of
Norway's foreign trade. If these countries join EMU some time in the future, it
is possible that the use of the euro by Norwegian households and businesses
will increase somewhat. However, extensive use of the euro as
a means of settling domestic payment transactions is unlikely. In those cases
where we have seen partial or total currency substitution, such as in some
countries in Eastern Europe and Latin America, it has usually been a result of
strongly deteriorating confidence in the local currency. Confidence can
deteriorate when inflation is high and variable or when government finances are
on the verge of collapse.
By influencing the volume of
NOK in circulation, Norges Bank will always be able to ensure that the internal
value of the Norwegian krone is maintained in line with the guidelines for
monetary policy.
If the introduction of the
euro increases efficiency and economic
growth in the participating countries, this will have positive spillover
effects on the Norwegian economy. Stable economic developments in the euro area
are also very important for the Norwegian economy.
Thank you for your attention.
GDP calculated in a common currency based on purchasing power
parity.
(c) 2001 Norges Bank webmaster@norges-bank.no