Economic perspectives.

Address by Governor Svein Gjedrem at the meeting of the Supervisory Council of Norges Bank on Thursday, 17 February 2005

Introduction

This year, Norway is commemorating the centenary of the dissolution of the union with Sweden. Historically, an important part of nation-building has been the establishment of a monetary system and a central bank. In Norway, the stage was set for the introduction of a national currency in autumn 1814. With the prospect of a union with Sweden, a clause was included in the Constitution stipulating that Norway should maintain its own bank and its own monetary system. The monetary unit was the specie daler.

In 1875, the Storting (Norwegian parliament) decided to join the currency union that Denmark and Sweden had established two years earlier. The specie daler was then replaced by the krone. One Norwegian krone was worth 0.40323 grains of fine gold.

In the latter part of the 1800s, Norway benefited from free trade and free capital movements and became a relatively prosperous country. The standard of living in Norway did not lag behind that of Sweden (Chart 1).

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The currency union was maintained after the political union with Sweden was dissolved. The agreement lost its practical significance after the gold standard was suspended in 1914. The agreement was not formally terminated until 1972.

From an economic viewpoint, the dissolution of the union in 1905 was a painless process. Former Central Bank Governor Nicolai Rygg (1) wrote: "For 1905, (Norges Bank) points to the bright aspects of developments over the year, i.e. rising exports...., but it takes time for confidence and the enterprising spirit to grow sufficiently to generate greater vitality and activity". Norges Bank's role was primarily to secure confidence in the monetary system. There were fairly large cash withdrawals from banks. Many sought to safeguard their wealth by investing in foreign bonds. Banks had to resort to loans from Norges Bank. The Board of Norges Bank nevertheless chose to leave the interest rate unchanged at 5 per cent. In Rygg's words, this would not contribute to undermining the confidence-inspiring calm that marked major historical events.

Economic developments were favourable up to World War I.

International real interest rates have fallen

The interest rate level is lower today than in 1905. In fact, Norges Bank has not allowed the key rate to be this low since the Bank was established in 1816. This partly reflects international conditions.

In many countries interest rates were reduced considerably when the economic situation deteriorated early in 2000. Interest rates adjusted for inflation, i.e. real interest rates, are now also low.

The first decades following World War II were marked by stable nominal interest rates, moderate inflation and low, but positive real interest rates. In subsequent periods, real interest rates have fluctuated (Chart 2).

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In the 1970s inflation surged. Nominal interest rates rose, but to a lesser extent than the inflation rate, and real interest rates turned negative. Early in the 1980s, monetary policy was tightened considerably in many countries. Real interest rates moved up. Inflation gradually fell and stabilised again at a low level. This paved the way for a decrease in real interest rates in the 1990s before they fell further after the economic turnaround in 2001.

Low real interest rates may be ascribed to several factors:

Inflation has been low for such a long period that savers require a low premium as a hedge against unexpected inflation in the future.

In order to prevent an appreciation against the dollar many Asian central banks have been buying US government bonds, exerting downward pressure on yields.

Low short-term interest rates in the US, Japan and euro area countries are inducing investors to shift into more long-term securities, with an attendant fall in long-term interest rates.

The US and some other countries have increased their key rates, but expectations of the rate of increase ahead have been dampened. The fall in long-term interest rates may be attributable to new assessments of the growth outlook for the world economy.

In Norway, the real interest rate may deviate from external real interest rates when growth prospects diverge. This will also lead to a change in the real krone exchange rate, so that the expected return on investments in Norway and abroad become about the same. However, over time long-term real interest rates have largely followed international rates, and in line with international developments long-term interest rates in Norway have also fallen markedly (Chart 3).

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Low risk?

Real interest rates abroad are unusually low, and the risk premium is also low. Savers and investors are offered a wide range of investment options. Risk and expected returns are assessed when choosing among the alternatives. The premium that investors require to take risk has fallen considerably in recent months and is now generally low.

For example, there is little difference between government bond yields and yields on bonds issued by private enterprises. The extra premium that emerging economies have to pay on loans is also small. Moreover, premiums paid to hedge against future fluctuations in foreign exchange and equity markets are small (Chart 4).

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The low risk premiums may reflect fairly solid growth in the world economy and a strengthening of corporate profits and financial positions. It seems that credit risks are fairly well diversified in securities markets and international banks appear to be solid. Fewer major negative events have shaken the markets in recent periods.

But another explanation may be that low interest rates have prompted investors to take more risk, thereby pushing down risk premiums. In that case, lower premiums reflect an expansionary monetary policy rather than low real risk.

Imbalances in the world economy

Low interest rates and risk premiums stand in stark contrast to the considerable imbalances in the world economy.

There are particularly larges imbalances both with regard to the US trade and current account balance. This partly reflects the US federal budget deficit. Moreover, US households have a high level of consumption and a low level of saving. Strong demand in the US has sustained growth in the world economy. The deficit in the US is matched by surpluses in Europe and Asia (Chart 5).

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A persistent deficit has pushed up US foreign debt to a high level (Chart 6).

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The US population is growing faster than that of other OECD countries. This may suggest that saving in the is somewhat lower and investment somewhat higher, but the impact is now considerably greater than implied by demographic factors alone.

The imbalances may continue for a period. International capital markets are deep and liquid with an ample supply of credit for US borrowers. If creditors begin to fear a fall in prices and withdraw, this may still trigger substantial corrections. This may lead to higher interest rates and perhaps also a fall in US equity markets that spills over to other countries' financial markets. In that case the dollar will also depreciate. The household debt burden in the US may be another source of instability if households abruptly reduce both demand for housing and consumption.

The Federal Reserve is now gradually increasing interest rates and the first measures aimed at reducing the US budget deficit have been announced. This may curb growth in domestic demand and imports of goods and services. However, the US authorities will probably not go as far as to bring economic growth to a halt, with an accompanying increase in unemployment.

The US issues the world's most important settlement and reserve currency. States and agencies in the US have access to dollar-denominated loans in major international capital markets. The exchange rate risk lies with foreign creditors. The US may have a long-term interest in maintaining a stable dollar that is used in international...