Economic perspectives.

Author:Gjedrem, Svein
 
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1 Introduction

The poet Rolf Jacobsen would have been 100 years old this year. He was particularly interested in geography. In an interview with Telemark Arbeiderblad in 1971, he stated that the Bible was a work of substantial importance, but that the same could be said about the comprehensive guide to public transport in Norway. (1) In one of his geography poems, he writes:

"When the sun is shining on China the stars are twinkling here. And the reverse. Asia is vast. Half the earth's land mass [...]>>. (2)

Yes, Asia is vast. The rapid expansion in China and other Asian countries is of growing importance to Norway. These countries are a major source of cheap consumer goods and services and demand for our raw materials.

2 Interest rates, inflation and the business cycle

The Norwegian economy is now booming following the pronounced upswing since summer 2003 (Chart 1). The upturn followed a period of slower growth as from 1998 and a mild recession in 2002 and into 2003. Even though there have been cyclical changes, growth has been very high over the past 15 years.

Norway is one of the nations that has gained most from trade liberalisation and increased cross-border flows of capital, technology and labour. Norway has experienced the benefits of shifts in the division of labour across countries and regions.

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First, Norway's terms of trade have improved markedly (Chart 2). We can buy one and a half to two times the volume of imports for the price paid for our exports than was the case only 5-6 years ago. Prices for oil and gas, shipping, fish, industrial commodities and engineering products have increased considerably. Moreover, Norwegian importers have gained access to new markets in central Europe and Asia which offer considerably cheaper consumer goods. A similar situation has not been seen since World War I, when earnings in the shipping industry and other export industries were exceptionally high for a period. (3)

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Second, the supply of foreign labour has increased markedly after EU enlargement in 2004 (Chart 3). Over the past two years, these labour inflows have accounted for more than 30 per cent of growth in our labour force. Norwegian companies have also been able to be considerably bolder in undertaking new assignments and investments knowing that they can procure labour throughout Europe. In addition to increased labour inflows from Poland, Lithuania and other central European countries, we have long benefited from inflows of labour from Sweden. Many workers are on temporary assignment and their consumption is primarily concentrated in their home country. The Norwegian economy has seen a net capacity increase.

Third, the Norwegian business sector has been quick to integrate information technology. This applies both to companies competing on international markets (Chart 4) and those supplying goods and services to the domestic market. In comparison with other countries, it is particularly productivity gains in banks and other service sectors that stand out. Examples are automated processes and swifter payments in the financial industry and improved inventory and management systems in commerce and transport.

In Norway, monetary policy is oriented towards low and stable inflation. The operational target is consumer price inflation of close to 2.5 per cent over time. We operate a flexible inflation targeting regime. Both variability in output and inflation are given weight in interest-rate setting.

A decline in import prices, ample supply of labour and high productivity growth have boosted the growth potential of the Norwegian economy and led to very low inflation. Against this background, it has been appropriate to stimulate demand for goods and services. We consider a normal real interest rate to be in the order 2 1/2 to 3 1/2 per cent (Chart 5). We have kept the interest rate markedly lower than that level since autumn 2003.

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Since the economic recovery started, it has gradually broadened. Capacity utilisation is now at a very high level (Chart 6). There are reports of limited capacity in most industries and regions and labour shortages in almost every occupational category. There are shortages of drivers, pre-school teachers, supervisors, engineers, carpenters, architects, auditors, accountants, IT personnel and health workers. It has probably not been since the 1970s that we find such widespread reports of purely physical production constraints, for example now in the form of shortages of rigs and other equipment in the petroleum industry or shortages of plank, concrete and insulation in the construction industry.

When we reduced the interest rate in 2003, demand and output rapidly picked up. However, it took a long time for employment to rise and the next phase from a pick-up in employment to a fall in unemployment was also long. But now the upturn has entered into a mature phase. As illustrated in Chart 7, capacity utilisation was higher than its normal level in 2006. Nevertheless, wage growth has thus far been moderate and inflation is clearly lower than the target of 2 1/2 per cent.

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The decline in import prices, increased labour flows and higher productivity came into clear evidence when wage and price inflation fell markedly 3-4 years ago. A period of low real interest rates would nevertheless have been appropriate in order to realise the added growth potential. However, after several years of strong growth, resources are now in short supply. With the substantial number of businesses now facing capacity constraints, we can expect inflation to pick up. It is uncertain whether inflation will then rise quickly or only gradually near target.

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Strong export growth, high oil investment and after a period higher growth in general government demand have contributed to the upswing in production and employment. But the low level of interest rates has also been a prominent driving force. This reflects the dynamics inherent in interest-rate setting. Low interest rates have stimulated demand and production and should lead to higher inflation, to which we are now reacting by raising interest rates.

Under inflation targeting, it is important to be mindful of the effects of higher interest rates on the krone exchange rate when inflation is low. Interest rate developments in other countries are thus of importance to interest rates in Norway.

Unemployment has declined sharply in recent quarters (Chart 8). The pace of decline and the level of unemployment are reminiscent of two earlier cyclical peaks, one in the mid-1980s and the one that began at the end of the 1990s and continued into the present decade. Both booms culminated in sharply accelerating cost and wage inflation.

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Some of the driving forces that have boosted the growth potential of the Norwegian economy and restrained inflation may diminish. Prices for imported goods are no longer decelerating at the same pace. Labour market conditions are tightening in Sweden and Poland. There are also signs that productivity growth in service sectors is slackening.

We are now seeing the first signs of higher wage growth. We cannot ignore previous episodes of abrupt shifts in wage growth during boom periods. On the other hand, improved labour market adaptability and the supply of foreign labour may have a dampening impact. Unemployment may thus stabilise at a lower level than earlier. Moreover, the social partners' experience of the impact of substantial wage increases on interest-rate setting may also restrain pay increases in the centralised settlements.

Economic policy will increasingly have to reflect the capacity constraints facing many Norwegian enterprises.

Given the high level of activity and the prospect of a...

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