Report on monetary policy in 2003 - the first eight months1)
3 Monetary policy in 2003
3.1 The monetary policy meeting on 22 January
3.2 The monetary policy meeting on 5 March
3.3 The monetary policy meeting on 30 April
3.4 The monetary policy meeting on 25 June
3.5 The monetary policy meeting on 13 August
This year’s inflation reports included a broad discussion of the conduct
of monetary policy. The presentation below is largely based on this discussion.
While interest rates in the US and Europe were low in 2002, Norway’s
economy remained buoyant with a high level of activity. The cyclical divergence
fed through to the krone exchange rate. In isolation, this pointed to lower
inflation. However, the main factors behind the appreciation of the krone
were the high level of activity and strong wage growth in Norway compared
with trading partners. According to the assessment of the inflation outlook,
the appreciation of the krone would not fully offset higher wage growth and
stronger growth in domestic demand. At the one year horizon, the krone exchange
rate would dominate and push down inflation to below 2½ per cent, but
in the longer term it was assumed that the effects of a stronger krone would
diminish, and the effect of strong wage growth would dominate. A tight monetary
policy stance was therefore appropriate.
Towards the end of 2002, current data indicated that growth in output and
employment might be weaker than previously projected by Norges Bank. Inflation
was projected to be lower than the target at the two-year horizon. There were
also signs that the outlook was deteriorating relatively rapidly. On 11 December,
the key rate was lowered by 0.5 percentage point to 6.5 per cent. It was Norges
Bank’s assessment that with an interest rate of 6.5 per cent the probability
that inflation two years ahead would be lower than 2½ per cent was
greater than the probability that it would be higher. For further details,
see Norges Bank’s Annual Report for 2002.
Norges Bank reduced the key rate by 0.5 percentage point to 6 per cent on
22 January 2003. On 5 March and 30 April, the key rate was also lowered by
0.5 percentage point at each meeting. On 25 June and 13 August, the key rate
was reduced by 1 percentage point at each meeting. At the end of August 2003,
the key rate stood at 3.0 per cent (see Chart 1).
Chart 1
3.1 The monetary policy meeting on 22 January
At the monetary policy meeting on 22 January, Norges Bank’s Executive
Board decided to reduce the key rate by 0.5 percentage point to 6.0 per cent.
It was Norges Bank’s assessment that with an interest rate of 6.0 per
cent the probability that inflation two years ahead would be lower than 2½
per cent was greater than the probability that it would be higher.
The krone continued to appreciate after the interest rate reduction on 11
December and was about 3 per cent stronger than assumed in the baseline scenario
in the October inflation report (Inflation Report 3/02). This was
also considerably stronger than the assumption underlying the Executive Board’s
strategy decision in October (Strategy Document 3/02) and in line
with a path in the inflation report presented at the same time, where inflation
was below target at the two-year horizon. Against this background, the key
rate was set below the interval indicated in Strategy Document 3/02.
3.2 The monetary policy meeting on 5 March
Projections for growth in output and employment were revised downwards in
the March inflation report (Inflation Report 1/03) compared with
the October report. This partly reflected weaker global growth prospects.
Growth was assumed to pick up internationally, but the upturn was expected
to come at a later stage than previously anticipated. It could not be ruled
out that the world economy was facing a fairly long period of stagnation.
Low interest rates in the US and Europe reflected this risk. Developments
in the Norwegian economy were weaker than projected earlier. Norwegian industrial
leaders had become more pessimistic. Even though the krone had depreciated
somewhat, profitability in the business sector was still weak. Unemployment
had increased markedly over the preceding three months. According to information
from Norges Bank’s regional network, manufacturing industry had reduced
its demand for goods and services from Norwegian sub-contractors. This reduced
demand for goods and services from industries that are sheltered from direct
international competition.
Household expectations concerning economic developments fell further in the
first quarter, probably reflecting political and economic uncertainty as well
as the increase in unemployment in Norway. At the same time, electricity prices
rose sharply in December and January. These developments were estimated to
have a greater impact on household demand in 2003 than the interest rate cuts
in December and January. Household credit growth had edged down, but was still
higher than 10 per cent on an annual basis. House prices seemed to be levelling
off. As a result of developments in the labour market, the projection for
wage growth was revised downwards.
In his annual address on 20 February, the Governor stated that a stagnating
global economy had changed the domestic inflation outlook in the preceding
months. With a continued tight monetary stance, inflation would probably be
lower than the inflation target. It was announced that a gradual easing of
monetary policy therefore seemed appropriate.
Inflation Report 1/03 presented two scenarios for the Norwegian
economy based on different assumptions concerning the orientation of monetary
policy. In the baseline scenario, the sight deposit rate was held constant
at 5.5 per cent and the krone exchange rate was assumed to be equal to the
average for February. On the basis of these assumptions, consumer price inflation
was projected to remain below 2½ per cent to the end of 2005. If the
projections were instead based on a monetary policy easing in line with market
expectations, there were prospects that inflation would be slightly above
target at the two-year horizon (see Chart 2).
Chart 2
On the basis of these prospects, the Executive Board planned on an interval
for the sight deposit rate at the end of June of 4¾ - 5½ per
cent (Strategy Document 1/03).
In line with this strategy, Norges Bank’s Executive Board decided to
reduce the sight deposit rate by 0.5 percentage point to 5.5 per cent on 5
March. It was still Norges Bank’s assessment that the probability that
inflation two years ahead would be lower than 2½ per cent was greater
than the probability that it would be higher. It was stressed that there was
substantial uncertainty, including the uncertainty associated with exchange
rate developments. The uncertainty warranted a gradual approach to interest
rate changes.
3.3 The monetary policy meeting on 30 April
Information in March and April broadly confirmed the weak growth outlook
and prospects of low inflation ahead as projected in the Inflation Report.
International growth did not pick up. Interest rates were reduced further
in the euro area, Denmark, Sweden and New Zealand. There were expectations
of additional interest rate cuts in a number of countries. The krone appreciated
somewhat during March and April. In Norway, new national accounts figures
indicated that economic growth had come to a halt towards the end of 2002.
Current statistics showed few signs of improvement in the first months of
2003. Unemployment had risen further. Credit growth slowed somewhat as a result
of lower business demand. Growth in household credit demand was still high,
however. The wage settlement in the manufacturing sector pointed to lower
wage growth in 2003 than in 2002 and somewhat lower than projected in Inflation
Report 1/03. On balance, this indicated that a further easing of monetary
policy was appropriate.
At the meeting on 30 April, Norges Bank’s Executive Board decided to
reduce the key rate by 0.5 percentage point, to 5.0 per cent. With an interest
rate of 5.0 per cent, it was still Norges Bank’s assessment that the
probability that inflation two years ahead would be lower than 2½ per
cent was greater than the probability that it would be higher.
3.3.1 New information from 30 April up to the Governor’s speech on
3 June
New information in May and up to the Governor’s speech at BI/Centre
for Monetary Economics on 3 June contributed to confirming or reinforcing
the impression of weaker economic developments in Norway and abroad, and that
the interest rate reductions had not had the effect that might have been expected.
- The international outlook deteriorated further. Developments in US industry
were sluggish, and unemployment increased further. Hopes of a rapid recovery
following the war in Iraq diminished. The appreciation of the euro had a
negative impact on the outlook for the euro countries, particularly Germany.
- Expectations of further interest rate cuts in the US, the euro area and
Sweden grew stronger (see Chart 3). This reflected the deterioration in
growth prospects in these countries. Interest rate reductions in line with
expectations would lead to a wider interest rate differential against NOK.
Chart 3a Chart
3b
- The krone exchange rate did not depreciate in the period to 3 June, following
the monetary policy meeting on 30 April, but rather showed a tendency to
appreciate (see Chart 10).
Chart 10
- The wage settlements suggested that pay increases would be low. The wage
settlements in the distributive trades and the central and local government
sector were completed on 30 April and 1 May respectively. These settlements
confirmed that annual wage growth would probably be lower than the forecast
of 5 per cent. The wage settlement for the financial industry was concluded
on 26 May, and provided further confirmation that wage growth this year
would be lower than projected in Inflation Report 1/03. This might
imply that substantial emphasis had been placed in the wage negotiations
on weak labour market developments and the situation in the internationally
exposed sector.
- The Revised National Budget was presented on 15 May, and fiscal policy
appeared to be less expansionary than assumed in Inflation Report
1/03. Fiscal policy would have an approximately neutral effect on the economic
situation in 2003 and the next two years. In Inflation Report 1/03,
fiscal policy was assumed to have an expansionary effect for the next few
years. Moreover, public sector employment growth appeared to be appreciably
lower than assumed earlier.
- Employment developments were more sluggish than projected. According to
the LFS, employment was 0.6 per cent lower in March this year than the average
for 2002. This decline was larger than expected in Inflation Report
1/03. Seasonally adjusted LFS unemployment was approximately in line with
the projections in the Inflation Report, but registered unemployment rose
more than expected.
- Seasonally adjusted goods consumption increased by 2.8 per cent from March
to April, following a seasonally adjusted decline of 1.4 per cent in March.5
The timing of Easter affected the seasonally adjusted time series, however,
creating particular uncertainty in the months around Easter. Because of
the low figures for March, seasonally adjusted growth was expected to be
strong in April. Year-on-year growth in April was 2.5 per cent. Growth in
goods consumption was somewhat higher than projected in Inflation Report
1/03, but the deviation was within the random variations in the time series.
Retail trade increased by 4.0 per cent in the same period (unadjusted figures).
- The investment intentions survey for manufacturing in the second quarter
showed that investment fell more than projected in Inflation Report
1/03. The production index for manufacturing showed a decline in the period
from March to May.
- In Norway, the consumer confidence indicator fell further from the first
to the second quarter of 2003. Household pessimism concerning Norway’s
current economic situation had a particularly negative impact, whereas household
expectations regarding their own financial situation next year reflected
greater optimism than in the first quarter.
- According to the real estate industry’s housing statistics, seasonally
adjusted house prices remained unchanged from April to May. House prices
dropped by 1.1 per cent from May 2002 to May 2003. Assuming an unchanged
seasonally adjusted level for the remainder of the year, house prices would
fall by about 1 per cent from 2002 to 2003. The average turnover time increased
from April to May.
All in all, the information indicated that in the next two years wage growth
and inflation would be lower than projected in Inflation Report 1/03.
Inflation could remain more than 1 percentage point below the inflation target
for some time ahead, and there were signs that the Norwegian economy was facing
a period of a fairly rapidly deterioriating outlook. Nor were there clear
indications that interest rate cuts had had the expected short-term effect,
and further interest rate reductions could be expected internationally. In
his address of 3 June, the Governor therefore signalled that the easing of
monetary policy would continue and that Norges Bank’s Executive Board
would carefully consider changing the interest rate in larger steps. The Governor
also stressed that in some situations it may be appropriate to change the
interest rate swiftly and markedly. For example, it would be appropriate to
change the interest rate in larger steps when there are prospects that inflation
will deviate substantially from the inflation target for a long period.
3.4 The monetary policy meeting on 25 June
Money market interest rates dropped from 4 June to 25 June. The krone depreciated
markedly. Key rates were reduced in several countries, including the US and
the euro area. In May 2003, the year-on-year rise in consumer prices, as measured
by the CPI-ATE, was 1.2 per cent. This was lower than the projection in Inflation
Report 1/03 and substantially lower than the inflation target. The fall
in inflation primarily reflected the sharper-than-expected fall in prices
for imported consumer goods.
The projections for 2003 were revised downwards in Inflation Report
2/03, which was presented on 25 June. The analyses in the Report indicated
that underlying inflation was likely to be low for a period ahead. The wage
projections for 2003 and 2004 were revised down compared with the previous
Inflation Report. According to the projections, even with a sight
deposit rate of 4 per cent (prior to the monetary policy meeting the interest
rate was 5 per cent) and a krone exchange rate at approximately the June level,
underlying inflation would remain below the inflation target for the next
two years. Interest rate cuts totalling 3 percentage points since December
2002 would translate into relatively high growth in private consumption. Business
sector investment would gradually pick up. With an interest rate of 4 per
cent, economic growth would nevertheless be so slow that production capacity
would probably not be fully utilised in the next few years.
Two scenarios based on other assumptions concerning the interest rate, the
exchange rate and wage growth were also presented. Market participants expected
the interest rate to approach 3 per cent fairly rapidly. The scenarios showed
that inflation might in this case reach the target in the course of 2005,
depending on developments in wage growth (see Chart 4).
Chart 4
At its meeting on 25 June, Norges Bank’s Executive Board therefore
decided to reduce the sight deposit rate by 1 percentage point to 4 per cent.
With an interest rate of 4.0 per cent, it was still Norges Bank’s assessment
that the probability that inflation two years ahead would be lower than 2½
per cent was greater than the probability that it would be higher.
It was pointed out that in the past an easing of monetary policy had had
a substantial effect on demand, output and inflation. Although the effects
of monetary policy occur with considerable and variable lags, the first effects
of monetary policy easing were quickly apparent. That did not happen this
year. Households and the business sector remained predominantly pessimistic.
The housing and property market had levelled off and fallen. Credit demand
had declined.
Moreover, it was emphasised that low inflation could influence inflation
expectations. So far, indicators suggested reasonably stable expectations
of inflation at 2½ per cent. The fall in inflation abroad, and persistent
low inflation in Norway, could change that. The outlook for the Norwegian
and international economy therefore implied that the period of monetary policy
easing could continue.
It was pointed out that the outcome of this year’s wage settlement
could provide a basis for expecting wage settlements in the period ahead that
are more moderate than in the years from 1998 to 2002 and more consistent
with the target that has been set for developments in inflation over time.
Given this outlook, there might also be a basis for an easing of monetary
policy further than implied by expectations in money and foreign exchange
markets.
3.5 The monetary policy meeting on 13 August
Developments in the Norwegian and international economy since 25 June were
broadly in line with the projections in the Inflation Report, but
consumer price inflation was lower than expected. The year-on-year rise in
the CPI-ATE in July was 0.7 per cent. The fall in inflation primarily reflected
the marked decline in prices for imported consumer goods coupled with a slower
rise in prices for domestically produced consumer goods that are influenced
by world market prices. There were indications that underlying inflation in
Norway would remain very low for a period ahead. At the same time, inflation
in other countries was low.
At end-June, key rates were cut by 0.25 percentage point in the US, Canada,
New Zealand, the UK and Sweden. Key rates abroad were expected to remain at
a historically low level for a long period. The krone had depreciated in line
with assumptions in the June inflation report (Inflation Report 2/03).
At the monetary policy meeting on 13 August, Norges Bank’s Executive
Board decided to reduce the sight deposit rate by 1 percentage point, to 3.0
per cent. With an interest rate of 3.0 per cent, Norges Bank still judged
that the probability that inflation two years ahead would be lower than 2½
per cent was greater than the probability that it would be higher.
It was pointed out that in situations where there may be a risk of inflation
expectations taking hold at too low a level, it will be appropriate to take
larger steps in interest rate setting than is customary. It was also stressed
that this year’s wage settlements and information about wage developments
at the local level provided a basis for expecting more moderate wage settlements
in the period ahead than in the years from 1998 to 2002. This outlook provided
a firmer basis for taking larger steps in the easing of monetary policy.