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Monetary Policy Report

Reports from the Central Bank of Norway No. 1/2010

March

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Monetary Policy Report

1/2010

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Norges Bank Oslo 2010

Address: Bankplassen 2

Postal address: Postboks 1179 Sentrum, 0107 Oslo, Norway Phone: +47 22 31 60 00

Fax: +47 22 41 31 05

E-mail: central.bank@norges-bank.no Website: http://www.norges-bank.no

Governor: Svein Gjedrem Deputy Governor: Jan F. Qvigstad

Editor: Svein Gjedrem Cover and design: Burson-Marsteller Printing: 07 Lobo Media AS

The text is set in 10½ point. Times New Roman / 9½ point Univers

ISSN 1504-8470 (print) ISSN 1504-8497 (online)

Monetary Policy Report

The Report is published three times a year, in March, June and October/November. The Report assesses the interest rate outlook and includes projections for developments in the Norwegian economy and analyses of selected themes.

At its meeting on 3 December, the Executive Board discussed relevant themes for the Report. At the Executive Board meeting on 11 March, the economic outlook was discussed. On the basis of this discussion and a recom- mendation from Norges Bank’s management, the Executive Board adopted a monetary policy strategy for the period to the publication of the next Report on 23 June 2010 at the meeting held on 24 March. The Executive Board’s summary of the economic outlook and the monetary policy strategy is presented in Section 1. In the period to the next Report, the Executive Board’s monetary policy meetings will be held on 5 May and 23 June.

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Monetary policy in Norway

Objective

The operational target of monetary policy is low and stable inflation, with annual consumer price inflation of approximately 2.5% over time.

Implementation

Norges Bank operates a flexible inflation targeting regime, so that weight is given to both variability in inflation and variability in output and employment. In general, the direct effects on consumer prices resulting from changes in interest rates, taxes, excise duties and extraordinary temporary disturbances are not taken into account.

Monetary policy influences the economy with a lag. Norges Bank sets the interest rate with a view to stabilising inflation close to the target in the medium term. The horizon will depend on disturbances to which the economy is exposed and the effects on prospects for the path for inflation and the real economy.

The decision-making process

The main features of the analysis in the Monetary Policy Report are presented to the Executive Board for discussion at a meeting about two weeks before the Report is published. Themes of relevance to the Report have been discussed at a previous meeting. On the basis of the analysis and discussion, the Executive Board assesses the consequences for future interest rate developments, including alternative strategies. The final decision to adopt a monetary policy strategy is made on the same day as the Report is published. The strategy applies for the period up to the next Report and is presented at the end of Section 1 in the Report.

The key policy rate is set by Norges Bank’s Executive Board. Decisions concerning the interest rate are normally taken at the Executive Board’s monetary policy meeting every sixth week. The analyses and the monetary policy strategy, together with assessments of price and cost developments and conditions in the money and foreign exchange markets, form a basis for interest rate decisions.

Communication of the interest rate decision

The monetary policy decision is announced at 2pm on the day of the meeting. At the same time, the Execu- tive Board’s monetary policy statement is published. The statement provides an account of the main aspects of economic developments that have had a bearing on the interest rate decision and the Executive Board’s assessments. The Bank holds a press conference at 2:45 pm on the same day. The press release, the Executive Board’s monetary policy statement and the press conference are available on www.norges-bank.no.

Reporting

Norges Bank reports on the conduct of monetary policy in the Monetary Policy Report and the Annual Report.

The Bank’s reporting obligation is set out in Section 75c of the Constitution, which stipulates that the Stor- ting shall supervise Norway’s monetary system, and in Section 3 of the Norges Bank Act. The Annual Report is submitted to the Ministry of Finance and communicated to the King in Council and to the Storting in the Government’s Kredittmeldingen (Credit Report). The Governor of Norges Bank provides an assessment of monetary policy in an open hearing before the Standing Committee on Finance and Economic Affairs in con- nection with the Storting deliberations on the Credit Report.

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Editorial

Gradual increase in the key policy rate

In preparing this Report, 600 enterprises were contacted through Norges Bank’s regional network. The main im- pression is that output is rising, but growth is not high and some industries are still in decline. The current level of activity appears to be somewhat below the level expected in autumn 2009. Wage growth also appears to be weaker than projected and inflation may be somewhat lower than anticipated.

Growth is strong in Asia, but the upswing in Europe is only moderate. In recent months, developments have been fairly weak among Norway’s neighbouring countries.

Rapidly rising government debt has fuelled uncertainty about developments, and fiscal tightening has begun in some countries. Low interest rates have contributed to holding up activity. Since autumn, expectations of interest rate hikes in Europe and the US have been moved forward into the future and the Norwegian krone has been stronger than expected.

Norges Bank raised the key policy rate by a total of 0.50 percentage point towards the end of 2009. The Executive Board’s strategy is that the key policy rate should be in the interval 1½–2½% in the period to the publication of the next Monetary Policy Report on 23 June unless the Norwegian economy is exposed to new major shocks.

The projections in this Report do not differ substantially from those in the October Report. Based on our current assessment, the interest rate increase will occur somewhat later than expected in autumn 2009, more in line with the outlook in summer 2009. The projections in this Report imply that the key policy rate will increase to about 2½%

around the end of the year and increase further towards a more normal level thereafter.

Jan F. Qvigstad 24 March 2010

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1 Monetary policy assessments and strategy

The economic situation

The most acute phase of the global economic crisis appears to have passed. Output growth has resumed in most parts of the world and the recovery has been strongest in emerging market economies in Asia (see Chart 1.1). It appears, however, that the upturn in advanced economies will only be moderate. Substantial spare output capacity will continue to have an impact on many countries ahead.

The crisis has given rise to new imbalances that will dampen the recovery. Fiscal deficits are substantial in many countries and government debt is rising rapidly. Higher risk premiums on government bonds have pushed up bor- rowing costs for some governments. Deficits have increased markedly because of reduced tax revenues and sti- mulus measures to underpin activity, but also due to government support measures for banks. Debt growth may become self-reinforcing unless tax revenues increase or spending is reduced quickly enough. Reducing government debt in the US and many European countries will probably take several years.

Even with substantial tax cuts, strong growth in public spending and low interest rates, unemployment has risen considerably in both the US and Europe. In many countries, unemployment has grown by 3–4 percentage points (see Chart 1.2). There is a risk that unemployment will become entrenched, perhaps particularly in Europe.

Commodity prices fell sharply in autumn 2008, resulting in very low inflation in most countries through 2009.

Commodity prices have now rebounded and inflation has moved up, but inflation expectations have remained stable. Spare capacity and high unemployment will nonetheless exert downward pressure on inflation in the years

-25 -20 -15 -10 -5 0 5 10 15 20 25

2002 2003 2004 2005 2006 2007 2008 2009 2010 1) Weighted by GDP weights (PPP). See Economic Commentaries 8/2009 for an overview of countries included in the different regions

Sources: IMF, Thomson Reuters and Norges Bank

OECD Central and Eastern Europe Asia Latin America

Chart 1.1 Manufacturing output in OECD and emerging markets¹⁾. Twelve-month change. Per cent. January 2002 – December 2009

0 2 4 6 8 10 12

1970 1974 1978 1982 1986 1990 1994 1998 2002 2006 2010 Source: Thomson Reuters

Chart 1.2 Unemployment. Share of labour force. Per cent. Seasonally adjusted.

January 1970 – February 2010

US Euro area UK Sweden

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0 1 2 3 4 5 6 7

Jun-07 Jun-08 Jun-09 Jun-10 Jun-11 Jun-12

US Euro area UK

Chart 1.3 Key rates and estimated forward rates at 28 October 2009 and 18 March 2010.¹⁾ Per cent. 1 June 2007 – 31 December 2012²⁾

1) Broken lines show estimated forward rates as at 28 October 2009. Thin lines show forward rates as at 18 March 2010. Forward rates are based on Overnight Indexed Swap (OIS) interest rates

2) Daily figures from 1 June 2007 and quarterly figures as at 18 March 2010 Sources: Bloomberg and Norges Bank

ahead. Consumer price inflation among Norway’s trading partners is expected to be 1½% in 2010 and around 1¾%

in 2012.

Forward rates among trading partners have fallen markedly since the October Report. Imbalances related to high unemployment and high debt in some countries have dampened growth expectations. At the same time, China has tightened economic policy and implemented measures to restrain bank lending growth.

Key rates are close to zero in many countries. A number of central banks have signalled that key rates will be kept low for an extended period, and key rate expectations abroad fell through autumn and winter. Market participants do not anticipate a rise in key rates in the US, the euro area and the UK until the end of 2010 (see Chart 1.3). Sveriges Riksbank expects to begin raising the key rate this summer and that the rate can be gradually increased thereafter. In Norway, market participants still expect the key policy rate to rise, but key rate expectations have fallen markedly and are now lower than projected in the October Report.

Equity markets have risen by about 60–70% since the trough at the beginning of March 2009. Oslo Børs reached a peak around the turn of the year, but fell back somewhat in the first two months of 2010, partly reflecting unrest in government bond markets. Overall prices on Oslo Børs are nonetheless around 13% higher than at the end of October 2009.

Spot prices for oil (Brent Blend) have hovered around USD 70^–80 per barrel since the October Report, underpinned by the recovery in emerging market economies.

OPEC has also restricted output. OECD oil stocks are still at elevated levels and OPEC spare production capacity is high. The price of oil for delivery one year ahead is approximately USD 83.

Forward prices indicate that other commodity prices may also rise somewhat ahead. Since the October Report, me- tals prices have increased as a result of improved global economic prospects, although they are still somewhat lower than in summer 2008.

-15 -10 -5 0 5 10 15 20 25 30

2002 2003 2004 2005 2006 2007 2008 2009 2010 1) Credit from domestic sources, C2

2) House prices to February. Credit growth to January

Sources: Statistics Norway, OPAK, the real estate industry (NEF, EFF, FINN.no and ECON Pöyry), OBOS and Norges Bank

House prices Credit to households

Chart 1.5 Credit to households ¹⁾and house prices.

12-month change. Per cent. January 2002 – February 2010²⁾

-3 -2 -1 0 1 2

2007 2008 2009 2010

Mainland GDP GDP trading partners

1) Projections from 2010 Q1

Sources: Statistics Norway, OECD, Thomson Reuters and Norges Bank Chart 1.4 GDP growth on previous quarter. Norway and trading partners.

Seasonally adjusted. Per cent. 2007 Q1 – 2010 Q4¹⁾

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Growth in the Norwegian economy came to a halt in autumn 2008, and Norway entered a downturn in early 2009. Mainland GDP fell by 1½% in 2009. The decline appears to have ended in 2009 Q2. Capacity utilisation is lower than normal, but the downturn seems to be relatively mild (see Chart 1.4).

Activity has been underpinned by substantial interest rate cuts combined with higher public spending and high oil investment. Information that has emerged since the Oc- tober Report indicates that the recovery in the Norwe- gian economy is continuing. Enterprises in Norges Bank’s regional network report moderate growth, although with considerable differences across sectors. Growth is particularly evident in the service industry, while manufacturing and building and construction activity is still low.

Exports have picked up after an earlier and somewhat stronger rebound in world trade than expected. Private consumption showed a slightly more moderate increase than expected in the latter half of 2009. The household saving ratio increased markedly in 2009 and at the end of the year was at its highest level since the end of the 1970s. House prices have been somewhat higher than expected, but fell slightly in February. Household credit growth has been relatively stable in recent months at 6–7% (see Chart 1.5).

During the financial crisis, the spread between money market rates and the key rate widened. In autumn 2008, premiums had reached 2 percentage points. Since then, premiums have fallen back and are now around 0.4 percentage point (see Chart 1.6). This is in line with the projections in the October Report. Norges Bank raised the key policy rate on two occasions by a total of 0.50 percentage point in 2009 Q4. The feed-through to bank lending rates has so far been somewhat smaller. The average private lending rate increased by 0.09 percentage point from 2009 Q3 to Q4, but the December interest rate increase will probably not feed through until 2010.

Weighted mortgage lending rates have increased by 0.24 percentage point since the key rate was raised for the first time in October (see Chart 1.7).

The interest rate differential between Norway and trading partners has increased. The three-month money market

0 1 2 3 4 5 6 7 8 9

Jun-07 Dec-07 Jun-08 Dec-08 Jun-09 Dec-09

Money market rate Key policy rate

Bank lending rates (mortgage loans) Average lending rates to enterprises

Chart 1.7 Key policy rate, money market rate¹⁾, weighted bank lending rates on new loans²⁾ and average lending rates to enterprises³⁾. Per cent.

1 June 2007 – 18 March 2010

1) 3-month NIBOR (effective)

2) Interest rate on new mortgage loans of NOK 1m within 60% of purchase price with variable interest rate. Figures for the 20 largest banks, weighted according to market share 3) Non-financial enterprises. 2007 Q2 – 2009 Q4

Sources: Norsk familieøkonomi AS, Statistics Norway and Norges Bank

-2.5 0 2.5 5 7.5

2002 2003 2004 2005 2006 2007 2008 2009 2010 Chart 1.8 Consumer prices. 12-month change. Per cent.

CPI CPI-ATE 1)

Weighted median 20 per cent trimmed mean

CPIXE 2) CPI-FW 3)

1) CPI adjusted for tax changes and excluding energy products

2) CPI adjusted for tax changes and excluding temporary changes in energy prices. CPIXE is a real time series. See Staff Memo 7/2008 and 3/2009 from Norges Bank for a description of the CPIXE 3) CPI adjusted for frequency of price changes. See Economic commentaries 7/2009 from Norges Bank for a description of the CPI-FW

Sources: Statistics Norway and Norges Bank

0 1 2 3 4

Jun-07 Dec-07 Jun-08 Dec-08 Jun-09 Dec-09

US Norway Trading partners

Chart 1.6 Difference between 3-month money market rate and key rate expectations in the market. Percentage points. 5-day moving average.

1 June 2007 – 18 March 2010

Sources: Bloomberg, Thomson Reuters and Norges Bank

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0 2.5 5

2002 2003 2004 2005 2006 2007 2008 2009 2010 1) Average of expectations of employer/employee organisations and economists (financial industry experts, macro analysts and academica)

Sources: TNS Gallup and Perduco Expected inflation 5 years ahead Expected inflation 2 years ahead

Chart 1.9 Expected consumer price inflation 2 and 5 years ahead.¹⁾

Per cent. 2002 Q1 – 2010 Q1 rate differential is now 1.7 percentage points. This is 0.3

percentage point higher than at the time of the October Report.

The krone exchange rate has remained fairly stable through winter, although it is somewhat stronger than projected in October. Measured by the import-weighted exchange rate index (I-44), the krone has appreciated by approximately 1% since the publication of the October Report.

In Norway, various measures of underlying inflation have been close to 2½% in recent months (see Chart 1.8). Lo- wer wage growth, reduced capacity utilisation and low global inflation have counterbalanced the effects of high energy prices and the krone depreciation in autumn 2008.

The various measures of underlying inflation have been broadly in line with expectations since the October Re- port. Energy prices in the consumer price index (CPI), however, have risen more than expected in the October Report.

According to Perduco’s expectations survey, long-term inflation expectations were revised up by most groups in the survey in 2010 Q1 following some decline in 2009 Q4. Inflation five years ahead is expected to be about 3%

(see Chart 1.9). Inflation expectations among financial market participants can also be derived from the expected five-year interest rate differential between Norway and the euro area five years ahead. Because of a higher inflation target in Norway, this long-term differential will normally be around ½–1 percentage point, depending on bond premiums. In recent months, the differential has been in this range (see Chart 1.10), indicating that long- term inflation expectations for Norway are close to 2.5%.

The outlook ahead and monetary policy assessments

The operational target of monetary policy in Norway is low and stable inflation, with annual consumer price inflation of close to 2.5% over time. Over the past ten years, average inflation has been close to, but somewhat below 2.5% (see Chart 1.11). Consumer price inflation has ge-

0 0.5 1 1.5 2

2002 2003 2004 2005 2006 2007 2008 2009 2010 Sources: Thomson Reuters and Norges Bank

Chart 1.10 5-year forward rate differential 5 years ahead between Norway and the euro area. Percentage points. 1 January 2002 – 18 March 2010

0 2 4 6 8 10 12 14

1980 1985 1990 1995 2000 2005 2010

Variation CPI Inflation target

1) The moving average is calculated 10 years back

2) The band around the CPI is the variation in the CPI adjusted for tax changes and excluding energy products in the average period, measured by +/- one standard deviation 3) Projections for CPI from this Report form the basis for this estimate

Chart 1.11 Inflation. Moving 10-year average¹⁾ and variation²⁾ in CPI³⁾. Per cent. 1980 – 2010

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nerally been somewhat below target since 2003 and monetary policy was then oriented towards pushing up inflation. In 2007 and 2008 inflation picked up to slightly above target (see Chart 1.8). The key policy rate was gradually raised to a more normal level. Inflation close to target and firmly anchored inflation expectations were essential for monetary policy to be effective when substantial cuts were made in the key policy rate from autumn 2008 to summer 2009.

The key policy rate was reduced to prevent inflation from falling too far below target and to mitigate the impact of the global downturn on the Norwegian economy. In the period to October 2009, developments in the Norwegian economy were more favourable than expected in June.

There was also a sense of growing optimism in other countries and interest rate expectations rose. The forecast for the key policy rate was revised up and Norges Bank’s analyses indicated that the key rate could be gradually raised to around 2% in the first half of 2010. In 2009 Q4, the key policy rate was raised by a total of 0.50 percentage point to 1.75%.

In the period to the turn of the year and thereafter, developments have been more mixed. Underlying inflation is now below target and there are prospects that inflation will fall to a somewhat lower level through 2010 than projected in October. Growth in the Norwegian economy appears to have been somewhat lower towards the end of 2009 and into 2010 than projected earlier. This has probably contributed to somewhat lower capacity utilisation now than envisaged in autumn 2009. With these prospects, both the objective of keeping the rise in consumer prices close to the inflation target and the objective of stable developments in output and employment indicate that the key policy rate should be kept low for a period ahead.

The low interest rate level among Norway’s trading partners also pushes down the interest rate level in Norway.

Market participants have again revised down their interest rate expectations. A markedly wider interest rate differential against other countries would probably result in a stronger krone for a period. A substantial appreciation of the krone would make it difficult to bring inflation up to

Criteria for an appropriate interest rate path

The operational target of monetary policy is low and stable inflation, with annual consumer price inflation of approximately 2.5% over time. In interest rate setting, the forecast for future interest rate developments should satisfy the following main criteria:

1) The interest rate should be set with a view to stabilising inflation close to the target in the medium term. The horizon will depend on disturbances to which the economy is exposed and the effects on the prospects for the path for inflation and the real economy.

2) The interest rate path should provide a reasonable balance between the path for inflation and the path for capacity utilisation.

In the assessment, potential effects of asset prices, such as property prices, equity prices and the krone exchange rate on the prospects for output, employment and inflation are also taken into account. Assuming the criteria above have been satis- fied, the following additional criteria are useful:

3) Interest rate developments should result in acceptable developments in inflation and output also under alternative, albeit not unrealistic as- sumptions concerning the economic situation and the functioning of the economy.

4) Interest rate adjustments should normally be gradual and consistent with the Bank’s previous response pattern.

5) As a cross-check for interest rate setting, it should be possible to explain any substantial and systematic deviations from simple monetary policy rules.

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0 1 2 3 4 5 6 7 8 9

2008 2009 2010 2011 2012 2013

Source: Norges Bank

Chart 1.12a Projected key policy rate in the baseline scenario with fan chart.

Quarterly figures. Per cent. 2008 Q1– 2013 Q4

30% 50% 70% 90%

-4 -3 -2 -1 0 1 2 3 4 5

2008 2009 2010 2011 2012 2013

Chart 1.12b Estimated output gap¹⁾ in the baseline scenario with fan chart.

Quarterly figures. Per cent. 2008 Q1 – 2013 Q4

30% 50% 70% 90%

1) The output gap measures the percentage deviation between mainland GDP and projected potential mainland GDP

Source: Norges Bank

-1 0 1 2 3 4 5

2008 2009 2010 2011 2012 2013

Chart 1.12c Projected CPI in the baseline scenario with fan chart.

4-quarter change. Per cent. 2008 Q1 – 2013 Q4

30% 50% 70% 90%

-1 0 1 2 3 4 5

2008 2009 2010 2011 2012 2013

Chart 1.12d Projected CPIXE¹⁾in the baseline scenario with fan chart.

4-quarter change. Per cent. 2008 Q1 – 2013 Q4

1) CPI adjusted for tax changes and excluding temporary changes in energy prices. As from August 2008, CPIXE is a real time series. See Staff Memo 7/2008 and 3/2009 from Norges Bank for a description of the CPIXE

Source: Norges Bank 30% 50% 70% 90%

target within a reasonable time horizon. A strong krone might also result in lower activity in exposed industries and thereby lower capacity utilisation in the Norwegian economy.

On the other hand, house prices have risen sharply since the trough in November 2008 and are now higher than the June 2007 peak level. Household debt growth has remained stable at around 6–7% in recent months. The aim of guarding against the risk of debt accumulation, with abrupt changes in behaviour that could disturb activity and inflation somewhat further ahead, suggests that the interest rate should be brought closer to a more normal level. At the same time, the new guidelines for prudent residential mortgage lending issued by Finanstilsynet (the

Financial Supervisory Authority of Norway) may curb household debt accumulation.

An overall assessment of the outlook and the balance of risks suggest that the key rate should be gradually increased to a more normal level in the years ahead (see Charts 1.12 a-d). New information suggests that the key rate should be raised somewhat later than projected in the October Monetary Policy Report (see Chart 1.13 and the box on page 16). The interest rate forecast implies an interest rate level of around 2½% at the turn of the year 2010-2011.

Money market premiums are expected to revert to the previous normal level of approximately 0.25 percentage

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point as from 2010 Q3 (see Chart 1.14). Furthermore, the krone is expected to remain at about the current level to the end of Q3 and then gradually depreciate somewhat thereafter (see Chart 1.15).

The interest rate is set with a view to stabilising inflation over time close to 2.5% and bringing capacity utilisation back to a normal level (see Chart 1.16). The Norwegian economy is expected to pick up gradually through the remainder of 2010 and in 2011. Capacity utilisation is projected to be close to a normal level in 2011 and to reach this level in 2012. The recovery in the Norwegian economy is being driven by continued high growth in demand for goods and services in the household sector and after a period by demand in the corporate sector. Oil investment, on the other hand, is projected to decline by about 6% over the next two years. A further pickup in world trade will support export growth. Measured by relative labour costs, Norwegian labour has never been as costly as it is now (see Chart 1.17). As a result, the Nor- wegian export industry may lose market shares ahead.

There are no prospects of another rise in export prices as sharp as in the 2000s, when Norway’s terms of trade improved considerably.

Consumer price inflation is expected to fall to somewhat below 2% in 2010 following the krone appreciation over the past year. Inflation is expected to pick up gradually thereafter to 2.5% towards the end of the projection period as capacity utilisation reaches a normal level and the effect of the krone appreciation unwinds. It appears that wage growth in 2010 will be lower than previously projected. Annual wage growth is now projected at 3¾%.

Towards the end of the projection period, wage growth is expected to pick up to between 4½ and 5%. The projections are based on a gradual rise in productivity. Im- proved productivity will ease cost pressures for firms.

The projections are also based on increased scope for firms to strengthen profitability by raising prices. Regis- tered unemployment is estimated to have reached a peak of 3% or approximately 80 000 at the beginning of 2010.

0 1 2 3 4 5 6 7 8 9

2008 2009 2010 2011 2012 2013

1) Norges Bank's projections from 2010 Q2 Source: Norges Bank

Chart 1.14 Key policy rate in the baseline scenario and key policy rate plus premiums in the Norwegian money market.¹⁾Per cent. 2008 Q1 – 2013 Q4

Key policy rate in the baseline scenario Key policy rate plus money market premiums

0 1 2 3 4 5 6 7 8 9

2008 2009 2010 2011 2012

Source: Norges Bank

Chart 1.13 Key policy rate in the baseline scenario in MPR 1/09, MPR 2/09, MPR 3/09 and MPR 1/10. Per cent. 2008 Q1 – 2012 Q4

MPR 1/09 MPR 2/09 MPR 3/09 MPR 1/10

-2 -1 0 1 2 3 4 5 85

88 91 94 97 100 103 106

2002 2004 2006 2008 2010 2012

I-44, left-hand scale

3-month rate differential, right-hand scale

1) A rising curve indicates a stronger krone exchange rate Sources: Thomson Reuters and Norges Bank

Chart 1.15 Three-month money market rate differential between Norway and trading partners and the import-weighted exchange rate index (I-44)¹⁾. Monthly- (historical) and quarterly figures (ahead). January 2002 – December 2013

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-1 0 1 2 3 4 5 6

-4 -3 -2 -1 0 1 2 3 4

2008 2009 2010 2011 2012 2013

1) CPI adjusted for tax changes and excluding temporary changes in energy prices.

From August 2008, CPIXE is a real time series. See Staff Memo 7/2008 and 3/2009 from Norges Bank for a description of the CPIXE

Chart 1.16 Projected inflation¹⁾and output gap in the baseline scenario.

Per cent. Quarterly figures. 2008 Q1 – 2013 Q4

Output gap, left-hand scale CPIXE, right-hand scale

A real interest rate that is lower than the normal real interest rate will stimulate activity, even after the effects of the decrease itself have dissipated. The interval for the normal level of the real interest rate is estimated at 2–3%

(see box on page 22). The real interest rate will increase and approach the normal real interest rate in the course of the projection period (see Chart 1.18).

The interest rate forecast is assessed in the light of simple monetary policy rules that can be robust to different as- sumptions about the functioning of the economy. Unless there are prospects for abrupt changes in economic developments, monetary policy could be more robust if the interest rate level does not deviate too far from that indicated by the simple rules. The Taylor rule is based on the output gap and inflation. The growth rule is based on GDP growth and inflation. The rule involving external interest rates also takes account of changes in the interest rate level among our trading partners that may result in changes in the exchange rate and thereby influence the inflation outlook. These simple rules generally indicate a key policy rate somewhat above our interest rate forecast for the latter half of 2010 (see Chart 1.19).

Norges Bank has estimated an interest rate rule that seeks to provide a rough explanation of the Bank’s previous interest rate setting based on a few variables. The rule includes inflation developments, wage growth, mainland GDP and other central bank key rates. The interest rate in the previous period is also important. This rule shows an increase in the key policy rate ahead broadly in line with the projections in this Report (see Chart 1.20).

Forward money market rates provide another cross-check for the interest rate forecast. Estimated forward rates indicate that financial market participants expect money market rates to rise approximately to the same extent as currently projected (see Chart 1.21).

-20 -15 -10 -5 0 5 10 15 20 25

1970 1975 1980 1985 1990 1995 2000 2005 2010

Relative consumer prices Relative wages

Chart 1.17 Real exchange rate. Deviation from mean over the period 1970 – 2009. Per cent. 1970 – 2010¹⁾

1) The squares show the average so far in 2010. A rising curve indicates weaker competitiveness

Sources: Statistics Norway, Technical Reporting Committee on Income Settlements, Ministry of Finance and Norges Bank

-2 -1 0 1 2 3 4 5 6 7

2005 2007 2009 2011 2013

Interval for the normal real interest rate 10-year bond yield

Key policy rate 3-month money market rate

Chart 1.18 Real interest rates based on 3-month money market rate¹⁾, key policy rate¹⁾, 10-year bond yield²⁾and the normal real interest rate in Norway.

Per cent. March 2005 – December 2013

1) Deflated by the 12-quarter moving average (centred) of inflation measured by the CPI.

Projections for the CPI from this Report and the inflation target form the basis for this estimate.

2) 10-year swap rate deflated by the inflation target.

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The interest rate forecast in this Monetary Policy Report has been revised down compared with the October Report (see Chart 1). The forecasts are based on an overall assessment of the situation in the Norwegian and global economies and on our perception of the functioning of the economy. The interest rate is set so that inflation is close to 2.5% over time. Chart 2 shows a technical illustration of how news and new assessments in isolation have affected the changes in the interest rate forecast through their impact on the outlook for inflation, output and employment. The isolated contri- butions from the different factors are shown by the bars. The overall change in the interest rate forecast is shown by the black line.

Forward rates among trading partners have fallen markedly since the October Report and the interest rate differential between Norway and trading partners has widened. The three-month money market rate differential is now

1.7 percentage points. This is 0.3 percentage point higher than at the time of the October Report.

Measured by the import-weighted exchange rate (I-44), the krone so far in 2010 is approximately 2%

stronger than projected in Octo- ber. This contributes to lower imported inflation and would indicate a somewhat lower key policy rate (see red bars).

Energy prices have risen more sharply than assumed in the Octo- ber Report, contributing in isolation to higher inflation. Lower-than- expected wage growth, on the other hand, is exerting downward pressure on inflation. On balance, these factors will contribute to somewhat lower inflation ahead than previously envisaged, indicating that the key policy rate should be lower (see orange bars).

Growth in the Norwegian economy appears to have been somewhat slower towards the end of 2009 and into 2010 than projected in the October Report. This has

probably contributed to somewhat lower-than-expected capacity utilisation, partly as a result of a decline in oil investment. Household consumption in the latter half of 2009 has also shown a somewhat smaller increase than expected.

Exports, on the other hand, have picked up after an earlier and somewhat stronger rebound in world trade than expected.

Growth in oil investment is projected to be somewhat lower than envisaged in the October Report.

On balance, the estimate for capacity utilisation has been revised down slightly compared with the October Report. This would suggest that the key policy rate should be lower (see blue bars).

Changes in the projections for other key variables are summa- rised in Table 1. The changes in the projections reflect the change in the interest rate forecast as shown in Chart 2.

Changes in the projections since Monetary Policy Report 3/09

0 1 2 3 4 5 6 7 8 9

2007 2008 2009 2010 2011 2012

Chart 1 Key policy rate in the baseline scenario in MPR 3/09 with fan chart and key policy rate in the baseline scenario in MPR 1/10 (red line).

Per cent. Quarterly figures. 2007 Q1 – 2012 Q4

30% 50% 70% 90%

Source: Norges Bank

-2 -1 0 1 2

10 Q2 10 Q4 11 Q2 11 Q4 12 Q2 12 Q4

Source: Norges Bank

Chart 2 Factors behind changes in the interest rate forecast since MPR 3/09.

Accumulated contribution. Percentage points. 2010 Q2 – 2012 Q4

Demand Productivity, wages and prices

Interest rates abroad and the exchange rate Change in the interest rate forecast

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Table 1 Projections for macroeconomic aggregates in Monetary Policy Report 1/10. Percentage change from previous year (unless otherwise stated). Change from projections in Monetary Policy Report 3/09 in brackets.

2010 2011 2012 2013

CPI 2½ (¾) 1¾ (-½) 2½ (0) 2½

CPI-ATE 1½ (-¼) 2 (-¼) 2½ (0) 2½

CPIXE¹⁾ 1¾ (0) 2 (-¼) 2½ (0) 2½

Annual wage growth 3¾ (-½) 4¼ (-¼) 4¾ (0) 4¾

Mainland demand 3 (-¼) 4¼ (0) 3¼ (½) 2¼

GDP mainland Norway 2¼ (-½) 2¾ (-½) 2½ (-¼) 2¼

Output gap mainland Norway²⁾ -¾ (-¼) -¼ (-¼) -¼ (-½) 0

Employment 0 (¼) ¾ (-¼) 1 (¼) ½

LFS unemployment (rate) 3¾ (0) 3¾ (¼) 3½ (0) 3½

1) CPIXE: CPI adjusted for tax changes and excluding temporary changes in energy prices. See Staff Memo 7/2008 and Staff Memo 3/2009 from Norges Bank for a description of the CPIXE

2) The output gap measures the percentage deviation between mainland GDP and projected potential mainland GDP

Source: Norges Bank

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Uncertainty surrounding the projections

The projections for the key policy rate, inflation, output and other variables are based on our assessment of the economic situation and our perception of the functioning of the economy and of monetary policy. If economic developments are broadly in line with projections, economic agents can expect that the interest rate path will also be approximately in line with that projected. However, the interest rate path may differ if the economic outlook changes or if the effect of interest rate changes on inflation, output and employment differs from that projected.

In line with the National Budget for 2010, our projections are based on the assumption that the structural non-oil deficit for 2010 will remain at the same level to the end of the projection period. This implies that the structural non-oil deficit will not revert to 4% of the Government Pension Fund Global (GPFG) until 2018. The projections in this Report suggest that capacity utilisation in the Nor- wegian economy may rise to a normal level in the course of roughly two years. The fiscal rule implies that the fiscal deficit should be reduced to about 4% of the capital in the GPFG when the economy resumes a normal level of activity. If economic developments are broadly in line with projections, a fiscal stance in line with the fiscal rule could result in a lower interest rate and a weaker krone than projected.

The uncertainty surrounding our projections is illustrated using fan charts (see Charts 1.12a-d). The width of the fan charts is based on previous disturbances and there- fore expresses an average that includes periods of high and low uncertainty.¹

Household spending is expected to remain high. Expec- tations indicators show that households have become more optimistic. The saving ratio is record high. If uncertainty eases and unemployment levels off, there is a possibility of a steep fall in the saving ratio and a sharper rise in consumption than currently envisaged.

1 A more detailed review of fan charts is provided in Inflation Report 3/05.

0 1 2 3 4 5 6 7 8

2008 2009 2010

Key policy rate Taylor rule Growth rule

Rule with external interest rates

Chart 1.19 Key policy rate and calculations based on simple monetary policy rules¹⁾.Per cent. 2008 Q1 – 2010 Q4

1) The calculations are based on Norges Bank's projections for the output gap, consumer prices adjusted for tax changes and excluding temprary changes in energy prices (CPIXE) and three-month money market rates. To ensure comparability with the key policy rate the simple rules are adjusted for risk premiums in three-month money market rates Source: Norges Bank

0 1 2 3 4 5 6 7 8 9

2002 2003 2004 2005 2006 2007 2008 2009 2010

90 % confidence interval Key policy rate

1) Interest rate movements are explained by developments in inflation, mainland GDP growth, wage growth and key policy rates among trading partners. The equation is estimated over the period 1999 Q1 – 2010 Q1. See Staff Memo 3/2008 for further discussion Source: Norges Bank

Chart 1.20 Key policy rate and interest rate developments that follow from Norges Bank's average pattern of interest rate setting.¹⁾Per cent.

2002 Q1 – 2010 Q4

0 1 2 3 4 5 6 7 8 9

2008 2009 2010 2011 2012 2013

Estimated forward rates

Money market rates in the baseline scenario

1) Forward rates are based on money market rates and interest rate swaps. The blue band shows the highest and lowest forward rates in the period 5 - 18 March 2010

Source: Norges Bank

Chart 1.21 Three-month money market rates in the baseline scenario and estimated forward rates¹⁾. Per cent. Quarterly figures. 2008 Q1 – 2013 Q4

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Charts 1.22 a-c (yellow lines) illustrate the effects of household demand that is about 2% higher than expected over roughly the next two years and a gradual fall in the saving ratio towards zero. In that event, the interest rate will be raised to a higher level and more rapidly than currently envisaged and the krone will appreciate. This will in isolation contribute to lower imported inflation and somewhat lower exports. The interest rate path will stabilise inflation close to 2.5%.

Norwegian exports are expected to hold up, but the export industry is losing market shares due to Norway’s high cost level. Norwegian manufacturing may lose additional market shares and the import content of oil investment may increase more than currently envisaged. This will contribute to a fall in exports and a weaker impetus from oil investment to the Norwegian economy, as illustrated in Charts 1.22 a-c (red lines) where exports in the years ahead are approximately 4% lower than projected. The interest rate is kept lower for a longer period in order to ensure that capacity utilisation holds up and inflation re- turns to target.

0 1 2 3 4 5

2008 2009 2010 2011 2012 2013

Baseline scenario Lower demand Higher demand

30% 50% 70% 90%

1) CPI adjusted for tax changes and excluding temporary changes in energy prices. As from August 2008, CPIXE is a real time series. See Staff Memo 7/2008 and 3/2009 from Norges Bank for a description of the CPIXE

Source: Norges Bank

Chart 1.22c CPIXE¹⁾ in the baseline scenario and in the alternative scenarios.

Per cent. 2008 Q1 – 2013 Q4

0 1 2 3 4 5 6 7 8 9

2008 2009 2010 2011 2012 2013

Source: Norges Bank

Chart 1.22a Key policy rate in the baseline scenario and in the alternative scenarios. Per cent. Quarterly figures. 2008 Q1 – 2013 Q4

Baseline scenario

Lower demand

Higher demand

30% 50% 70% 90%

-4 -3 -2 -1 0 1 2 3 4 5

2008 2009 2010 2011 2012 2013

Source: Norges Bank

Chart 1.22b Output gap in the baseline scenario and in the alternative scenarios. Per cent. Quarterly figures. 2008 Q1 – 2013 Q4

Baseline scenario Lower demand Higher demand

30% 50% 70% 90%

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Summary

The most acute phase of the global economic crisis appears to have passed. Output growth has resumed in most parts of the world. It appears, however, that the upturn in advanced economies will only be moderate and that the economies of many countries will be marked by considerable spare output capacity and high unemployment ahead. The crisis has given rise to new imbalances that will dampen the recovery. Weak prospects have contributed to a marked decline in interest rate expectations in many countries.

Activity in the Norwegian economy picked up towards the end of 2009. The interest rate was raised by 0.50 percentage point towards the end of the year with a view to maintaining inflation at 2.5% over time. New information suggests that the recovery in the Norwegian economy is continuing, but that capacity utilisation is probably somewhat lower than anticipated in autumn 2009. Com- bined with lower interest rates abroad, a stronger krone and lower wage growth suggest that the interest rate forecast should be revised down somewhat in relation to the October Report.

Interest rates in Norway are low. The effect on private consumption of the substantial interest rate cuts in 2008 and 2009 has probably not been exhausted and high consumption growth is expected to continue in 2010. House prices have risen. The new guidelines for prudent residential mortgage lending issued by Finanstilsynet (the Financial Supervisory Authority of Norway) may curb household debt accumulation. Over time, household bor- rowing may nevertheless increase considerably and saving may fall. The aim of guarding against the risk of future imbalances that may disturb activity and inflation somewhat further ahead suggests that the interest rate should be gradually brought closer to a more normal level.

On the other hand, a marked interest rate increase in Nor- way and a wider interest rate differential between Norway and other countries may entail a risk of a considerably stronger-than-projected krone, resulting in inflation that is too low. This will make it difficult to bring inflation up to target within a reasonable time horizon. A strong kro-

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0 1 2 3 4 5 6 7 8 9

2007 2008 2009 2010 2011 2012 2013

1) The Executive Board's decision of 24 March 2010 is not shown in the chart Source: Norges Bank

Strategy period

3/06 1/07

2/07 3/07 1/08

Key policy rate 2/08

Chart 1.23 Interval for the key policy rate at the end of each strategy period, actual developments¹⁾ and projected key policy rate in the baseline scenario.

Per cent. January 2007 – December 2013

3/08

17 Dec 08 1/09

2/09 3/09 1/10

ne may also lead to lower activity in exposed industries and thereby lower capacity utilisation in the Norwegian economy. This suggests that the interest rate should not be raised too rapidly.

Monetary policy cannot fine-tune developments in the economy, but it can mitigate the most severe effects when the economy is exposed to shocks. Overall, the outlook and the balance of risks suggest that the key rate should be gradually increased ahead, although somewhat later than envisaged in October 2009 (see Chart 1.23).

The projections are uncertain. New information may re- veal aspects of economic developments that suggest the Norwegian economy is following a different path than projected. Higher capacity utilisation or a weaker-than- projected krone may result in higher inflation than currently envisaged. On the other hand, inflation may be lower if the krone remains strong or activity in the Nor- wegian economy proves to be weaker than projected.

Executive Board’s strategy

The key policy rate should be in the interval 1½–2½% in the period to the publication of the next Monetary Policy Report on 23 June unless the Norwegian economy is exposed to new major shocks.

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The level of the normal interest rate

The level of the normal real interest rate in Norway is estimated at between 2% and 3%. With an inflation target of 2.5%, Norges Bank estimates the normal level of short-term interest rates to be 4½ –5½% (three-month money market rates). The assumed point estimate of the normal interest rate is unchanged on the October Report.¹

The normal interest rate may be regarded as the interest rate level that over time is consistent with inflation at target and normal capacity utilisation in the economy.

Monetary policy is then neither expansionary nor contractionary.

A key question is whether the low, long-term rates prevailing today (Chart 1) are the result of expectations of lower potential growth or lower inflation over the next ten years and thus a lower long-term interest rate level. This

does not seem to be the case. In contrast with spot rates, implied forward rates are less affected by the current cyclical situation and reflect to a greater extent future growth and inflation expectations.² Chart 2 shows implied forward rates for Norway (implied five-year rates five years ahead, alternatively based on government bond yields and swap rates, and implied one-year rates nine years ahead based on swap rates). In the period 2007–2010, forward rates based on swap rates have ranged between 5% and just below 6%, while forward rates estimated on the basis of government bond yields have been somewhat lower, at around 5%

over the past year. Market participants do not appear to have revised down their long-term interest rate expectations as a result of the financial crisis. Developments in recent years indicate that the market expects money market

rates in the long term to be in the range 4½–5½%.

The normal interest rate is closely linked to potential economic growth. The consensus forecast from Consensus Economics, which is an average of predictions made by various market participants, predicts economic growth in Norway in the range 2½–2¾%

in the period 2014-2019. This is in line with our estimates for the normal real interest rate.

See Economic Commentaries 1/2010 for further discussion of the normal interest rate.

1 The normal interest rate has previously been estimated (since Inflation Report 3/2005) to be in the lower end of the range 2½–3½%.

2 In the absence of maturity premiums and other risk premiums, implied forward interest rates can be interpreted as market expectations as to future interest rates.

0 1 2 3 4 5 6 7 8

2000 2002 2004 2006 2008 2010

Source: Thomson Reuters

Chart 1 10-year swap rates for selected countries.

Norway US Euro area UK Sweden

0 1 2 3 4 5 6 7 8

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 Chart 2 Nominal forward interest rates for Norway.

Five-year rates five years ahead, based on government bond yields Five-year rates five years ahead, based on swap rates One-year rates nine years ahead, based on swap rates

Source: Thomson Reuters

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Monetary Policy Report

Reports from the Central Bank of Norway No. 1/2010

March

1 10

Monetary Policy Report

1/2010

Norges Bank Oslo 2010

Monetary Policy Report

Table of contents

Monetary policy in Norway

Editorial

Gradual increase in the key policy rate

1 Monetary policy assessments and strategy

The economic situation

The outlook ahead and monetary policy assessments

Criteria for an appropriate interest rate path

Changes in the projections since Monetary Policy Report 3/09

Uncertainty surrounding the projections

Summary

Executive Board’s strategy

The level of the normal interest rate