Evaluation of Norges Bank's projections for 2007.

• Author: Lokshall, Raymond
• Position: Report

The economic upswing since the summer of 2003 has been stronger and lasted longer than projected by Norges Bank. Growth in the mainland economy in 2007 was the highest since the early 1970s and strong in the light of the advanced phase of the current cyclical upswing. Capacity utilisation in the Norwegian economy in 2007, as measured by the estimated output gap, was higher than projected in 2006 and 2007. Unemployment was lower than expected. Underlying inflation was nevertheless low, broadly in line with that projected. There are several reasons why growth in 2007 was stronger than expected. Improved terms of trade in recent years have probably had a greater effect on demand than anticipated. At the same time, an ample supply of labour and high productivity growth provided a higher-than-expected boost to the economy's potential output. Norges Bank's projections of developments in 2007 were broadly in line with those of other forecasters.

1 Introduction

Norges Bank's projections of inflation and economic developments are an important basis for setting interest rates. Evaluating these projections can give us information about the reasons for deviations between actual and projected developments in the economy. Such deviations may, for example, be related to misinterpretation of the current state of the economy or to unforeseen disturbances. Forecast errors may also be due to insufficient understanding of how the economy works. Evaluations of our projections can therefore provide additional insight into the workings of the economy and possible structural changes. We can use this insight when preparing projections and when developing and improving our analytical instruments.

The Bank's short-term and long-term projections are prepared on different bases. This must also be taken into account when evaluating projections in retrospect. The short-term projections are based largely on interpretation and assessment of incoming data. The projections of economic developments in the somewhat longer run should be assessed in the light of interest rate projections. Norges Bank sets interest rates with a view to stabilising inflation around the target in the medium term. Interest rates must also be set to achieve a reasonable balance between developments in inflation and capacity utilisation.

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This article evaluates the projections of economic developments in 2007 published in the Inflation Reports in 2006 and the Monetary Policy Reports in 2007. We look first at developments in inflation and output in 2007. We then analyse deviations between the projections and actual developments in more detail. Finally, our projections are compared with those of other forecasters, both for 2007 and over a longer period.

2 Inflation, output and interest rates in 2007

Inflation as measured by the consumer price index (CPI) was heavily influenced by a fall in electricity prices in 2007. The CPI rose by 0.8 per cent from 2006 to 2007, down from 2.3 per cent the previous year. The CPI adjusted for tax changes and excluding energy products (CPI-ATE) climbed from 0.8 per cent in 2006 to 1.4 per cent in 2007. Other measures of underlying inflation have also risen since late summer 2007 (see Chart 1). A higher rise in prices of domestically produced goods and services pushed up CPI-ATE inflation from 2006 to 2007, reflecting higher wage growth and slower productivity growth. The rate of increase in prices for imported consumer goods fell in 2007, due partly to a strong krone. Inflation was pushed down by a fall in prices for audiovisual equipment and clothing and footwear.

The economic upswing that has marked the Norwegian economy since the summer of 2003 gained momentum in 2007. Growth in mainland GDP from 2006 to 2007 was the strongest since the early 1970s at no less than 6.0 per cent (see Chart 2).

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Consumption increased by 6.4 per cent in 2007 and provided the main contribution to growth in aggregate demand for goods and services (see Chart 3). Goods consumption rose by 7.7 per cent, while spending on services rose by 4.6 per cent. Car purchases showed a sharp increase in 2007, accounting for around 1 percentage point of consumption growth. Business investment in mainland Norway also made a significant contribution to overall growth in 2007, and a somewhat larger contribution than in 2006. As in 2006, public sector consumption and investment made a considerable contribution to overall growth.

Strong growth in the supply of labour and a long period of high productivity growth have boosted the underlying potential output of the Norwegian economy. In Monetary Policy Report 1/08, potential output was estimated to have increased by 4 1/4 per cent in 2007. Strong growth in potential output has helped to keep inflation low during the present economic upswing despite rapid economic growth.

The high rate of growth in productivity can be attributed partly to increased specialisation, new technology, better logistics and more efficient organisation of production. (2) The economic upswing may have contributed to further growth in productivity in recent years, partly because there has been a need to make more efficient use of the labour and capital available. This potential is probably now in the process of being exhausted. Productivity growth in the mainland economy fell from 2006 to 2007.

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Employment grew by 3.8 per cent in 2007, the highest rate of growth recorded for more than 40 years (see Chart 4). Growth was also strong in 2006 at 3.4 per cent. The record-high employment growth of recent years has led to a sharp fall in unemployment. Unemployment as measured by Statistics Norway's Labour Force Survey (LFS) has not been that low since the latter half of the 1980s.

The strong growth in employment has coincided with an ample supply of labour in recent years. The supply of labour from other countries has shown a particularly strong increase since EU enlargement in 2004 (see Chart 5). Foreign labour inflows account for almost half of the growth in the labour force in recent years. Labour force participation in general has also risen, with a particularly strong increase among younger and older age groups.

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Interest rates were raised further in 2007 (see Chart 6). The key policy rate was 3.5 per cent at the beginning of the year. It was raised in seven increments of 0.25 percentage point, and ended the year at 5.25 per cent.

3 Deviations between projections and actual developments

Table 1 shows the key assumptions and projections for 2007 from the three Inflation Reports in 2006 and the three Monetary Policy Reports in 2007. (3) As illustrated, economic growth was stronger than expected, while underlying price inflation was largely as projected.

Interest rates

The key policy rate was higher in 2007 than projected in the reports published in 2006 and 2007. In Inflation Report 1/06, the interest rate path indicated a rate of 3.7...