Evaluation of Norges Bank's projections for 2006.

• Author: Nordbo, Einar W.

Growth in the mainland economy in 2006 was appreciably higher than projected by Norges Bank and it is likely that the output gap was also more positive than projected. At the same time, consumer price inflation adjusted for tax changes and excluding energy products was lower than expected. Unexpectedly low inflation coupled with higher-than-projected output and employment growth may reflect the influence of unforeseen factors on the supply side of the economy. In recent years, for example, inward labour migration has been higher than assumed by Norges Bank. This has eased labour shortages and contributed to growth in potential output. Productivity growth has also been higher than expected in many industries. Other forecasters' projections for developments in output and prices in 2006 were not substantially better than Norges Bank's projections.

1 Introduction

Projections for inflation and future economic developments are an important basis for monetary policy decisions. Therefore, Norges Bank works continuously to improve the basis for these projections. Analysing deviations between actual developments and projections is an important part of this work. This article evaluates the projections for 2006. First, we describe briefly actual economic developments in 2006. We then look at the deviations between actual developments in 2006 and Norges Bank's projections at different times. We place most emphasis on the projections in Inflation Report 1/05 and subsequently. Next, we compare Norges Bank's projections with those of other institutions. Finally, we consider the historical accuracy of Norges Bank's projections.

In the Inflation Reports, Norges Bank has presented projections for developments during the next three years or over a longer period. The methods utilised for preparing projections depend on the forecast horizon. The two-to-three-quarter-ahead forecasts depend largely on the analysis of the current economic situation and an assessment of how various disturbances which have affected the economy will unfold. Monetary policy influences the economy with a lag. Therefore, the interest rate path on which the Report's projections are based will not have a significant impact on the short-term projections. Simple statistical models where economic theory is not a main component and econometric equations for developments in individual variables are useful in preparing the short-term projections.

The projections for developments in the somewhat longer run are important for determining the interest rate path that is best suited to reaching the inflation target and stabilising developments in output and employment. Economic models that incorporate monetary policy directly are therefore important for these projections. At the same time, the assessment of the current situation and the short-term projections are an important premise for the more long-term projections. The longer-term projections also depend on developments in the exogenous variables, such as government spending and global economic developments, being in line with projections. (2)

The projections for economic developments are necessarily uncertain. This is partly because the forecasts are based on incomplete information about the current economic situation, about the driving forces in the economy in the period ahead and about the functioning of the economy. (3) Therefore, Norges Bank presents the projections for the most central economic variables with a fan chart. (4) According to the Bank's assessment, the most probable outturn is the midpoint on the fan, but the probability of realising this exact outturn is relatively small. Therefore, it would be incorrect to say that the projections are wrong if actual developments are not the midpoint on the fan. A more interesting question is whether the fan charts illustrate the correct probabilities of different outturns. We will return to this question in Section 5. In the following sections, we will concentrate on the point forecasts.

2 Inflation, output and interest rates through 2006

The economic recovery that has marked the Norwegian economy since 2003 continued in 2006. Low interest rates, strong and sustained growth in the global economy and a substantial improvement in Norway's terms of trade have been important driving forces behind the upturn. Low interest rates have contributed to strong growth in private consumption and housing investment, while high oil prices have made it advantageous to increase investment in the petroleum sector. Growth in business investment and non-petroleum exports has also picked up gradually.

Strong growth in productivity and a temporary decline in sickness absence made it possible to increase output without increasing employment for a long period. Since end 2005 and through 2006, however, increasing demand for labour resulted in strong employment growth and a pronounced decline in unemployment (see Chart 1). At end 2006, unemployment was in line with the level prevailing during the previous boom at the end of the 1990s. Some of the increasing labour demand has been satisfied by labour inflows from the new EU member states (see Chart 2). The output gap, which summarises Norges Bank's view of capacity utilisation in the economy, was clearly positive at the end of 2006 according to the Bank's assessment.

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Consumer price inflation was pushed up by a sharp increase in energy prices and was close to the inflation target in 2006, but in spite of a boom that had persisted for more than three years, underlying inflation remained low. Consumer price inflation adjusted for tax changes and excluding energy products did not rise from 2005 to 2006. Other measures of underlying inflation also indicated relatively stable developments (see Charts 3 and 4). The low underlying inflation must be seen in the light of relatively low wage growth in relation to the economic situation. Increased labour market competition as a result of increased inward labour migration and the threat of relocating production abroad may have contributed to restraining wage growth. Productivity growth has also been high and the continued shift towards imports from low-cost countries has contributed to a low rise in prices for imported consumer goods and imported intermediate goods. Increased competition in some Norwegian product markets has also been cited as one explanation of the low underlying inflation. (5)

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Although underlying inflation has remained low, increasing capacity utilisation in the Norwegian economy has contributed to a gradual increase in the key policy rate since early summer 2005 towards a more normal level. In 2006, the key policy rate was increased by 0.25 percentage point at five out of nine monetary policy meetings, and at the end of the year the key policy rate was 3.5 per cent (see Chart 5). This was 1.75 percentage points higher than when interest rate increases began in June 2005.

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3 Deviations between projections and actual developments

Table 1 shows central assumptions and projections for 2006 in the Inflation Reports published since spring 2005. (6)

The output gap

The output gap expresses the relationship between the actual level of output in the economy and the output level that is consistent with stable inflation over time, i.e. potential output. Since potential output is not directly observable, historical values for the output gap must also be estimated. Norges Bank's projections for the output gap in 2006 had been stable at around one per cent before they were revised up in the last two Inflation Reports in 2006. The projected development in the output gap through 2006 has also changed somewhat. In Inflation Report 1/05, the output gap was projected to peak in the first part of 2006, but since then the estimated cyclical peak has been pushed out in time. At the same time, the economic upturn has been stronger than projected by Norges Bank (see Chart 6).

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The output gap was revised up in 2006 primarily because actual growth in the economy has been considerably higher than projected. In Inflation Report 1/05 and 2/05, growth in mainland GDP was projected at 3 per cent, but from Inflation Report 3/05 the projection was gradually revised up, and the first national accounts figures published for 2006 as a whole show annual growth of 4.6 per cent. Growth in employment was also considerably stronger than expected in 2006, and unemployment fell appreciably faster than projected. Employment and unemployment levels in 2006, however, were very close to the projections from early 2005 (see Chart 15 in Section 4).

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The estimate for the output gap in 2006 would have been significantly higher if Norges Bank had not revised up its estimate for growth in potential output. (7) Revised national accounts figures have shown that recent years' growth in both output and productivity has been stronger than indicated by earlier figures, and since the EU enlargement in 2004, the supply of foreign labour has increased more than expected. Overall, this indicates that potential growth in the Norwegian economy in recent years may have been stronger than previously assumed by Norges Bank. In Monetary Policy Report 1/07, the estimate for potential growth in 2006 was revised up from 2 1/2 to 3 1/4 percent. Potential growth was also revised up for several of the previous years.

Norges Bank has also revised up the estimate for potential output backwards in time in earlier Reports. As a result, the Bank now assumes that there was somewhat more spare capacity in the economy in 2005 than projected in the Reports published that year (see Chart 6). The third factor that can in principle contribute to a larger- or smaller-than-projected output gap, i.e. the uncertainty surrounding the level of the output gap at the time the projection was prepared, has pointed towards a somewhat lower output gap if we look at the...