1 SUMMARY 2 RECENT DEVELOPMENTS 2.1 Price developments 2.2 Interest rates, the exchange rate and monetary conditions 2.3 The cyclical situation Box: - The Y2K problem and the effect on financial markets 3 NORGES BANK'S INFLATION PROJECTIONS 3.1 The inflation outlook the next two years 3.2 Inflation expectations 3.3 The risks to the inflation outlook Boxes: - Competitiveness - Inflation differential between Norway and trading partners 4 ECONOMIC DEVELOPMENTS 4.1 Main features 4.2 The international environment and the balance of payments 4.3 Domestic demand 4.4 The labour market The cut-off date for the Inflation Report was 10 September 1999
Norges Bank expects a gradual reduction in consumer price inflation towards the level aimed at by euro countries. Consumer price inflation is projected at 2 1/4%, or slightly lower, in 1999. Price inflation is projected at 2% in 2000 and 1 3/4% in 2001. The main picture is broadly in line with the overview presented in the June Inflation Report. The underlying rise in consumer prices, ie excluding changes in indirect taxes and electricity prices, is put at about 0.1 percentage point higher than the rate of increase of the total consumer price index in 1999. In the following years, underlying price inflation is expected to be the same as the overall rise in consumer prices.
After expanding sharply since 1992, the Norwegian economy is now experiencing a period of weaker growth. Mainland GDP growth is estimated at 1/2% in 1999 and 1/4% in 2000. Thereafter, growth is expected to pick up to 1 1/2% in 2001.
Following several years of strong growth in employment, labour market reserves now appear to be exhausted, and the economy is nearing capacity limits. This has translated into a deterioration in cost competitiveness in the business sector. Over the past two years, wage growth has stood at a good 10 per cent, primarily owing to the income settlement in 1998.
Weaker corporate profits imply a fall in investment in 1999 and 2000. A number of large projects in the petroleum sector will be completed this year, which will be followed by a sharp contraction in investment demand next year.
Lower household spending on consumer goods, in conjunction with the decline in investment, will be reflected in a pronounced downturn in traditional merchandise imports. The estimate for the current account surplus has been adjusted up to NOK 31bn for 1999 against the background of a lower trade deficit for traditional goods and higher oil prices. In the period ahead, the surplus will increase further as a result of strong growth in oil production.
There is considerable uncertainty attached to the amplitude of the turnaround. Growth in domestic demand may be stronger than estimated in the baseline scenario, which would imply continued strong labour market pressures. In recent months, several commodity and energy prices have edged up and some economies are showing stronger-than-expected growth. Unless the US economy suffers a severe setback, a steep rise in commodity and producer prices is more likely than a comparable fall. This implies an increased risk of higher imported inflation in the Norwegian economy.
The projections are based on the assumption that interest rates move in line with market expectations as indicated by forward rates. The exchange rate is assumed to remain stable against European currencies.
2 RECENT DEVELOPMENTS
2.1 Price developments
Lower-than-expected price inflation
In recent months price inflation has been more moderate than expected. In August, the CPI increased by 1.9% on the same month one year earlier (see Chart 2.1). Excluding changes in indirect taxes and electricity prices, the rise in prices was 2.2% in the same period. Falling electricity prices have contributed to the moderate rise in prices. So far this year, electricity prices have declined by more than 5%, which means that the underlying rise in prices has been higher than the rise in the CPI since the beginning of the year.
[Chart 2 OMITTED]
Food prices rose at markedly slower rate during the summer compared with the same period last year. External trade statistics for the second quarter show that prices for imported food fell by around 4% compared with the same quarter of 1998. This may also have had an influence on prices for food produced in Norway.
After rising by around 0% in previous months, prices for imported consumer goods fell by 1.0% in August. Service prices, with wages as a dominant price factor, are still pushing up price inflation, although the rate of increase is slowing (see Chart 2.2).
Price inflation among our traditional trading partners was 1.0% in July. Measured in terms of the harmonised index of consumer prices (HICP), price inflation in the euro area was 1.1% in the same month. In spite of markedly higher oil prices, consumer price inflation among trading partners has remained subdued in recent months (see Chart 2.3). In August, the HICP showed a 1.7% rise in Norway. A planned broadening of the basis for the HICP will probably entail an increase in price inflation in Norway measured by this index, bringing it to the level measured by the ordinary CPI. The broadening is not expected to influence the rise in the HICP in euro countries.
2.2 Interest rates, the exchange rate and monetary conditions
Short rates down and stable krone exchange rate
So far this year, Norges Bank has reduced interest rates in four steps by a total of 2 percentage points. Norges Bank has not reduced its key rates since the June Inflation Report. The three-month money market rate has fallen by about 0.5 percentage point since the June report (see Chart 2.4). The nominal three-month rate was 5.9% on 10 September. In the period to April, three-month rates fell more rapidly than Norges Bank's key rates, and were at times substantially lower than Norges Bank's deposit rate. Since April, money market rates have fallen at a slower pace than Norges Bank's key rates. This is probably due to widespread market expectations of the reductions in key rates in April and June and declining expectations of further cuts thereafter.
The pricing of FRAs may indicate that market participants do not expect much change in three-month rates in the coming year (see Chart 2.5). Special conditions may have contributed to pushing up money market rates and FRA rates beyond the level implied by expectations concerning Norges Bank's key rates. Two such conditions may be developments in the international economy and a higher risk premium in global financial markets in connection with the year 2000. The Y2K effects on the Norwegian financial market are discussed further in a separate box.
The yield on ten-year government bonds is now 6.0%, or 0.6 percentage point higher than in June. Since April, the yield has risen by 1.3 percentage points. The yield differential against corresponding German bonds has hovered around 1 percentage point since June.
The krone has appreciated in the period since June. The exchange rate was strongest at the beginning of July when it reached 8.06 against the euro. Since then, the krone has depreciated against the euro and the exchange rate is now at about the same level as in June (see Chart 2.6). Measured against USD, the krone has firmed by about 1% since the June Inflation Report. Measured in terms of the effective import-weighted exchange rate index, which comprises 44 countries, the krone weakened by 0.8% between May and August.
Stable credit growth
The growth in domestic credit (C2) has been relatively stable in recent months after moving on a downward trend for a year. The reduction in interest rates so far this year may have contributed to sustaining the growth in credit, but may also reflect the sharp rise in house prices in 1999.
The growth in total credit (C3), which includes both domestic and foreign sources, slowed in the first six months of the year. At the end of the second quarter of 1999, total gross debt was 10% higher than one year earlier. Credit growth quickened at the end of last year, and was 12% in the period to end-December 1998. This increase is primarily due to the sharp rise in twelve-month growth in foreign credit, which reached close to 30% at the end of December. State enterprises, a group that includes some of the large oil companies, accounted for a large share of the increase as a result of increased foreign borrowing in this period. The slowdown in total credit growth in the first quarter of 1999 was ascribable to slower growth in domestic credit (C2). The year-on-year growth in credit from domestic sources fell in both the enterprise and the household sector in this period. Growth in foreign credit remained high, but tapered off during the second quarter. At the end of June, twelve-month growth was about 21%. A further reduction in the period ahead may take place if investment activity in the oil industry falls sharply.
In the first five months of 1999, the year-on-year growth in M2 varied between 3.5% and 5.5% followed by somewhat higher growth in June and July (see Chart 2.7). In July, M2 was 7.7% higher than one year earlier. Part of the increase must, however, be seen in connection with tax refunds that were disbursed earlier this year than in 1998 as a result of the simplified tax return.
2.3 The cyclical situation
Slower economic growth
There is now clear evidence of a slowdown in growth in the Norwegian economy. According to the quarterly national accounts for the second quarter, mainland GDP growth (market prices) slowed to 0.5% between the first half of 1998 and the first half of 1999. Fixed investment was the main factor behind the slower growth rate. In the first half of the year, fixed investment in the mainland economy contracted by 7.2% compared with the same period one year earlier. GDP at market prices provides an indication of total value added. Adjusted for indirect taxes and correction items, mainland GDP increased by 1.4% in the first...