October 27, 1998
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Norway -- 1998 Article IV Consultation Preliminary Conclusions of the Staff Mission October 27, 1998
3. Norway’s existing economic strategy has gradually become inoperative. The breakdown began with fiscal policy, and subsequently spread to incomes and exchangerate policy. Reflecting the rapid expansion of mainland GDP, output had returned to levels consistent with full utilization of normal productive capacity by 1996, and since then significant excess demand pressures have emerged. Nevertheless, fiscal policy, as measured by the cyclically-adjusted, non-oil budget position of the central government, was close to being neutral in 1997-1998. 4. While labor and employer groups are to be commended for their efforts to moderate wage settlements in 1996-97, in the face of excess demand and tight labor markets, these were not sufficient to maintain incomes policy discipline in the 1998 wage round. Average wage increases are expected to be about 6 percent this year, some 2 percentage points above the average rates of wage increase registered in the five preceding years. Wage settlements taking effect during the last months of 1998 are particularly high, implying that the average rate of increase in wages next year could well be in the range of 6-7 percent. 5. Against this background, the exchange rate of the krone has come under significant downward pressure since early August and domestic interest rates have risen. In part, the depreciation of the krone appeared to reflect market reactions to continued low prices for oil and other primary commodities and a shift in portfolios toward assets in major money market centers, as a result of turmoil in international markets. However, domestic developments, including the high rate of wage settlements and uncertainty about the future course of macroeconomic policy in Norway, may well have exacerbated the downward pressure on the exchange rate. The government and Norges Bank have indicated that they consider the current orientation of monetary instruments, including short-term interest rates, to be consistent with a return of the exchange rate toward its previous trading range, once uncertainties about fiscal policy are resolved.
Put Macroeconomic Policy on a Sounder Footing 7. Recent exchange market and wage developments provide further evidence of the need for a significant tightening of fiscal policy, both to address demand pressures and to help restore a more appropriate long-run balance. IMF staff estimates suggest that the positive output gap--the amount by which mainland real GDP exceeds its historical trend--is at least 2½ percent this year. A fiscal contraction of about 1 percent of mainland GDP, as reflected in the government’s budget proposal, should be viewed as the minimum necessary to begin reining in excess demand. As discussed further below, one reason that neither an exchange rate target nor an inflation target could be credible in the absence of fiscal discipline is that excessive reliance on monetary policy to achieve the target can lead to lower growth than a more balanced policy mix, tending to undermine the political basis for the policy. 8. While the first priorities are the size and timeliness of the fiscal adjustment, it would be preferable for the reduction to come as much as possible through control of expenditure, rather than revenue increases. This reflects two considerations. First, the tax burden in Norway is already high by international standards. Increasing already high rates of taxation would tend to undermine Norway’s international competitiveness. Second, the analysis of long-term prospects in connection with the budget proposal demonstrates that, while it should be feasible to accumulate balances in the State Petroleum Fund that are sufficient to enable the government to meet its future pension liabilities, this will require holding public employment and expenditure to rates of increase in the coming decades that are well below the actual increases experienced in the recent past. Over the past two years the potential imbalance has actually become larger, as a result of changes in early retirement schemes and pension entitlements that would raise pension obligations over the long run by about 2 percent of GDP. Norway should not lose the opportunity to use its oil wealth to put fiscal policy on a sound long-term footing. 9. With regard to monetary and exchange rate policy, it is clear that a nominal anchor can help to guide wage and price expectations and safeguard competitiveness in a small, open economy. For that reason, the debate about monetary policy in Norway has generally focused on the choice between two relatively transparent nominal anchors, an exchange rate target or an inflation target. For the near term, we would make the same policy prescription under either of these alternative monetary frameworks: interest rates should not be reduced until there are clear prospects for a reduction of wage and inflationary pressures. It is important to bear in mind that the existing, large interest rate differential with EMU currencies could be interpreted in part as a reflection of concern that there may be a further deterioration in Norwegian competitiveness in the coming year. Agreement on an appropriate budget for 1999 would be a crucial step toward addressing this concern. 10. A major intermediate objective of Norwegian economic policy in the coming year must be to moderate the increase in wages. While this is unlikely to be possible without a strengthening of fiscal policy, it will also be important for the social partners to maximize their own contribution to the process. It would be extremely desirable to restore the consensual, growth-oriented approach to economic policy followed in recent years. If, however, this effort is not fully successful, further high wage settlements in 1999 would need to be met by determined application of all available policy instruments, including further increases in interest rates, to contain the damage and help prevent a recurrence.
12. First, recent experience underscores the importance of fiscal policy for price and exchange rate stability, no matter which monetary framework is chosen. Thus, the choice between exchange rate and inflation targeting should not be misconstrued as a choice between the presence or absence of fiscal discipline. While it might be possible to achieve an inflation target for a time despite an excessive non-oil fiscal deficit, this would come at the cost of higher than necessary interest rates. This could have profound effects on growth performance that would tend to undermine the political acceptability (and hence, the credibility) of the policy. 13. Second, the impending completion of the third stage of European Monetary Union could have a major influence on exchange market dynamics in Norway. As a country with strong economic and financial ties to the Euro area but not participating in EMU, Norway can expect to experience a higher degree of exchange rate volatility in the immediate future. This will make it more difficult to pursue an exchange rate target. In principle, the constraint could be overcome through a formal association with the EMU but such a decision is not, in any event, up to Norway alone. While countries that are unsure of their ability to target the exchange rate narrowly have at times tried to address this problem by setting the exchange rate objective within a broad or ambiguously-defined range, such an approach is unlikely to provide a clear or credible anchor for wage and price expectations. 14. Third, since exchange rate changes have a major effect on costs and prices in Norway, they would need to be taken into account as an important indicator of the appropriate stance of monetary policy, under an inflation targeting framework.2 Under an inflation targeting framework the authorities would need to assess carefully any significant depreciation of the nominal exchange rate. Under a variety of circumstances it might be appropriate to resist depreciation; however, the situation could be more complex if the depreciation was interpreted as a response to a real shock, such as a change in the terms of trade. In that case it might well be appropriate to accommodate the initial depreciation of the exchange rate, but to use monetary and fiscal policy to resist any second-round effects on wage and price performance. 15. Finally, exchange rate and inflation targeting may have different implications for the operational independence of the central bank. In most countries that have adopted inflation targeting, this was accompanied by arrangements under which the goal of monetary policy is established by law, but the central bank is given independence in using its available instruments to pursue that goal. The central bank is required to provide complete and timely information about its activities and is strictly accountable for the results. In Norway this would require the replacement of the current monetary policy regulation by a decision adopting (and defining quantitatively) the goal of price stability. In addition, it would appear necessary for any shift to inflation targeting to be accompanied by arrangements to increase the operational independence of Norges Bank. Interest rate policy is carried out by Norges Bank, but the King in Council retains the ability to overturn Norges Bank’s decision. While this possibility has never been used, its continued existence would tend to undermine the credibility of the inflation target.
17. The IMF staff would like to commend the government and people of Norway for their commitment to overseas development assistance.
1By running fiscal surpluses during the period of peak oil production, the government was able to begin saving much of Norway's oil export earnings in the State Petroleum Fund (SPF). The accumulation of large balances in the SPF during the period of high oil production provides resources to help the public sector to meet future pension and health care obligations to the current working population, as these obligations rise in line with demographic trends. 2Since imported goods account for about 40 percent of the basket of goods in the consumer price index, an exchange rate depreciation of 5 percent could be expected to result in an increase of about 2 percentage points in the CPI, with the full effect becoming evident within about 1½–2 years. |
