Monetary policy in an uncertain world
Deputy Central Bank Governor Jarle Bergo
Address at a meeting of Sparebank 1 Nord-Norge
Sommarøy, 23 November 2001
Please note that the text may differ slightly from the actual presentation
Summary
The address is based on the assessments presented at Norges Bank's press conference following the Executive Board's
monetary policy meeting on 31 October.
Norway's economic policy is based on new guidelines for fiscal and
monetary policy. The new guidelines were published by the Government on 29
March 2001 in connection with the presentation of the Government's Long-Term
Programme. The inflation target for monetary policy became effective
immediately. The guidelines for fiscal policy were discussed in the Storting in
June. A majority were in favour of using the expected real return on the Government
Petroleum Fund.
Monetary policy is oriented towards low and stable
inflation. The inflation target is set at 2½ per cent. In general, direct
effects on consumer prices resulting from changes in interest rates, taxes,
excise duties and extraordinary temporary disturbances shall not be taken into
account.
Low and stable inflation is the best contribution
monetary policy can make to growth, prosperity and income distribution. In the
long term, monetary policy has little effect on employment and output. Low and
stable inflation can provide fertile ground for stability and growth. It
reduces the possibility of unsound investments and bubbles in the financial and
property markets. Nominal stability will also reduce the risk of sudden changes
and shocks that may lead to cyclical turnarounds.
In the last hundred years, we have had three extended
inflationary periods - during World War I, World War II and after the oil price
shocks in the 1970s and 1980s, which triggered spiralling wage and price
inflation. None of these periods will be remembered as being particularly
fruitful. The best contribution monetary policy can make to employment, growth
and welfare is low and stable inflation.
Historically, economic growth has been strong in
periods of relatively low inflation and weak in periods of especially high
inflation. Hence, during the last 20 years, real wage growth, which over time
reflects productivity trends, has been strongest when inflation was low. In
the 1980s, nominal wage growth was robust without a basis for this in the real
economy. The result was inflation and subdued real wage growth. In the 1990s,
there was a basis for high real wage growth. Moderate nominal pay increases
coincided with strong real wage growth because inflation was low.
The interest rate affects inflation through several
channels. An increase in the interest rate will normally contribute to reducing
inflation by curbing demand for goods and services and by strengthening the
krone against other currencies. A lower interest rate has the opposite effect.
The effects will depend on the situation prevailing at the time of the interest
rate change and how the change is perceived. The effects may also vary over
time.
Monetary policy influences the economy with
considerable and variable lags. Analyses performed by Norges Bank indicate that
a substantial share of the effects on inflation occurs within two years. Two
years is thus a reasonable time horizon for achieving the inflation target of
2½ per cent.
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. 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.
The inflation target provides the framework for
monetary policy. Norges Bank's Executive Board makes decisions about changes in
the interest rate. The members of the Executive Board are collectively
responsible for the Bank's decisions. The Executive Board meets every three
weeks. At every second meeting, the Executive Board discuss monetary policy in
depth. Decisions regarding changes in the interest rate will normally be made
at these monetary policy meetings. The Executive Board discusses the economic
outlook at a separate meeting three weeks before the Inflation Report is
presented. On the basis of preliminary projections for the report, the
Executive Board assesses the outlook for inflation in two years and the
uncertainty surrounding these projections. The following day, the Executive
Board summarises its discussions and assesses the consequences for monetary
policy for the next four months. This assessment constitutes an important
internal reference point when the Executive Board later makes a decision
regarding the interest rate. It will also provide the basis for our external
communication through speeches and the media. The Executive Board's decision is
published in a press release immediately after monetary policy meetings every
six weeks.
Inflation in Norway is determined by both domestic and
international inflationary impulses. Domestic inflationary impulses are
influenced by the situation in the Norwegian economy. Wage growth, demand for
goods and services and competitive conditions are very important for price
inflation. International inflationary impulses come via prices for imported
consumer goods and intermediate goods. These impulses will be affected by
developments in international commodity prices, consumer prices and the
exchange rate.
The international environment
Uncertainty surrounding international developments is unusually high. The
terrorist attacks in the US on 11 September may have influenced behaviour and
response patterns in such a way that historical experience is no longer a
reliable guide. Signs of a recession in the US, Japan and other Asian countries
have become increasingly clearer and European countries are marked by stagnation.
The situation has shifted rapidly in the US, following strong growth
throughout most of the 1990s. This is reflected in both the stock market and
household expectations. The terrorist attacks occurred at a time when the
economy was very vulnerable. The consumer confidence indicator fell sharply in
October. Retail sales figures for October may nevertheless indicate that
consumers have started spending again. Car sales in particular boosted growth
in October. Car dealers' interest-free loan offers have contributed to this.
Other goods also recorded growth in retail sales. The decrease in interest
rates has probably contributed to the attractiveness of purchasing consumer
durables like cars and appliances.
The decline in the US has spilled over to the European economies.
Channels other than trade have probably had a considerable impact. Expectations
may be influenced rapidly.
Industrial output is declining markedly in all major regions in the world
economy.
A high correlation between share prices in different countries may be an
important channel of contagion. International share prices declined through the
summer. After a sharp drop on 11 September, share prices have rebounded and are
at the same level as at the beginning of September.
The turnaround also spreads through other channels. Vulnerable economies
with large government debt must pay very high interest rates to borrow funds.
Credit risk premia have also increased in the US. The yield differential
for different bonds with credit risk measured against government bonds has been
high for a long time and has increased in connection with the terrorist
attacks.
With the prospect of a decline in their economies, many central banks
have cut interest rates. A further reduction in interest rates is expected in a
number of countries in the short term (3 months). Interest rates are expected
to increase somewhat, however, in the longer term (12 months). Real interest
rates are at a historical low in many countries.
Growth forecasts for the global economy in 2001 have been lowered
substantially during the year. Earlier, a decline in some regions has often
been counteracted by an upswing in other regions. The downturn now appears to
be more synchronised than in 1975, 1982 and 1991. During the summer and autumn,
there has been a lot of bad news from the global community. Due to the tragic
events of 11 September, the picture has become gloomier and uncertainty has
increased. Growth forecasts for next year have also been lowered substantially.
We have lowered the projection for GDP growth for our trading partners.
It is uncertain when the global economy will recover. Nonetheless, we expect
that the reduction in interest rates and the fiscal stimuli that have been
initiated in the US and many European countries will contribute to boosting
growth in both the US and Europe in the second half of 2002 and the beginning
of 2003.
Projections for consumer price inflation have also been revised downwards
for our trading partners - by ¼ percentage point in 2002.
The outlook for the Norwegian economy
Through the summer, it appeared that international developments had
little effect on Norwegian business and industry. During the autumn, it has
become increasingly clearer that the turnaround will also be felt in Norway.
The export industry in particular is now encountering lower demand and falling
prices. The price of oil has dropped to less than USD 20 per barrel. However,
the labour market remains tight. The new guidelines for fiscal policy involve
increased use of petroleum revenues and will contribute to maintaining the
pressure on resources in the years ahead.
The price of oil has fallen substantially since 11 September. OPEC has
now made any production cut conditional on cuts by other producers. In the last
few days, the oil price has been around USD 18 per barrel, a decline of USD 10
since 10 September. In the oil futures market, the price of oil is less than
USD 20 the next two years. The uncertainty that is factored into the price in
the oil futures market is higher now than before the terrorist attacks in the
US.
The krone exchange rate measured against our most important trading
partners has appreciated by 7% since the spring of 2000. However, the krone
exchange rate is about 2.5% weaker than in 1990 and at the same level as in the
mid-1990s. The appreciation of the effective krone exchange rate in the last 18
months has largely coincided with the depreciation of the Swedish krona. The
Norwegian krone has appreciated by nearly 20% against the Swedish krona since the
spring of 2000. The Norwegian krone is more stable against other currencies.
The volume of exports and export prices are falling. Figures from
External Trade Statistics indicate a 4.2% decline in the volume of exports and
a 3.0% decline in export prices from the third quarter last year to the same
time this year. The price of aluminium is nearly 20% lower than in October last
year. Salmon prices dropped by more than 10% during the same period.
Norway's manufacturing output has declined somewhat this year, but less
than in the US, Europe and Sweden. On the other hand, Norway did not experience
the upswing in the latter part of the 1990s. According to Statistics Norway's
business tendency survey, industrial leaders reported a decline in employment,
output and new orders from the second to the third quarter this year. Export
industries in particular show signs of a weaker trend. Industrial leaders'
assessment of the fourth quarter is less positive than their assessment prior
to the third quarter.
The labour market has few available resources. Registered unemployment
has remained steady at about 2.5% since the beginning of 1998. Long-term
unemployment is low. The majority are unemployed for a short period (frictional
unemployment). Unemployment has increased somewhat the last few months.
Employment growth is limited. In Eastern Norway in particular, unemployment
has increased. In the aftermath of the terrorist attacks, the aviation and
travel industries have announced job cuts. Cutbacks in the process industry
have also been announced.
The new guidelines for fiscal policy will stimulate activity because
petroleum revenues will now be phased in to the economy. According to the
Government's estimate, the guidelines increase the use of petroleum revenues in
the central government budget by an average of about 0.4% of mainland GDP each
year from 2002 to 2010.
In the Inflation Report no. 3/2001, we based our projections for fiscal
policy on the National Budget for 2002. The new coalition government is
calling for a number of changes in a supplementary proposition. They still
recommend that the use of petroleum revenues should be increased by NOK 6
billion or 0.6% of trend GDP from 2001. They also propose a reduction of NOK
7.2 billion in direct and indirect taxes (recorded). This is NOK 3.4 billion
more than in the original budget proposal. Underlying real growth in central
government spending is estimated at 1¼%. This is ¾ percentage points less than
the recommendation from the Stoltenberg Government. The limits for the central
government budget will be discussed and clarified in a debate in the Storting
on 27-28 November.
We expect moderate growth in the mainland economy in the next two years.
The projections for GDP growth are approximately in line with the growth
potential of the economy. Household consumption and public spending are the
main forces underpinning growth. Fixed investment and exports are restraining
growth. Solid consumption growth translates into high demand for labour in
public and private services, while slow growth in the international economy and
lower petroleum investment curbs growth in employment. Given that the labour
market remains tight, we expect wage growth to remain high during the next few
years.
Inflation projection
An expansionary fiscal policy, growth in private consumption and
continued high growth in labour costs contribute to high price inflation on
domestically produced goods and services. We also expect a temporary drop in
prices for imported consumer goods due to lower commodity and producer prices
in the international market, a slower rise in international consumer prices and
the appreciation of the krone. As these effects wane, and if global economic
growth picks up in line with expectations, import price inflation may reach a
more normal level.
In addition to providing point forecasts, we attempt to analyse the
uncertainty surrounding our inflation forecasts. Some manufacturing sectors are
experiencing profitability problems as a result of a high cost level and the
international economic situation, while demand is high in the sheltered sector.
Increased strains in the labour market are exerting pressure on the traditional
wage determination process.
However, the balance of risks is marked by the uncertainty surrounding
international developments. There are few upside risks internationally and a
good possibility that international stagnation will last longer than we have
assumed. In this case, there is a good possibility that this will have a
negative impact on other private domestic demand.
If growth in the global economy recovers as we have assumed, we expect
price inflation to be about 2½% in two years. Meanwhile, price inflation may be
somewhat lower due to the downturn abroad and the decline in prices for
imported goods. On the whole, it is Norges Bank's assessment that the
probability that inflation two years ahead will be lower than 2½ per cent is
greater than the probability that it will be higher.
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