Evaluation of Norges Bank's projections for 2004.

• Author: Lilleas, Per Espen

The assessments of capacity utilisation in the Norwegian economy in 2004, measured by estimates of the output gap, changed only moderately through 2003 and 2004. For the past year, Norges Bank has projected that the Norwegian economy was approaching normal capacity utilisation towards the end of 2004. In the Inflation Reports in 2003, the rise in the consumer price index adjusted for tax changes and excluding energy products (CPI-ATE) was projected to move up by 2 per cent cent in 2004. The projection was revised downwards to 1/2 per cent in the March 2004 Inflation Report. Price inflation in 2004 was substantially lower than projected in 2002-2003, but the projections in the 2004 were close to the mark in relation to actual developments.

1. Introduction

   This article provides an evaluation of the projections for inflation and economic developments in 2004 that have been made since the last Inflation Report in 2002.

   There may be many reasons why projections deviate from actual developments. These reasons can be grouped into four main categories:

   Random disturbances

   --The economy is subjected to unexpected events or shocks that it is not possible to take account or in advance.

   Description of the current situation

   --There is uncertainty surrounding the actual state of the economy at the time the projections are made. This is because it takes time for the statistics to be published, and because the statistics are often extensively revised subsequently. An incorrect starting point for the assessment of developments in the period ahead may cause deviations between projections and actual developments.

   Assumptions

   --The protections in the Inflation Reports in 2002-2004 were based on technical assumptions about interest and exchange rates. The projections in Inflation Report 3/02 and 1/03 are based on the assumption of an unchanged interest and exchange rate through the projection period. As the interest rate declined to a lower level, the assumptions regarding the interest and exchange rate changed. Two sets of projections were presented in Inflation Report 2/03. One was based on unchanged interest rate and exchange rate through the projection period. The other was based on an assumption that the interest rate and exchange rate would shadow market forward interest and exchange rates. The projections in Inflation Report 3/03 and thereafter have been based on similar assumptions. One important reason for the change was that projections based on a clearly unreasonable interest rate assumption would be of limited value as a basis for decision-making. (2) Nor would there be any point in evaluating projections based on unrealistic assumptions. In the shorter term, monetary policy assumptions normally have a more limited influence on the projections.

   --The projections are also based on assumptions concerning international economic developments, oil prices, public expenditure and direct and indirect taxes. These are factors that influence economic developments, but which monetary policy cannot influence. If developments differ from the assumptions concerning these variables, the projections will not be accurate. How closely in line these assumptions are with actual developments depends partly on the quality of Norges Bank's analyses, but will also be influenced by various random disturbances.

   Structural changes and understanding of the functioning of the economy

   --Economic relationships may change over time. This may be partly due to changes in framework conditions, such as market deregulation, which results in stronger competition.

   --It is uncertain how monetary policy influences both the real economy and prices. The analytical apparatus that is used may provide an inaccurate or inadequate description of actual economic relationships. Over time, these relationships will also be influenced by structural changes.

2. Developments in inflation and output in 2004

   Consumer price inflation fell markedly from summer 2003 and continued to fall up to spring 2004. Consumer price inflation adjusted for taxes and excluding energy products (CPI-ATE) was 0.3 per cent in 2004. Inflation was very low in the first half of 2004, but gathered pace through the autumn and reached 1.0 per cent in November and December and 0.7 per cent in January and February 2005. The rise in prices for domestically produced goods and services moved up to about 1 1/2 per cent at the end of 2004. Prices for imported consumer goods were more unstable. At the end of the year, these prices were about 1/2 per cent lower than at end-2003 (see Chart 1). After adjusting the CPI-ATE for the introduction of maximum rates for day-care places, which has a one-off effect on inflation, and the direct effect of interest rates on house rents, underlying inflation was about 3/4 per cent in 2004. (3) Alternative measures of underlying inflation also show that inflation was low in 2004 (see Chart 2). Generally, the indicators show an underlying annual rise in consumer prices in the order of 1/2-1 1/2 per cent. (4)

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   While inflation was primarily pushed down by the fall in imported consumer goods in 2003, the more subdued rise in house rents and the fall in prices for services with important price components other than wages made a strong contribution in 2004 (Chart 3).

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   After a relatively moderate recession in the first half of 2003, growth in the Norwegian economy picked up markedly in 2004. Cost inflation fell to a more sustainable level after a short period with a tight monetary policy. Monetary policy easing through 2003 and into 2004 contributed to a sharp rise in private consumption and housing investment. Activity in service industries and the construction sector rose sharply. Conditions for manufacturing improved as a result of high petroleum investment, the global economic recovery and a weaker krone. Profitability improved for mainland enterprises. Investment began to increase in a number of industries. Export growth picked up markedly.

   The growth potential of the Norwegian economy seems to have increased more than normal in 2004. This is related to increased competition and a sharp decrease in sickness absence. It is likely that these developments will contribute to somewhat stronger growth in the Norwegian economy in the short term without the supply of labour or productive capital constraining growth. Nevertheless, the strong growth in 2004 implies that capacity utilisation has increased and has now probably reached its historical normal level.

   The output gap, as estimated by Norges Bank, was slightly negative but closing in 2004. The recent downturn was nonetheless fairly mild compared with previous downturns in the Norwegian economy. Although the output gap estimates are highly uncertain, other institutions' output gap estimates present a similar picture (see Chart 4).

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3. Deviations between projections and actual developments

   Table 1 shows key assumptions and projections for 2004 in the Inflation Report published from autumn 2002 to end-2004. The last column shows actual developments. The box "Changes in the projections" at the end of this article provides a more detailed account of changes in the projections in the various inflation reports.

   There has been relatively little change in the projections for capacity utilisation in the Norwegian economy in 2004. The output gap has been estimated at fairly close to zero through 2003 and 2004 (see Chart 5). Growth in the Norwegian economy in 2004 was higher than projected by either Norges Bank or other institutions (see Chart 6). Growth estimates for 2004 were gradually revised upwards through 2003 and in early 2004, which must be viewed in the light of the easing of monetary policy, among other things. The reason that Norges Bank has nonetheless left the estimate of the output gap in 2004 unchanged is that potential output in the Norwegian economy probably also increased more than normal in 2004, while capacity utilisation was somewhat lower in 2003 than previously assumed. However, national accounts figures published in December 2004 and March this year have provided a basis for a downward revision of the estimated output gap in 2004. The Norwegian economy is nevertheless assumed to have approached normal capacity utilisation towards the end of 2004.

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   In 2004, inflation measured by the CPI-ATE was substantially lower than projected by Norges Bank in 2002 and 2003. In the Inflation Report published from autumn 2002 to autumn 2003, the rise in the CPI-ATE was projected at about 13A percentage points higher than the actual rise of 0.3 per cent in 2004. Since Inflation Report 1/04, inflation in 2004 has been closely in line with Norges Bank's projections.

   The difference between actual and projected developments in output and prices must be viewed in the light of developments in the various assumptions underlying the projections.

   Normal capacity utilisation towards the end of 2004 in line with previous assessments

   Capacity utilisation lower than projected in 2003

   Our assessment is now that capacity utilisation in the Norwegian economy was lower in 2003 than projected in the Inflation Report in 2003. The output gap is now estimated at -1 1/4 per cent, whereas in Inflation Report 1/03 it was estimated at zero. The downward adjustment reflects weaker-than-projected developments in output and the labour market, at the same time as domestic inflation was lower than expected. National accounts figures published in December last year also show that growth in the Norwegian economy was lower in 2002-2003 than projected through 2004. This indicates that there were probably more available resources in the economy in 2003 and at the beginning of 2004 than previously assumed.

   ... higher-than-projected growth in the Norwegian economy in 2004

   More expansionary monetary policy led to higher growth in the Norwegian economy

   Pressures in the Norwegian economy...