Economic Perspectives.

• Author: Gjedrem, Svein
• Position: Transcript

Annual address by Governor Svein Gjedrem at the meeting of the Supervisory Council of Norges Bank on Thursday 15 February 2001

Introduction

Norway's economy is today characterised by substantial petroleum revenues, sharp growth in government expenditure, a tight labour market and high cost inflation. High oil prices and sizeable petroleum production are contributing to surpluses on the current account and the central government budget. This has also resulted in a vigorous rise in Norway's disposable income. The current account surplus in 2000, which was equivalent to about 14 per cent of GDP, is among the highest surpluses recorded by an OECD country in the post-war period. The total general government budget surplus also rose sharply, reaching 14 1/2 per cent of GDP.

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With the exception of a brief pause in growth from the summer of 1998, the Norwegian economy has been expanding since 1993. Employment has risen and unemployment has fallen to just over 3 per cent. A shortage of labour in many sectors has resulted in a relatively sharp growth in labour costs in Norway.

Whereas the upturn was balanced for a long period, the public sector has laid claim to a large share of the increase in the labour supply in recent years. Manufacturing employment has fallen markedly since 1998.

The mainland economy features some aspects that are associated with a boom period, although growth is low. After several years of mainland GDP growth in the order of 3-4 per cent, activity is now increasing by less than 2 per cent a year. The economy is operating near capacity limits.

New working time reforms, increased use of sick pay and disability benefits and a reduced supply of labour from other Nordic countries are restraining growth in many sectors. Moreover, there is no evidence suggesting that productivity growth in Norway has picked up to the levels in some of our neighbouring countries.

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International equity prices declined sharply last autumn. In the US, output and employment are stagnating. As shown in Chart 3, the risk premium in capital markets on long-term credit to enterprises has increased. In addition, many international enterprises now have a poorer credit rating than earlier This has also affected borrowing in Norwegian companies, which now have to place greater emphasis on their customers' ability to honour commitments. International financial and capital markets are characterised by uncertainty and unrest.

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This unrest is not found among economic agents in Norway. As long as oil prices are high, the Norwegian economy is fairly sheltered. Many central banks are now reducing their key rates. As our economy is affected to a lesser extent, the differential between short rates in Norway and abroad may widen.

Monetary policy

The long-term objective of monetary policy is to provide the Norwegian economy with a nominal anchor -- domestic price stability, and thereby the basis for a stable krone. Nominal stability is the best contribution monetary policy can make to economic growth and prosperity. A nominal anchor is also a necessary precondition for stable financial markets and property markets. High inflation and wide swings in the exchange rate impair the function of prices as an information vehicle. This leads to booms followed by busts and an arbitrary redistribution of income and wealth. Inflation therefore poisons the economy.

By linking movements in the krone to the euro, we have chosen to follow the same standard for nominal stability in the economy as set by the euro area countries.

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Since 1997, inflation has been higher in Norway than in the euro area. The difference partly reflects a period of strong growth in Norway, while the level of activity in Europe has been low. The higher level of inflation in Norway cannot be sustained, however, as this would undermine the basis for stability in the krone exchange rate and confidence in monetary policy.

Short-term capital inflows and outflows are probably the most important factor determining movements in the krone exchange rate from day to day, from week to week and from one quarter to the next. They are governed by expectations concerning future returns. Changes in expectations concerning the future value of the krone can trigger extensive capital movements.

As a rule, Norges Bank does not intervene in foreign exchange markets with a view to influencing the krone exchange rate. The krone is floating, and the value of the krone fluctuates in periods by the same magnitude as exchange rates in other open economies. Nevertheless, the prevailing stability of the krone is largely a reflection of confidence that inflation in Norway will be kept at a low level.

Our experience is that changes in the Norwegian interest rate level only have a predictable effect on the krone exchange rate when the change in interest rates also contributes to stabilising inflation. However, the relationship between interest rates and price and cost developments is uncertain. The setting of interest rates thus requires the use of professional judgement and discretion. The basis for exercising discretion is subject to limitations, however. Should any doubt arise as to whether the interest rate is oriented towards nominal stability, this would trigger substantial capital movements.

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An inappropriate setting of interest rates could easily jeopardise financial stability in the domestic economy. The experience of Norway and other countries shows that credit and property markets can be very unstable. If interest rates are kept at too low a level for too long, credit demand will rise sharply, as we witnessed in the 1980s. At that time, rising property prices generated expectations of further price increases, which in turn led to rising credit demand. When the bubble burst, recession ensued with falling asset values, a debt crisis and a growing number of bankruptcies. It is important to bear in mind that this instability is inherent in financial and property markets. We cannot rely on the memory of market participants.

Interaction with income formation

A precondition for a stable krone exchange rate against European currencies is that price and cost inflation in Norway must over time not exceed the corresponding aim for inflation of the European Central Bank (ECB). The ECB orients monetary policy instruments towards price stability, and has defined price stability as an inflation rate below 2 per cent. The rise in prices for imported goods is expected to continue to be relatively low, leaving room for a somewhat higher rise in prices for domestically produced goods and services. Corporate profits and margins vary and influence price inflation from one year to the next, but are to some extent self-regulating. High margins tend to result in stronger wage growth, while low margins lead to tighter cost control. Profits will thus revert to previous levels. Over time, productivity growth therefore determines the level of wage growth that is consistent with stability in prices and the exchange rate. With productivity growth around the average for the 1980s and 1990s, ie in the order of one and a half per cent per year, nominal wage growth should be brought down to between 3 and 4 per cent. There will be room for higher wage growth if productivity growth increases, as seems to be the case in Sweden and Finland.

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In recent years, cost...