Report on monetary policy in 2003 - the first eight months1)

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4 Evaluation of monetary policy

4.1 Consumer price inflation in 2003 and the background for deviations from the target
4.2 To what extent has the conduct of monetary policy in 2003 increased the prospects for bringing inflation close to target two years ahead?
4.3 Has the conduct of monetary policy contributed to stability in output and employment?
4.4 Has monetary policy in 2003 underpinned confidence that future inflation will be 2½ per cent?
4.5 Was monetary policy in 2003 predictable for financial market participants?

4.1 Consumer price inflation in 2003 and the background for deviations from the target

4.1.1 Consumer price inflation

In Norges Bank’s Annual Report for 2002, developments in inflation in 2002 were summarised as follows:

“The rate of increase in consumer prices adjusted for tax changes and excluding energy products, CPI-ATE, exhibited a gentle downward trend through 2002. CPI-ATE inflation averaged 2.3 per cent between 2001 and 2002. Inflation was increasingly marked by an appreciating krone over the year. Prices for imported consumer goods, particularly clothing and footwear, fell markedly towards the end of the year. At the same time, the rise in prices for domestically produced goods and services in the CPI-ATE remained at a high level as a result of strong growth in labour costs.” (p. 25)

Consumer price inflation, as measured by the CPI-ATE, continued to slow through the first seven months of 2003. Compared with the same period last year, the rise in prices was 1.8 per cent in the first quarter of 2003. In the second quarter, the figure was 1.2 per cent. The year-on-year rise in prices was 0.7 per cent in July 2003. In August, the year-on-year rise increased to 0.9 per cent. In the first eight months of 2003, the CPI-ATE was 1.3 per cent higher than in the same period last year.

Chart 5

This was due in particular to a decline in prices for imported consumer goods, which is pushing down overall price inflation (see Chart 5). The fall in prices must be seen in connection with the appreciation of the krone through 2002 and weak external inflationary impulses. In June 2003, prices for imported consumer goods were 4.4 per cent lower than one year earlier. These prices fell slightly less in July and August, standing at 4.1 and 3.5 per cent respectively. Prices for clothing and footwear and audio-visual equipment in particular have fallen (see Chart 6). Car prices have also fallen somewhat.

Chart 6

Prices for domestically produced goods, excluding energy products, also pushed down CPI-ATE inflation to below 2.5 per cent in July and August 2003. Services with wages as the dominant factor and rents are continuing to push up inflation (see Table 1).

Table 1

The rise in prices adjusted for tax changes and excluding energy products in the first seven months of 2003 was lower than projected in the 2001 and 2002 Inflation Reports, and substantially lower than the inflation target. In the period May-August, inflation was below target by more than 1 percentage point.

The year-on-year rise in the consumer price index including tax changes and energy products (CPI) has been considerably higher than the year-on-year rise in the CPI-ATE this year. This is due to a sharp rise in electricity prices at the beginning of the year. The year-on-year rise in electricity prices, as measured by the CPI, reached 82.5 per cent in January. Since then, prices have fallen substantially and contributed to pushing down the year-on-year rise in the CPI from 5 per cent in January to 1.5 per cent in July. In August, electricity prices rose and contributed to an increase in the year-on-year rise to 2.1 per cent. In the first eight months of 2003, consumer prices were 3.0 per cent higher than in the same period last year.

4.1.2 Background for deviations from the target in 2003

Norges Bank’s inflation projections in spring 2001 indicated that inflation would fall and would be close to 2½ per cent in the first half of 2003. The inflation outlook changed from autumn 2001. It was now projected that inflation would be below target for a period. These changes were a result of the appreciation of the krone and lower inflation in other countries.

The projections in the 2002 Inflation Reports indicated a similar path for inflation. Exchange rate assumptions were gradually revised in the course of the year to take into account a stronger krone (see Chart 10). In the July 2002 Inflation Report, this was reflected in an expected temporary decline in inflation. The CPI-ATE was expected to remain below the inflation target until late 2003. Without a tightening of monetary policy, it nevertheless seemed likely that wage growth would remain high and push inflation above target two years ahead. To counteract this development, the interest rate was increased by 0.5 percentage point in July 2002.

Chart 10

Up to the publication of Inflation Report 3/02 in October, the krone had appreciated further. With an unchanged interest rate and a constant exchange rate, inflation was projected to remain below target until autumn 2004, reaching its lowest level at 1¾ per cent in summer 2003. The krone continued to appreciate from October and even though it weakened somewhat at the beginning of 2003, the projections in Inflation Report 1/03, published in March, were based on the assumption of an even stronger krone than in the Inflation Report from October.

Chart 7

The inflation rate and the inflation outlook were lower than projected in 2001 and 2002, particularly as a result of substantially weaker global developments than there was reason to expect last summer. Slower growth in the Norwegian economy has probably also contributed to reducing margins in the distributive trades and other service sectors.

Growth in the global economy has moved on a different path and has been substantially weaker than the IMF, OECD and other analysts and observers as well as Norges Bank expected last summer. The change in interest rate expectations internationally is a good indication of how far actual developments have differed from expectations (see Chart 8). Last summer, financial market participants had expected that the interest rate in the US that would rise to close to 4 per cent in the course of summer 2003. Expectations were gradually revised downwards through the winter and spring. The interest rate was reduced further. This summer developments stabilised and interest rate expectations increased somewhat again. The key rate in the US is now expected to remain at 1 per cent until the end of the year. Last summer, interest rates were also expected to increase markedly in Europe. Instead, interest rates were also reduced here and expectations were revised downwards substantially.

Chart 8a     Chart 8b

Projections for GDP growth among trading partners in 2003 have been revised downwards by a total of 1½ percentage points from summer 2002 to summer 2003 (see Chart 9). This is due in particular to the effects of accounting scandals in large US companies, fears of terror and war in Iraq and the spread of SARS. Furthermore, as a result of an excessive rise in equity prices and overinvestment in the business sector in earlier periods, it may have taken longer than normal for a recovery to take hold.

Chart 9

A number of institutions have been overly optimistic with regard to global developments. Developments according to Consensus Forecast Inc⁶ are shown in Chart 9. The Bank for International Settlements’ (BIS) Annual Report for 2002 states the following:

“The last year or so has been marked by economic disappointments. Interrelated developments in the geopolitical, economic and financial spheres held back growth and led to great uncertainty about the future. The recovery in the world economy seemed to stall. Indeed, the news got worse rather than better during most of the period under review. This was surprising to many given the high degree of policy stimulus being applied in large parts of the world.” (p. 3)

Weak global developments resulted in lower interest rates abroad. Last year’s wage settlement in Norway indicated that wage growth could remain high in the future. Financial market participants expected a continued tight monetary policy. In the course of 2002, the interest rate differential between Norway and other countries widened also as a result of a number of interest rate reductions among Norway’s trading partners. This contributed to the appreciation of the krone. However, analyses conducted by Norges Bank indicate that extraordinary developments in the global economy resulted in a stronger krone than might be expected on the basis of a wider interest rate differential alone:

“About 40 per cent of the appreciation from May 2000 to January 2003 can be explained by the wider interest rate differential. The positive interest rate differential led to an appreciation of the krone as a result of the fall in global stock markets and lower expected fluctuations between the main currencies. More than half of the appreciation of the krone can be explained by this effect. The appreciation in 2002 is also related to the sharp increase in oil prices and to the krone’s function as a geopolitical safe-haven currency.”
(Bjørn Naug (2003): “Faktorer bak utviklingen i kronekursen – en empirisk analyse” in Norges Banks skriftserie no. 31, in Norwegian only. The results are also presented in a box in Inflation Report 1/03: “Factors behind the development of the krone exchange rate”.)

Unexpected developments in the global economy, primarily the fall in stock markets and uncertainty with regard to the situation in Iraq, resulted in not only low inflation internationally but also a considerably stronger krone than the assumption underlying the inflation forecasts for 2003. Compared with the assumption in Inflation Report 3/02, the krone appreciated further by about 3 per cent before developments were reversed in January 2003.

Chart 10

Even though changes in the exchange rate can be analysed and explained in retrospect, it is difficult to project exchange rate movements in the short and medium term. Norges Bank has mainly based projections in the baseline scenario in its inflation reports on a constant exchange rate equal to the average for the previous three months, and in some cases the average for the previous month. Using these averages, very short-term variations in the krone exchange rate will have less effect on the exchange rate assumption. A more long-lasting change in the krone exchange rate will, on the other hand, be taken into account over time and will gradually have an effect on the inflation projection and on interest rate setting.

As a basis for the interest rate decisions, the inflation reports also systematically analyse other assumptions about exchange rate developments. Inflation Reports 2/02 and 3/02 included calculations based on the effects of an exchange rate assumption in line with forward rates in the market. The forward rates indicated a depreciation of the krone ahead. The inflation reports have also analysed the effects of a stronger krone exchange rate.

The pass-through from the krone exchange rate to inflation seems to have been less stable than first assumed. From September 2002 to end-February 2003, prices for imported consumer goods fell less than expected based on relationships quantified on the basis of historical data. This affected the projections in Inflation Report 1/03. Through the spring and summer the impact has been even stronger. The overall effect has been broadly in line with expectations.

Growth in the Norwegian economy has also been slower than projected. Last year’s high wage growth in the public sector contributed to low growth in public sector output and employment. Employment in the public sector fell from the first half of 2002 to the first half of 2003.⁷ Developments in other service industries have also been weaker than expected. This may be partly related to a high rise in costs and sluggish international developments, for example in sectors such as the airline industry, tourism and ICT. Developments in manufacturing have also been weak, due to low international demand for manufactured goods and weak competitiveness following several years of high wage growth and the strong krone last year.

Limited pricing power, due in part to increased competition in retail trade and expectations of low price increases in some business sectors, have probably made it difficult to pass on higher costs to prices. Margins have been under pressure, and many enterprises have reduced their workforce rather than raise prices. High electricity prices through the winter resulted in a reduction in household purchasing power. This may have curbed demand for some goods. According to information from Norges Bank’s regional network, parts of the clothing and audio-visual industries experienced a decline in demand from November to April, followed by increased sales activity in May. This is to some extent confirmed by retail trade statistics. For some brown goods, unfavourable international market conditions may also have led to excess supply and low prices this year.

4.1.3 Evaluation of the deviation from the inflation target

In the years 1998-2002, the Norwegian economy was characterised by substantial labour shortages and considerably higher wage growth than among trading partners. Wage growth in the economy is the result of an interplay between different factors and will vary from year to year. However, last year was the fifth consecutive year of very high annual growth. Wage growth was substantially higher than the level that over time is consistent with the inflation target and with normal productivity growth. Pay increases varied widely across the different groups. In Norges Bank’s view, there was therefore a substantial risk of new wage-wage spirals. Several rounds of such strong wage increases might have led to a larger decline in output and employment.

In retrospect, the question might be raised of whether monetary policy should have been tighter in 2000 and 2001 in order to curb the sharp rise in domestic costs. This could have contributed to lower wage growth in 2002. Norges Bank’s Annual Report for 2002 states the following:

“However, in the light of international developments in 2001 and a gradual erosion of profitability in internationally exposed industries, it is difficult to explain the developments in labour costs in 2002 on the basis of the empirical evidence we had at that time.” (p. 25)

Even though Norges Bank’s wage projections were high at the beginning of 2002, the outcome was even higher:

“Norges Bank’s analyses were based on expectations that wage growth would be significantly higher than that of our trading partners. This view was itself somewhat controversial. On the basis of available information through 2000 and 2001, we have not found any support for the view that monetary policy should have been based on expectations of even higher wage growth than projected.” (Norges Bank’s Annual Report for 2002. p. 25)

Wage growth in the years 1998-2002 indicated that labour shortages in all sectors of the labour market played an important role in wage formation. It appeared that profitability in traditional exposed manufacturing industries played a less significant role for the overall outcome of the wage settlement, both for manufacturing and otherwise.

In light of these developments, there was reason to expect that wage growth could remain high in 2003 and 2004. Furthermore, it seemed likely last summer that economic growth would pick up and inflation would accelerate internationally. Growth in household real disposable income in 2002 was at the highest level in several decades. Household borrowing was high, and house prices rose. Without monetary policy tightening in 2002, Norges Bank’s assessment indicated that it was probable that inflation would accelerate and overshoot the target when the effect of the previous appreciation of the krone waned.

Therefore, monetary policy was tightened by increasing interest rates last summer. At the one-year horizon, the strong krone would push down inflation to below 2½ per cent, but subsequently the effects of strong wage growth would dominate.

Last year, Norges Bank’s Executive Board struck a balance between the consideration of stable inflation developments in the short term and the consideration of stability in output and employment. It was expected that inflation would be low in 2003.

However, price developments are uncertain even 6 months to 1 year ahead. There was thus a possibility that inflation could fall even lower than projected, and be more than 1 percentage point below target. Nevertheless, the deviation between the outcome and the forecast is unusually large.

This is an indication that the economy was exposed to sizeable unexpected disturbances. The exchange rate appreciated more than projected. After the publication of Inflation Report 3/02 in October last year, the krone appreciated further. This was related to unexpectedly weak developments in the global economy resulting in lower interest rates and a wider interest rate differential between Norway and other countries. Negative events such as the accounting scandals in large US companies, fears of terror and war in Iraq and the spread of SARS contributed to weak growth and low inflation in other countries. Developments in the international equity markets and the risk of higher oil prices also contributed to strengthening the krone. Some developments in the Norwegian economy, including lower demand for some goods as a result of higher electricity prices, have probably contributed to reducing margins.

Wage growth has moderated more rapidly than assumed. This has been of considerable importance for the inflation outlook but does not contribute to any extent in explaining the low inflation so far this year.

Inflation projections are always surrounded by uncertainty. When the inflation outlook 6 months to 1½ years ahead deviates considerably from the target, there is a higher risk of the actual inflation rate falling below 1½ per cent or rising above 3½ per cent. However, if monetary policy is oriented towards keeping actual inflation closer to the inflation target even in the short term, this will generally result in wider fluctuations in output and employment (see Section 2). The halt in growth in the economy last winter was particularly related to global economic developments (see Section 4.3).

4.2 To what extent has the conduct of monetary policy in 2003 increased the prospects for bringing inflation close to target two years ahead?

Since the beginning of the year, the interest rate has been lowered by 3.5 percentage points. The sight deposit rate has been reduced to 3.0 per cent. The real interest rate has been reduced.

The krone has depreciated. Developments in the krone exchange rate can be measured in various ways. The import-weighted krone exchange rate index (I-44) measures the krone exchange rate against the currencies of Norway’s 44 most significant importing countries. This index partly reflects the direct inflationary impulses that result from changes in the krone exchange rate. I-44 has declined by about 12 per cent since it was at its strongest in January this year (see Chart 11), and it is still somewhat stronger than in 1995 and 1996.

Chart 11

The trade-weighted krone exchange rate index (TWI) shows the effect of exchange rate fluctuations on export- and import-competing industries. The weights therefore reflect export and import patterns and the competition facing Norwegian enterprises in foreign markets. The trade-weighted index has declined by about 12 per cent since January this year and is roughly on a par with the level in 1995 and 1996 (see Chart 11).

The real krone exchange rate may be measured as the ratio of Norwegian to foreign price levels in a common currency or as the ratio of Norwegian to foreign wage levels in a common currency. If the real krone exchange rate is based on developments in relative prices, this provides an indication of the Norwegian krone’s purchasing power. Norway’s experience indicates that the real exchange rate tends to revert to an historical average.⁸ Inflation in Norway has been higher than among our trading partners. In terms of relative consumer prices measured in a common currency, the real exchange rate has now reverted and is close to its historical average (see Chart 12).

Chart 12

The real exchange rate measured in terms of relative labour costs in a common currency is, however, still strong (see Chart 13) and competitiveness for Norwegian enterprises correspondingly weak. Competitiveness in 2003 can be estimated to be about 8 per cent weaker than the average for the last 30 years and about 15 per cent weaker than the years 1995-1996. The deterioration of competitive strength since the mid-1990s reflects the change in income distribution between wage earners and the business sector and the cost burden which the Norwegian business sector is bearing as a result of the expensive wage settlements in the period 1998-2002.

Chart 13

Monetary policy easing has been implemented with a view to bringing inflation up towards the target within the two-year horizon. The underlying rise in prices will nevertheless be lower than the inflation target for a period. The period last year and early this year when the krone was strong will continue to contribute to a low rise in prices for imported goods and services. International inflation is still likely to remain low.

The assessments of the inflation outlook at the time of a turning-point in the economy are usually marked by particular uncertainty. According to Norges Bank’s assessment, the uncertainty implied that caution should be shown in interest rate setting. In Strategy Document 1/03, which was approved by the Executive Board in March, several conditions that provide support for this view were highlighted:

• "The relationships in the foreign exchange market are unstable. The effect of a change in interest rates on the exchange rate may vary.
   
• There is a risk of continued wage-wage spirals as a result of wage settlements and it takes time to address the problems associated with wage formation. It is still uncertain how quickly the social partners will incorporate the inflation target as an anchor in wage negotiations.
   
• The effects of changes in the exchange rate on inflation and economic developments are uncertain. The impact on output and employment may be greater than we have assumed. This would be reflected in the labour market and thereby have implications for interest rate setting.
   
• The long period of expansion in the Norwegian economy has resulted in high house prices and a high debt ratio in large parts of the private sector. The rise in house prices now appears to be levelling off. Developments in the housing market and lower household optimism may reduce credit growth in the period ahead. Further interest rate cuts may, on the other hand, lead to a renewed acceleration in house prices and credit growth. Developments in the housing market and credit market through the spring are therefore important when assessing further monetary policy action.”

On 21 January 2003, the Government and the social partners discussed the economic situation prior to the 2003 wage settlement. In the meeting of the Technical Reporting Committee on Income Settlements, the parties stated that they would seek to bring wage growth in Norway “more into line with developments among our trading partners”. Wage growth among Norway’s trading partners hovers around 3½ per cent. Wage growth in Norway in 2002 was 5¾ per cent. The wording in the Committee’s statement did not therefore provide a clear indication of what the result of the wage settlement would be.

The pay increases in this year’s wage settlement were lower than projected by Norges Bank. This break with the relatively high wage growth in Norway from 1998 to 2002 must be viewed in connection with last year’s monetary policy tightening and weak developments in the international economy. It has probably been of considerable importance that the expensive wage settlement in 2002 had strong negative effects on the economy and activity in the public sector and that this was taken into account in the wage settlement this year. In many service industries, the possibility of passing on higher labour costs to prices has probably been more limited than before. On the basis of an assessment of the wage settlement and the information we have concerning wage developments at the local level, employment and unemployment, there is reason to expect more moderate wage settlements in the future than in the years 1998-2002, even though the interest rate has been reduced. The prospect that wage growth would fall to a more sustainable level has been an essential element in the substantial monetary policy easing that has been implemented.

The easing of monetary policy through the spring and summer, in gradually larger steps, also reflected that the effects of the interest rate reduction last winter seemed to be weaker than assumed. The effect on the exchange rate was dampened because interest rates in other countries were also reduced.

Consumer price inflation was expected to be well below the inflation target in 2003, but as discussed in Section 4.1.1, the year-on-year rise in inflation was less than 1 per cent this summer. Without considerable monetary policy easing, inflation might remain too low for an extensive period. This in turn might lead to expectations of continued low inflation. In such a situation, it may be more demanding to increase economic activity. The Executive Board decided, therefore, that it was appropriate to reduce the interest rate considerably.

When assessing the inflation outlook, it must be taken into account that the low rate of inflation primarily reflects the development in prices for imported consumer goods and domestically produced goods that are sold in competition with goods from abroad. The rise in prices for other domestically produced goods and services has remained at a high level (see Table 1). Since the fall in prices for imported consumer goods can be attributed largely to the strong krone exchange rate in 2002 and this past winter, it may be assumed that the fall in inflation will be temporary. Monetary policy easing will contribute to pushing up inflation. In the short term, the impact will become increasingly evident as the effect of the appreciation is gradually exhausted and through a subsequent depreciation of the krone. In the somewhat longer term, the interest rate reductions will also contribute by boosting demand in Norway. At the same time, Norges Bank expects international growth to normalise gradually and external inflationary impulses to pick up somewhat.

In Inflation Report 2/03, which was published in June 2003, the inflation outlook was assessed on the basis of an assumption that interest rate and exchange rate developments would be in line with forward market expectations. These expectations implied a reduction in the sight deposit rate to close to 3 per cent at the end of this year and a depreciation in the krone exchange rate toward the end of 2005. Projections in the Inflation Report indicated that monetary policy easing of this magnitude would bring inflation up to the target at the two-year horizon. Wage growth was projected at 4½ per cent this year and 5 per cent in 2004.

However, Norges Bank’s assessment on 13 August was that, even with a key rate of 3.0 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. This assessment partly reflected the prospects of more moderate wage settlements ahead.

Overall, this year’s relaxation of monetary policy, including the depreciation of the krone, will make a significant contribution to bringing inflation back to target.

4.3 Has the conduct of monetary policy contributed to stability in output and employment?

Norges Bank’s Annual Report for 2002 states the following:

“Through 2002, the interest rate was kept at a high level as long as demand for goods and services was high and the labour market was tight. Towards the end of the year, when the outlook shifted towards weaker demand, rising unemployment and inflation below the inflation target, the interest rate was reduced. Developments in 2002 illustrate that the inflation target is a vehicle for, not an obstacle to, monetary policy’s contribution to stabilising output and employment.” (p. 26)

It was also pointed out that monetary policy can only to a limited extent contribute to stabilising activity and employment when the functioning of the economy is disrupted by a substantial disturbance on the output or supply side:

“If unemployment rises when price and cost inflation is low or moderate, it may be due to a decline in total demand. An easing of monetary policy may then counter the increase in unemployment. However, when unemployment rises when price and cost inflation is high or accelerating, the reason may be that growth in real wages is higher than productivity growth, so that enterprises and public entities are unable to sustain the increase in labour costs. This results in downscaling and lower employment in enterprises. In this situation, a relaxation of monetary policy may result in even higher price and cost inflation and unstable developments in the economy. Monetary policy can therefore not counter an increase in unemployment that is due to a cost-push shock resulting from wage negotiations.” (p. 26)

The output potential of the economy increases over time. Stabilising the activity level implies avoiding large deviations from this output potential. Evaluating this requires an understanding of how actual economic activity compares with the output potential. Norges Bank bases its assessments on a broad set of analyses. These analyses include econometric models that incorporate historical data for the Norwegian economy. These model-based analyses, together with updated statistics, assessments of new economic developments and information from Norges Bank’s regional network⁹ provide the basis for our assessments of the functioning of the economy¹⁰. In addition, Norges Bank makes use of a number of indicators that together can indicate whether growth and the level of activity in the economy is high or low compared with the output potential¹¹.

The output gap is the difference between the actual level of output in the economy and the output level that is consistent with stable inflation over time, often referred to as trend output. Trend output is not observable and must be estimated. It is usually assumed that total output over time grows at trend because the labour force grows and productivity rises. The trend can vary because there are variations in labour force growth. New technology and new organisational forms can also affect productivity growth. Developments in the output gap provides a basis for assessing output stability and can thus also shed light on domestic inflationary pressures in the economy.

The output gap, as calculated by Norges Bank, has fallen from a relatively high level (see Chart 14). The output gap is projected to be about zero in 2003. Different measures yield different results. Other institutions, for example Statistics Norway, the IMF and the OECD, use other methods to calculate the gap. One of the differences is that Norges Bank has taken account of the influence of permanent changes in working hours on the trend growth. The introduction of additional vacation days in 2001 and 2002 reduced trend growth in the economy by an estimated ½ percentage point each of these years. The different calculations nevertheless provide a fairly similar picture of the output gap (for more details, see annex).

Chart 14

Other indicators may also contribute to shedding light on stability in output and employment:

• Wage growth is a direct indicator of the social partners’ perception of employment and labour shortages. Real wage growth must match productivity growth over time. If real wage growth is higher than underlying productivity growth, profitability in the business sector will deteriorate. The economic position of public entities will also weaken, which in turn leads to subsequent budgetary tightening and workforce reductions. Wage growth can thus be an indicator of the employment outlook. Productivity growth in mainland Norway in recent years has been about 2 per cent. The inflation target is set at 2½ per cent. This indicates that nominal wage growth of around 4½ per cent will be consistent with stable employment.
   
  In the period 1998-2002, wage growth was clearly higher than this. As late as last year, wage growth was 5¾ per cent. This may indicate that the level of job security was perceived by employees as high and that there were substantial labour shortages. However, high pay increases may also be the result of wage negotiations. If the social partners are not forward-looking and do not evaluate the employment outlook in wage settlements, but place considerable emphasis on the past year, wage growth can to a certain extent be a lagging indicator. Index-based adjustments and wage-wage-spirals may also contribute to high wage growth even after the peak of the upturn has been passed. Norges Bank now projects wage growth at about 4½ per cent this year. Wage growth has thus been reduced to a level that over time is consistent with the inflation target and more stable development in the labour market.
   
  In Chart 14, the wage gap is defined as the difference in wage growth between Norway and other countries up to 2000. The wage gap is thereafter defined in relation to wage growth of 4½ per cent. This level of wage growth will over time be consistent with the inflation target. There seems to be a close relationship between this wage gap and resource utilisation in the economy as Norges Bank measures it with the output gap. From 1990 to 1995, when unemployment was relatively high in Norway and actual output was below potential, wage growth in Norway was lower than that of its trading partners. From 1997, however, the wage gap was positive. In this period, resource utilisation increased markedly. Towards the end of the period, the wage gap narrowed as resource utilisation approached a more sustainable level.
  
  Chart 14
   
• Equilibrium unemployment refers to the level of unemployment where wage growth is consistent with stable and sustainable economic developments. The level of equilibrium unemployment is an expression of how wage formation works and must not be seen as a norm for the level of unemployment. Norges Bank has no specific perception of the level of equilibrium unemployment. In line with the paragraph above, equilibrium unemployment is the level of unemployment consistent with wage growth of about 4½ per cent. With a wage growth of 4½ per cent and inflation of 2½ per cent, real wage growth will correspond to growth in productivity. Such wage growth will therefore not change income distribution between employees and enterprises.
   
  The 1992 Employment Commission (NOU 1992:26 National strategy for increased employment in the 1990s) estimated that unemployment of 3-3.5 per cent (measured by LFS¹²) in 1990 and 1991 would result in unchanged competitiveness through wage growth in line with wage growth abroad. In the 1996 National Budget, the Ministry of Finance referred to research indicating that the level of equilibrium unemployment was higher than this. Reference was also made to calculations from the OECD indicating a level of about 5 per cent. The Ministry expressed the opinion that this figure was probably too high. It was pointed out that high equilibrium unemployment may reflect a substantial mismatch between enterprises’ demand for labour and qualifications and motivation in the labour force. Equilibrium unemployment may change over time and the OECD has estimated equilibrium unemployment (NAIRU¹³) at 3.6 per cent in 2001, and the IMF has estimated the level (NAWRU¹⁴) at 4.5 per cent in 1999. Unemployment measured as registered unemployed, registered unemployed including participants in labour market programmes and the LFS has increased somewhat in the last one to one and a half years. Unemployment is substantially lower than at the beginning of the 1990s measured by the number of registered unemployed and the LFS. The number of registered unemployed, including participants in labour market programmes, is lower than the average for the 1990s (see Chart 15). Average wage growth in the 1990s was 4½ per cent, while consumer price inflation averaged 2½ per cent, in line with the inflation target.
   
  Chart 15
   
• Both the labour force participation rate and the employment rate, that is the labour force and employment as a share of the working age population, has exhibited a rising trend since the early 1970s. This is related to the increase in the participation rate for women. Since 1996, these rates have been above trend (see Chart 16 and 17). Labour force participation and the employment rate appear to be at about trend this year. Both rates are still high. The mechanical linear trend used here probably exaggerates the trend increase in these rates towards the end of the period. Women’s labour force participation rate and employment rate are closing in on the level for men and growth in the overall trend will probably slow.
   
  Chart 16     Chart 17
   
• Credit growth is an indicator of private sector demand that over time is assumed to rise approximately in pace with nominal GDP. If it is assumed that mainland GDP at constant prices grows at a trend rate of close to 2½ per cent and inflation is on target, credit growth may be around 5 per cent. Underlying growth in private sector credit from domestic sources has fallen from more than 10 per cent in mid-2002 to around 7½ per cent in June. Year-on-year growth in total private sector gross debt fell to 5½ per cent at the end of June. Developments thus suggest more sustainable and stable credit growth in the period ahead. However, these relationships are uncertain in both the short and long term. The growth in credit may for example indicate that households and enterprises are making adjustments in their debts and assets beyond the level implied by the rise in nominal GDP due to deregulation or increased competition in the credit market. It may also reflect structural changes on the demand side in the credit market, for example that groups of households are more frequently taking loans using their homes or other real assets as collateral in order to finance other investments or consumption.

According to the indicators above, capacity utilisation has decreased from a high level and is now on a par with the level in the years 1995-97, before cost inflation accelerated.

Growth in the Norwegian economy slowed somewhat more rapidly than Norges Bank had projected and came to a halt during the winter, partly reflecting unexpected developments in the global economy in the second half of 2002. The contagion effects on the Norwegian economy of the international decline in the ICT and telecommunications industries persisted. Demand for products from export industries fell. Fears of war and terror affected the tourist industry. Electricity prices rose unexpectedly. Many enterprises, also those in sheltered sectors as well as public entities, grappled with the heavy cost burden resulting from another expensive wage settlement in 2002. Unemployment has increased in many professions (see Chart 18).

Chart 18

The interest rate reductions as from December 2002 must be viewed against the background of weak or negative growth in the Norwegian economy in the past few quarters. There are some signs that the interest rate reductions and expectations of further reductions have now begun to have the desired effect. The quarterly national accounts for the second quarter showed a moderate upturn in the mainland economy. As expected, consumer spending on goods is exhibiting positive developments. The consumer confidence indicator has risen this summer. House prices have started to edge up after stagnating earlier this year. Statistics Norway’s business tendency survey for the second quarter indicates that expectations concerning short-term developments have improved somewhat. On the other hand, there is substantial idle capacity in commercial property and corporate competitiveness is marked by the wage settlements in the years from 1998 to 2002.

Due to the past few years’ wage settlements, households have strengthened their financial position at the expense of private and public enterprises. Against this background, growth in private consumption is expected to be fairly high. At the same time, enterprises’ financial position is still marked by the sharp rise in labour costs from 1998 to 2002 (see Chart 13). Corporate demand for loans and investment are low. Business sector activity is stimulated most effectively by low interest rates and a weak krone.

Chart 13

The depreciation of the krone will gradually contribute to increased profitability in the exposed sector (see Chart 13). Demand for goods and services from sub-contractors is expected to pick up and, combined with lower interest rates and higher consumer demand, may stimulate new investment in the business sector. Demand for labour may gradually pick up. Norges Bank expects unemployment to stabilise next year and decrease somewhat in 2005. Growth in the Norwegian economy may already match trend growth in the course of 2004. The output gap and the wage gap are projected to remain around zero next year, and employment is projected to grow approximately in pace with the labour force until 2005.

According to Norges Bank’s assessment, the monetary policy tightening in 2002, which helped to improve the outlook for wage growth, and the substantial monetary policy easing through 2003 have made it possible for growth in the Norwegian economy to gradually be on a par with growth in production capacity. Thus, conditions are now more conducive to stability in output and employment ahead.

4.4 Has monetary policy in 2003 underpinned confidence that future inflation will be 2½ per cent?

When there is confidence in the inflation target, monetary policy can to a greater extent smooth fluctuations in the economy. Expectations concerning future inflation in Norway provide an indication of whether there is confidence that the inflation target will be achieved.

The survey of the third quarter of this year carried out by TNS Gallup shows that inflation two years ahead is generally expected to be lower than the inflation target of 2½ per cent. The panel of macroanalysts, academics and employer organisations have over the past year revised downwards somewhat their expectations of inflation two years ahead. These groups’ inflation expectations five years ahead have, however, remained fairly stable around the inflation target. Inflation expectations among employer organisations seem to vary relatively widely from one survey to the next. Households generally report relatively high expected inflation both one and two years ahead. Expected inflation for this group is between 3 and 4 per cent, but there is uncertainty about the interpretation of these figures.

Consensus Economics Inc. provides a monthly summary of various institutions’ forecasts for inflation in Norway. Projections are provided for up to two years ahead. In the August survey, the average projection for inflation in 2004 was 1.5 per cent. This low projection must be viewed in connection with developments in electricity prices. Projections with a longer time horizon are published twice a year, in October and April. The projections published in April 2003 showed that inflation was expected to edge up. Both 5 and 10 years ahead, inflation was projected at 2.4 per cent, which is 0.1 per cent lower than in October last year.

The forward rate differential between Norway and Germany may also provide an indication of inflation expectations in Norway. However, it must be taken into account that the inflation target in Norway is higher than in Germany. In the euro area, long-term inflation expectations are just below 2 percent¹⁵. Even with confidence in the inflation target, forward rates in Norway will thus be somewhat higher than in Germany. The forward rate differential also reflects premia for differences in liquidity in the Norwegian and German markets. In the short term, there will also be market noise. The level of the differential should therefore be assessed over a period of time. The long-term forward rate differential between Norway and Germany was around 1 percentage point through 2002 and narrowed to around ½ percentage point in December. From December to April, the forward rate differential narrowed further, but has since widened again and has been around ¾ percentage point for the past month. Pricing in the capital market therefore indicates that there is market confidence that the inflation target will be achieved.

Information from expectations surveys and long-term interest rates indicate that inflation is expected to be lower than 2½ per cent in the coming year. Looking further ahead, inflation expectations do not seem to deviate substantially from the inflation target. The easing of monetary policy this year has contributed to relatively stable expectations about future inflation around the inflation target.

4.5 Was monetary policy in 2003 predictable for financial market participants?

The central bank’s interest rate decisions should be predictable. The central bank sets the interest rate for overnight deposits in Norges Bank. This key rate largely determines the very short-term interest rates. For longer maturities, the effects depend on market expectations. If these rates and other prices for financial variables are adapted to the economic outlook, this will contribute to stabilising economic developments.

One indicator of predictability in interest rate setting is the changes in market rates following the Executive Board’s monetary policy meetings¹⁶. Substantial changes in market rates may indicate that the decision came as a surprise.

The effects on the three-month money market rate around the monetary policy meetings have been considerably less pronounced in the first half of 2003 compared with the effects last year (see Chart 19). In the first half of 2003, Norges Bank reduced the key rate on five occasions. The change in the key rate on 13 August seems to have been more pronounced than expected. All the other monetary policy decisions so far this year seem to have been expected.

Chart 19

This method of measuring predictability may have certain limitations, however. For example, interest rate expectations were adjusted after the Central Bank Governor’s speech on 3 June when it was stressed that the Executive Board would carefully consider changing the interest rate in larger steps.

Even if market participants are relatively familiar with the monetary policy response pattern, the use of instruments can be surprising if there are new developments. The economic situation, developments or outlook may be different from what was assumed. Such disturbances might lead to changes in the interest rate. However, in this case it would not be the behaviour of the central bank that takes market participants by surprise, but events. There may be uncertainty as to how such disturbances will affect the economic outlook. It may then not always be entirely clear what the appropriate monetary policy response should be. Thus, participants cannot always be expected to be able to predict the central bank’s interest rate setting with a high degree of precision.

Compared with other countries that have inflation targeting, the average effects on Norwegian market rates were relatively pronounced around the monetary policy meetings last year. So far this year, the effects relative to the same countries have been considerably less pronounced. Monetary policy in 2003 has thus been relatively predictable for market participants.

Footnotes