Report on monetary policy in 2003 - the first eight months1)
5 Summary and concluding remarks
5.1 Summary
5.2 Concluding remarks on monetary policy and its role in economic
policy
5.1 Summary
This report has provided an account of the conduct of monetary policy in
the first eight months of 2003. The introduction presented five criteria which
have received particular emphasis in the assessment:
5.1.1 Consumer price inflation in 2003 and the background for deviations
from the target
Consumer price inflation, adjusted for tax changes and excluding energy products
(CPI-ATE) has continued to slow through the first seven months of 2003. In
August, the year-on-year rise in the CPI-ATE increased somewhat. In the period
May-August, inflation has been more than 1 percentage point below target.
This was due in particular to a decline in prices for imported consumer goods,
which is pushing down overall inflation.
In the years 1998-2002, the Norwegian economy was characterised by substantial
labour shortages and a considerably higher rise in wage costs than among its
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 considerable decline in output and
employment.
Therefore, monetary policy was tightened by an interest rate increase 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. Even 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 abroad 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 bills, have probably contributed to reducing margins.
5.1.2 To what extent has the conduct of monetary policy in 2003 increased
the prospects of bringing inflation close to target two years ahead?
Since the beginning of the year, the interest rate has been reduced by 3.5
percentage points. The sight deposit rate is down to 3.0 per cent. The real
interest rate has fallen. The import-weighted krone exchange rate has depreciated
by 12 per cent since its strongest level in January this year. The prospect
that wage growth will slow to a more sustainable level has been of considerable
importance for the substantial easing of monetary policy.
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.
Without a considerable easing of monetary policy, inflation might be too
low for an extensive period. This might lead to expectations of continued
very low inflation. In such a situation, it may be more demanding to increase
economic activity. It was therefore appropriate to reduce the interest rate
considerably.
The relaxation of monetary policy will contribute to pushing up inflation.
In the short term, the effects will primarily be the result of the gradual
unwinding of the effects of the appreciation and the subsequent depreciation
of the krone. In the somewhat longer term, interest rate reductions will also
have an effect through increased demand in Norway.
All in all, the easing of monetary policy this year, including the weakening
of the krone, will make a substantial contribution to bringing inflation back
to target.
5.1.3 Has monetary policy contributed to stability in output and employment?
Capacity utilisation in Norway has declined from a relatively high level
and is now on a par with the level prevailing in the years 1995-1997, before
the rise in costs 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 international economy in the second half of
2002. The international decline in the ICT and telecommunication sectors continued
to spill over to the Norwegian economy. Demand for goods and services from
export industries declined. Fears of war and terrorism hit the tourist industry.
Many companies, including those in sheltered sectors and the public sector,
faced a heavy cost burden after yet another expensive wage settlement in 2002.
Electricity prices increased unexpectedly.
The easing of monetary policy from December 2002 must be seen in the light
of the weak or negative growth in the Norwegian economy over the last quarters.
There are some signs that the monetary policy easing and expectations of further
easing have now begun to have an effect.
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.
5.1.4 Has monetary policy in 2003 underpinned confidence that future inflation
will be 2½ per cent?
With confidence in the inflation target, monetary policy can make a greater
contribution to smoothing fluctuations in the economy. Inflation expectations
in Norway provide an indication of whether there is confidence that the inflation
target will be achieved.
The information from expectations surveys and long-term interest rates provide
an indication that the market expects inflation to be lower than 2½
per cent over the next year. Further ahead, it does not appear that inflation
expectations 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.
5.1.5 Was monetary policy in 2003 predictable for financial market participants?
It is desirable that the central bank’s interest rate decisions are
predictable. One indicator of predictability in interest rate setting is the
impact on money market rates around the Executive Board’s monetary policy
meetings. A pronounced impact on money market rates may indicate that the
decision was a surprise.
The change in the three-month money market rates around the monetary policy
meetings has been considerably smaller in the first half of 2003 compared
with last year. In the first half of 2003, Norges Bank reduced the sight deposit
rate on five occasions. The change in the sight deposit rate on 13 August
appears to have been somewhat greater than expected. All of the other interest
rate decisions so far this year appear to have been expected.
In relation to other central banks with inflation targets, the average impact
on Norwegian money market rates was fairly pronounced around the monetary
policy meetings last year. So far this year, the effects have been considerably
smaller relative to the same countries. Monetary policy in 2003 has been relatively
predictable for market participants.
5.2 Concluding remarks on monetary policy and its role
in economic policy
Experience shows that flexible inflation targeting anchors inflation expectations
and provides a sound framework for monetary policy’s contribution to
stabilising output and employment. In conclusion, we will discuss some other
aspects of monetary policy.
5.2.1 Monetary policy and stabilising exchange rate expectations
We must expect that the krone exchange rate will fluctuate in line with currencies
of other small economies with floating exchange rates. There is free trade
in goods and services and free capital movements. The krone is floating. Since
1997, the krone measured against the euro/ecu has fluctuated between NOK 9.24
and NOK 7.22.
At the same time, there has been a strong reversion mechanism in the krone
exchange rate. The krone has appreciated when economic activity has been high
and there have been expectations of a wide interest rate differential. The
krone has depreciated when activity has declined and the interest rate differential
has narrowed.
Based on experience so far, we have no evidence indicating that an inflation
target for monetary policy will weaken the reversion mechanism in the krone
exchange rate. Evidence indicates that the inflation target provides a sound
anchor for exchange rate expectations. However, these expectations will also
depend on fundamental conditions such as developments in government expenditure
and revenues, productivity growth, oil prices and the terms of trade, excluding
oil.
5.2.2 Monetary policy and competitiveness
Fluctuations in the nominal exchange rate will also be expressed in the measurement
of real exchange rates and competitiveness. There is evidence that reversion
mechanisms will also apply over time for real exchange rates. Reversion of
the nominal exchange rate will contribute to this when inflation in Norway
is approximately in line with inflation in other countries.
Although the nominal krone exchange rate has depreciated this year, the competitiveness
of Norwegian industries is still weak. Measured in a common currency, wages
in Norway rose about 15 per cent more than in other countries from 1995-1996
to 2003. The appreciation of the krone proved to be reversible, but the loss
of competitiveness and jobs caused by relatively high domestic wage growth
is difficult to recoup. A precondition for a considerable improvement in competitiveness
is that real wage growth is lower than productivity growth in the business
sector for a period. Experience shows that competitiveness improves in periods
with low resource utilisation. This also reflects that changes in competitiveness
over time depend on real economic factors and aspects of wage formation and
cannot be controlled by monetary policy.
5.2.3 The interplay between monetary policy and fiscal policy
According to the guideline for fiscal policy, the use of petroleum revenues
over the central government budget shall over time correspond to the expected
real return on the Government Petroleum Fund. This guideline implies that
petroleum revenues will gradually be phased into the economy. In the National
Budget for 2003, the Government states the following:
“The fiscal rule provides a medium-term anchor for fiscal policy.
Linking the use of petroleum revenues to the structural, non-oil deficit ensures
that automatic stabilisers can function. (…)
The new guidelines for economic policy also mean that monetary policy
has been given a clear role in stabilising economic developments. This means
that monetary policy should be the first to react when the outlook for the
economy changes.” (p. 7)
In its discussion of the economic programme for 2003, the Government also
placed emphasis on the interplay with monetary policy:
“A more expansionary budget will undermine the credibility of fiscal
policy. Such a policy will increase the pressure on monetary policy, which
can lead to higher interest rates and further appreciation of the krone. This
will lead to a deterioration in operating conditions for the internationally
exposed sector.” (p. 7)
According to Norges Bank’s assessment, the fiscal policy stance for
2003 has contributed to laying the basis for a substantial easing of monetary
policy. Fiscal policy and lower wage growth have contributed to a reduction
in interest rates and a depreciation of the krone. The outlook for the internationally
exposed sector is brighter today than a year ago because the rise in costs
has slowed markedly. This seems to be in line with the intentions expressed
by the Government in the National Budget.
5.2.4 The interplay between monetary policy and wage and income formation
When the monetary policy response pattern is known and consistent over time,
the social partners can take into account monetary policy responses when negotiating
wages. The result of last year’s settlement, which resulted in average
wage growth of 5¾ per cent, might have indicated that the inflation
target did not function as an anchor for wage formation.
It appears that wage growth in 2003 will be appreciably lower than in previous
years. The social partners may have placed greater emphasis on the effects
of pay increases on future developments in the interest rate, the exchange
rate and employment. Wage growth was lower, the interest rate was reduced
and the krone depreciated. The outcome of this year’s wage settlement
may thus provide a basis for expecting future wage settlements to be more
moderate than in the years from 1998 to 2002 and more in line with the inflation
target over time.
Monetary policy was tight as long as wage growth was high. When there is
confidence that monetary policy will keep inflation at a low and stable level,
high wage growth will in periods be accompanied by a strong krone. When pressures
in the economy subside and wage growth slows, an easing of monetary policy
will follow. Monetary policy provides an anchor for inflation expectations.
The social partners can base their wage negotiations on the assumption that
inflation over time will be 2½ per cent.
Moderation in wage growth will provide a strong impetus to the internationally
exposed sector. Lower wage growth will boost earnings and employment. It will
also provide the basis for low interest rates. Normally, it will lead to a
weaker krone than would otherwise be the case.
The prospect that wage growth will slow to a more sustainable level has been
of considerable importance for the substantial easing of monetary policy.