Norges Bank projects that consumer price inflation will gradually slow and in the course of next year approach the inflation rate aimed at by the euro area. The annual rise in consumer prices is projected at 2 1/4% in 1999, 2% in 2000, and 1 3/4% in 2001. The projections for 2000 and 2001 have been revised upwards by a quarter percentage point compared with the March Inflation Report, reflecting a moderate upward adjustment of wage growth the next two years and slightly higher import prices. The underlying rise in prices, excluding changes in electricity prices and indirect taxes, is expected to increase by 0.1 percentage point more than the consumer price index this year. For subsequent years, underlying price inflation is expected to shadow the overall rise in consumer prices.
Growth in the Norwegian economy is now slowing, with clear evidence of a contraction in business fixed investment, primarily in manufacturing and the petroleum sector. Low product prices, high pay increases and weak productivity growth have squeezed profits in many enterprises. Mainland business investment is expected to continue to fall, and employment in manufacturing and the construction industry is declining.
So far this year, however, house prices and household consumption have exhibited a sharp rise. Furthermore, there are signs of continued growth in the local government sector. Pressures in sectors that are not exposed to international competition are still substantial. On balance, the estimates for growth in domestic demand have been revised upwards somewhat compared with the March report. Mainland GDP growth is estimated at 3/4% in 1999, 1/4% in 2000 and 1 1/4% in 2001. The turnaround in the labour market is expected to be moderate, with unemployment projected to approach the 1996 level in 2001.
The scale of the turnaround in the economy is uncertain. Continued high growth in domestic demand may intensify pressures in parts of the labour market. This may result in stronger inflationary impulses and higher wage growth than indicated by our current estimates. Import prices may also rise by a greater margin than expected if the world economy rapidly picks up again. On the other hand, the turnaround in the business sector may be more pronounced than expected. If prices for Norwegian export goods remain low, continued weak profitability in the enterprise sector may amplify the decline in investment and increase labour shedding.
As in previous reports, the projections in this report are based on the technical assumption that interest rates remain unchanged over the next six months and then decline in line with market expectations, as measured by forward rates. It is assumed that the krone exchange rate will remain stable against European currencies.
2 RECENT DEVELOPMENTS
2.1 Price and wage developments
Price inflation in line with projections In recent months price inflation has edged up, approximately in line with projections in the March Inflation Report. In May, the year-on-year rise in the consumer price index was 2.5%, see Chart 2.1. Electricity prices have continued to fall. The underlying rise in prices, excluding changes in electricity prices and indirect taxes, has been higher than the rise in the consumer price index since the beginning of the year. In May, the underlying rise in prices was 2.7%.
[Chart 2.1 OMITTED]
Service prices continue to push up price inflation, primarily reflecting the fairly sharp rise in the sub-index for house rents in March. Other service prices are still increasing, albeit at a slightly slower pace in recent months (Chart 2.2).
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The contribution from domestically produced goods has also been slightly higher since April. Petrol prices have risen at a faster pace than the rise in oil prices would imply, reflecting higher margins. The year-on-year rise in prices for imported consumer goods remained unchanged in May.
The rise in prices among Norway's traditional trading partners was 1.1% in April (Chart 2.3) and the rise in prices in euro countries was also 1.1% in April, measured by the Harmonised Index of Consumer Prices (HICP). Price inflation in euro countries has edged up through the spring, primarily as a result of higher energy prices. The HICP showed a rise in prices in Norway of 2.2% in May. The planned common broadening of the coverage of the HICP is expected to bring price inflation in Norway, measured by this index, to the level of the normal CPI. The broadening of the coverage will probably not influence HICP inflation in euro countries.
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The wage settlements appear to have resulted in lower wage growth than projected in the March Inflation Report. The negotiations between the main employees' and employers' organisations gave a pay increase of NOK 1.20 to employees with an income of less than 95% of the average industrial worker's pay. This will contribute about 0.3 percentage point to total annual wage growth, which comes in addition to a carry-over of about 3%. In distributive trades, the contribution from the pay increases to annual wage growth is about 1 percentage point. This sector had a wage carry-over into 1999 of about 2%. Negotiations in the public sector also resulted in moderate pay increases. The pay increase in the local government sector will not be effective until December of this year, and will thus have little effect on wage growth in 1999. The substantial carry-over of 4 1/2% implies, however, relatively high annual wage growth in the local government sector.
2.2 Interest rates, the exchange rate and monetary conditions
Short rates down and stronger krone exchange rate
Since the March Inflation Report Norges Bank has reduced its key rates by 1 percentage point. Since the beginning of the year Norges Bank has reduced key rates on four occasions by a total of 2 percentage points. The European Central Bank has lowered its interest rate on the main refinancing operations by half a percentage point in this period.
The three-month money market rate has fallen by 0.4 percentage point since the March report (Chart 2.4) with the nominal rate down to 6.4% on 16 June. Developments in the market for FRAs (forward rate agreements) indicate that market expectations of a sharp drop in interest rates this year have subsided compared with three months ago. Implied forward rates are also higher than in March.
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The differential between three-month rates for NOK and the euro was 3.7 percentage points on 16 June. It appears that market participants do not expect the interest rate differential against euro countries to narrow as quickly as expected in March.
In the bond market, yields fell in the first half of April. The yield on ten-year government bonds was 4.7% in mid-April. Since the beginning of May bond yields have risen substantially, and the ten-year yield was 5.4% on 16 June. The increase since May reflects higher bond yields internationally, but the differential between yields on Norwegian and German ten-year government bonds has widened somewhat and is now about 1.0 percentage point. However, this differential is influenced by the considerably higher level of short-term rates in Norway compared with Germany. The differential between forward rates ten years ahead, which are not influenced by this, is about half a percentage point. The price expectations implied by the forward rate curve are discussed further in section 3.2.
The krone exchange rate against the euro has appreciated further since the March report, from about NOK 8.50 in mid-March to a little less than 8.20 in mid-June (Chart 2.5). The appreciation of the krone reflects the depreciation of the euro against USD and the rise in oil prices of USD 3 in the same period.
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Whereas the krone appreciated against the euro and the Swedish krona since the March report, it has remained virtually unchanged against pound sterling. The krone has depreciated somewhat against the US dollar and Asian currencies. Measured by the effective import-weighted exchange rate against 44 countries, the krone was 2.5% stronger in May than in March. Euro countries have a weighting of 38% of this broadened index.
Credit growth continues to slow
Twelve-month growth in domestic credit (C2) has slowed over the last year, from a peak of almost 11% in March 1998 to 7% in April this year (Chart 2.6). The high credit growth in 1998 primarily reflected the sharp expansion in fixed investment. The growth in corporate borrowing has been substantially higher than that of households. In recent months, however, this difference has narrowed, which underlines the contraction in investment and continued robust growth in household consumption. Foreign currency loans from domestic sources showed a sharp rise in the second half of 1998. The shift towards foreign currency loans must be seen in connection with Norges Bank's interest rate increases of a total of 4.5 percentage points last year, which made such loans more attractive. In recent months, however, the growth in foreign currency loans has levelled off. Foreign currency loans were primarily raised by enterprises.
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Twelve-month growth in the money supply (M2) was about 8% in the first half of 1998, but fell markedly over the summer. Since October 1998, twelve-month growth has hovered around 5%.
2.3 The cyclical situation
High consumption growth, but stagnation in manufacturing
Activity in the Norwegian economy is now slackening. However, the picture is mixed. While there is clear evidence of a turnaround in business investment, private and public consumption are still expanding.
Household consumption has picked up after exhibiting a sluggish trend towards the end of last year. Retail sales rose by 4.3% in volume terms in the first four months of this year compared with the same period one year earlier. New car sales have been low so far this year, probably reflecting relatively high...