This Selected Issues paper analyzes inflation in Norway with a view to shedding light on this surprising development and the possible near-term course of inflation, using statistical and econometric analyses. The paper reviews recent developments of monetary policy and inflation in Norway, applies statistical and econometric tools to identify factors influencing inflation, and describes the implications of the analysis for policymaking. Using data for six advanced small open economies explicitly targeting inflation, the paper examines empirically whether deviations of the exchange rate from their equilibrium levels systematically affect the conduct of monetary policy.

Abstract

This Selected Issues paper analyzes inflation in Norway with a view to shedding light on this surprising development and the possible near-term course of inflation, using statistical and econometric analyses. The paper reviews recent developments of monetary policy and inflation in Norway, applies statistical and econometric tools to identify factors influencing inflation, and describes the implications of the analysis for policymaking. Using data for six advanced small open economies explicitly targeting inflation, the paper examines empirically whether deviations of the exchange rate from their equilibrium levels systematically affect the conduct of monetary policy.

I. Inflation Dynamics in Norway1

1. Despite a significant easing of monetary conditions, the core inflation rate in Norway has been well below the 2½ percent targeted by Norges Bank since end-2002. This chapter analyzes inflation in Norway with a view to shedding light on this surprising development and the possible near-term course of inflation, using statistical and econometric analyses. The results suggest that the inflation rate will start increasing in the near term as the main factors which reduced it in 2003–04 are either reversing or waning. Moreover, the target rate of inflation may be overshot in the medium term if growth proves more robust than now projected. The first section reviews recent developments of monetary policy and inflation in Norway; the second section applies statistical and econometric tools to identify factors influencing inflation; and the third section concludes by spelling out the implications of the analysis for policymaking.

A. Introduction

From exchange targeting to inflation targeting

2. Before Norway adopted its current inflation targeting framework, monetary policy stabilized the exchange rate. From 1994 to 1999, Norway used a managed float to maintain stability against European currencies. Accordingly, interest rate movements in Norway were largely determined by those in Germany. This framework worked well during the recovery from the crisis in the early 1990s. Under it, fiscal policy was given the main role in stabilizing the economy, while the centralized wage bargaining system was supposed to help achieve full employment with low inflation. Monetary policy under such systems tends to be procyclical.

3. In the late 1990s, however, the strain of using monetary policy to achieve both the exchange rate and inflation targets became evident. In 1997, for example, Norwegian interest rates were lowered to curb the appreciation of the krone when the economy was experiencing excess demand pressures. This situation changed dramatically in August 1998. When the krone came under strong pressure in the exchange market as world commodity prices declined, Norges Bank raised short-term interest rates by 425 basis points.2 It became apparent that it is difficult for a commodity-exporting country such as Norway to maintain a fixed exchange rate without significant output volatility. Moreover, the decision to phase in the spending of some petroleum revenue, which is embodied in the 2001 fiscal guidelines, implied a slightly expansionary fiscal policy, interfering with its role in macroeconomic stabilization

4. An inflation targeting framework was implicitly adopted in 1999. Norges Bank innovatively interpreted the fixed-exchange rate instructions from the government as implying the target would be met only in the long run. In addition, Norges Bank stated that the best way to achieve this target was to aim for an inflation rate similar to that of the euro zone (Svensson and others, 2002). The inflation targeting framework reduced the procyclical tendency of a fixed-exchange rate regime, thereby allowing monetary policy to help with macroeconomic stabilization.

5. The current inflation targeting framework was formally adopted in March 2001. Originally, the framework aimed at achieving 2½ percent core inflation in a two-year time horizon.3 By setting the inflation target at a slightly higher level than that of trading partners (at about 2 percent), the government indicated its preference for the expected real appreciation (related to large oil revenues) to occur in the form of a slightly higher inflation rate rather than a nominal appreciation (J. Soikkeli, 2002). In addition to the inflation target, the new monetary guidelines aim to help stabilize output and employment. Thus, Norway has a flexible inflation targeting framework.

Recent inflation developments

6. Three underlying factors seem important in considering Norwegian inflation developments. First, since the mid-1990s, wages have increased considerably faster than the consumer price index. Although under the centralized wage bargaining system, social partners used exchange rates and wage growth abroad as anchors for wage settlements, during 1998–2002 wage growth in Norway outpaced that of other countries. Since productivity growth in Norway has not been much higher than elsewhere, unit labor costs also rose more rapidly, putting upward pressure on inflation relative to other countries and resulting in a real exchange rate appreciation (Table I-1). Second, as in other small open economies, import prices in Norway are important.4 Declines in import prices, which have also occurred in other Nordic countries, have helped to hold inflation down. Third, changes in administered prices as well as in taxes and import tariffs also have a significant impact on prices. For example, the reduction in the value-added tax (VAT) on food by 12 percent in July 2001 reduced headline inflation, whereas a 1 percent increase in the VAT at the beginning of 2005 is expected to increase headline inflation significantly.

Table I-1.

Inflation and its Determinants in Selected Countries

(Percentage change)

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Sources: Norwegian authorities, WEO, and April Consensus Forecasts.

Unless otherwise specified, actual numbers are from WEO, and projections are from the Consensus.

Norges Bank’s estimates. Numbers are from the IR 3/04.

Norges Bank’s estimates. Numbers are from the IR 1/05.

Wage Increases

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Source: The European Commission’s Annual Macroeconomic Database (AMECO).

Import Prices

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Source: OECD International Trade and Competitiveness Indicators.

7. From May 2000 to January 2003, the krone appreciated significantly, as Norges Bank maintained higher interest rates than in Norway’s trading partners. The interest rate differential widened in 2002 when Norway’s main trading partners reduced their interest rates to stimulate growth while Norges Bank increased its key interest rate in the wake of higher-than-expected wage pressures. High oil prices and conflicts in the Middle East also contributed to the strength of the krone, as investors considered the krone as a “safe-haven currency.”

8. These tight monetary conditions, the strong currency, and sluggish world economic activity caused declines in mainland GDP in Norway in late 2002 and early 2003, leading to negative output gaps and reduced inflationary pressure. In response, Norges Bank cut its key interest rate ten times from 7 percent in December 2002 to 1.75 percent in March 2004, well below levels considered cyclically neutral. This led to a 16 percent depreciation of the krone in nominal effective terms from January 2003 to February 2004, although this appreciation has since been in part reversed. Though growth resumed in the second half of 2003 on the back of very loose monetary conditions and improving economic activities worldwide, inflation has remained very low.

B. Empirical Analysis

9. The dynamics of core inflation are analyzed using a mark-up model for prices, with some elements relating to the Phillips curve. The central idea is that inflation is associated with costs of production and the business cycle. Accordingly, inflation is modeled as a mark-up over total unit costs, including unit labor costs and import prices.5 The output gap is also included as an explanatory variable, to capture the effects of economic activity on changes in the mark-up. This can be expressed as:

P=f(ULC,IP,OG),(1)

where P stands for prices, ULC for unit labor costs, IP for import prices, and OG for output gap. This model implicitly embeds the hypothesis of purchasing power parity by including import prices among costs of production.

10. The CPI-ATE, which measures headline inflation adjusted for the direct effects on consumer prices of changes in taxes and energy prices, is examined because this is Norges Bank’s policy target. The headline measure is subject to strong transitory effects, notably electricity prices (Figure I-1).6 Data for the CPI were kindly provided by Norges Bank. Import prices are from the OECD. Using data from Statistics Norway, unit labor costs are calculated as the difference between wages and productivity, and the output gap is calculated as the difference between mainland GDP (at 2001 prices) and trend GDP. The latter is estimated using a Hodrick-Prescott filter. All data are quarterly, spanning 1979:Q3 to 2004:Q2. A dummy variable is used to capture the impact of the formal introduction of the inflation targeting framework in 2001. Allowing for lags and transformations, the estimation period is 1982:Q1 to 2004:Q2.

Figure I-1.
Figure I-1.

Norwegian Inflation

Citation: IMF Staff Country Reports 2005, 197; 10.5089/9781451829778.002.A001

11. Graphs of import prices, unit labor costs, and the output gap are revealing (Figure I-2). Over the sample as a whole, import prices fell relative to the CPI, perhaps reflecting high productivity growth in the tradable-goods sector worldwide. This trend intensified in 2002–03, in part because of the appreciation of the krone in 2002. Unit labor costs decreased relative to the CPI from the late 1980s to early 1990s, but have risen significantly since then. Mainland GDP recorded wide deviations from its trend until the late 1980s, after which the amplitude of cycles appears to have fallen substantially. As mentioned, since the fourth quarter of 2002, the output gap has been negative. These stylized facts suggest that the low inflation rate since 2002 is related to the low rate of increase in prices for imported goods and the slowdown in economic activity. It is also worth noting that the difference between prices for imported consumer goods (CPI-IP) and import prices (IP) is positively correlated with the output gap (Figure I-3).7 Furthermore, prices for imported consumer goods that face competition from locally made goods fell significantly more than prices for goods without competition from locally made goods (Table I-2).

Figure I-2.
Figure I-2.

Real Import Prices, Real Unit Labor Costs, and Output Gap

Citation: IMF Staff Country Reports 2005, 197; 10.5089/9781451829778.002.A001

Figure I-3.
Figure I-3.

Import Prices, Difference between Consumer Prices and Import Prices, and Output Gap

Citation: IMF Staff Country Reports 2005, 197; 10.5089/9781451829778.002.A001

Table I-2.

Norway: Consumer Price Index for Imported Goods

(In percent)

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Source: Statistics Norway

12. Increased domestic competition also appears to have contributed to low inflation. The entry of a new company into the air transportation market caused large declines in airfares from the second half of 2003 to the first half of 2004. Increased competition also led to declines in prices for telecommunication services. As a result, prices for “other services” fell significantly. Moreover, entry of foreign chain stores into the Norwegian retail market may have increased competition in this sector.8 These factors, however, are not taken into account in the following empirical analysis because an index of competition is unavailable.

uA01fig01

CPI Components

(12-month percentage change)

Citation: IMF Staff Country Reports 2005, 197; 10.5089/9781451829778.002.A001

Source: Norges Bank.

13. Turning to the empirical results, most variables appear to have unit roots (Table I-3). CPI and unit labor costs seem to be I(2) based on the Dickey-Fuller statistics alone. However, the estimated roots for dp and dulc are 0.75 (=1-0.25) and 0.43 (=1-0.57), respectively, which are well below unity. Therefore, both variables are treated as I(1), while recognizing that some caveats may apply.9 The output gap seems to be I(0), which accords with intuition (Figure I-4).

Table I-3.

Augmented Dickey-Fuller (ADF) Statistics for Testing a Unit Root 1/2/

(Sample period is 1980 Q1-2004 Q2)

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Using seasonality dummy variables.

* indicates rejection of the null hypothesis at 5 percent level, and ** at 1 percent level.

Including a constant for all variables; and a trend for cpi, ulc, and imp.

Under a null order of I(1), the coefficent of the first lag should be zero.

14. No meaningful cointegrating relationship is found among the above variables in levels. Regressions are therefore run using og, which is an I(0) variable, and differences of the I(1) variables.10 Using a general-to-specific procedure yields the following model:11

Δpt=0.001+0.28Δpt10.23Δpt3+0.56Δpt4+0.16Δpt7++0.09Δulct+0.03Δulct20.06Δulct6+0.11log++0.03Δipt+0.03Δipt6+0.02Δipt8+Seasonality Dummies + ϵt,(6)
Figure I-4.
Figure I-4.

Inflation, Changes in Unit Labor Costs, and Changes in Import Prices

Citation: IMF Staff Country Reports 2005, 197; 10.5089/9781451829778.002.A001

15. The results can be summarized as follows. The output gap as well as changes in unit labor costs and import prices seem to be very important determinants of inflation. The inflation targeting dummy had the expected negative sign, but was not statistically significant and was therefore dropped.12

16. The estimated model performs by and large satisfactorily in terms of diagnostic tests. The adjusted R2 is over 90 percent. Tests for autoregression, normality, and heterogeneity do not reveal any serious problems. The RESET test suggests that there is some possibility of omitted variables (Table I-4 and Figure I-5). However, this result is not surprising given that many other factors also affect inflation, such as forces of domestic competition. Iterative estimations of the model suggest that the model parameters are largely stable.

Table I-4.

Diagnostic Staistics

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Source: Author’s calculations
Figure I-5.
Figure I-5.

Actual and Fitted Inflation

Citation: IMF Staff Country Reports 2005, 197; 10.5089/9781451829778.002.A001

17. The model forecasts inflation well. Graphs of the 1-step forecasts for 16-quarter shows that the fit for inflation is quite close and that the forecasts lie within their 95 percent confidence intervals (shown by error fans). Moreover, forecast errors seem to be unbiased and reverting toward zero (Figure I-6).

Figure I-6.
Figure I-6.

Actual and 16-step Forecasts of the Inflation Rate

Citation: IMF Staff Country Reports 2005, 197; 10.5089/9781451829778.002.A001

C. Implications for Policymaking

18. The main factors behind the low inflation since end-2002 seem to be the slowdown in economic activity in late 2002 and early 2003, declines in import prices, and increased competition domestically. Simulations of the estimated model (equation (6)), assuming no output gap during the 2003–04 period, suggest that the excess capacity in the economy reduced inflation during this period by about 0.8 percentage points each year. Similarly, simulations assuming unchanged import prices since early 2001 suggest that declining import prices reduced inflation by more than 0.6 percentage points. Inflation would have been by more than 1 percentage point higher had import prices increased during this period at a rate prevailing in the two years prior to 2001.

uA01fig02

Inflation Estimations Using Equation (6)

(In percent)

Citation: IMF Staff Country Reports 2005, 197; 10.5089/9781451829778.002.A001

Source: The author’s estimations.

19. Declines in import prices and increased competition domestically can be considered one-off factors that lower the price level, but have no long-run effect on inflation.13 The declines in import prices can be attributed to four factors: (i) a strong appreciation of the krone in 2002; (ii) a shift in imports from high-cost countries such as Europe and the U.S. to low-cost countries such as China and India; and (iii) lower trade barriers. While it is difficult to predict how long such factors might persist, they are expected to wind down eventually. Similarly, market entry and regulatory changes can enhance domestic competitive forces, but margins can only be cut so far. Indeed, evidence suggests that these import and domestic price declines are coming to an end.

20. The strong pickup in domestic activity and the waning of the so-called structural factors are thus likely to herald rising inflation. The authorities and staff project a sizable positive output gap in 2005–07 and tighter labor markets. Inflationary pressure is thus likely to rise. Forecasts using the estimated model, assuming that import prices stabilize and start increasing in 2006, suggest that the inflation target would be achieved in 2006-08, depending on the evolution of the output gap. To illustrate the sensitivity of inflation to the gap, simulations are performed under two scenarios: (i) the baseline, which assumes growth consistent with staff projections (which include, among other things, a gradual rise in interest rates toward cyclically neutral levels), involving about 0.9 percent output gap during 2005–08; and (ii) a high growth scenario (which could be consistent with continued low interest rates), involving a 2.9 percent output gap during 2005–08. Under the baseline scenario, the model predicts that the targeted rate of 2.5 percent would be achieved in 2008. Under the high growth scenario, the model predicts that the targeted rate of 2.5 percent would be overshot by about 1 percentage point in 2008.

uA01fig03

Prices for Imported Consumer Goods

(12-month percentage change)

Citation: IMF Staff Country Reports 2005, 197; 10.5089/9781451829778.002.A001

Source: Norges Bank.
uA01fig04

12-month Inflation Forecasts

(In percent)

Citation: IMF Staff Country Reports 2005, 197; 10.5089/9781451829778.002.A001

Source: The author’s estimations

References

  • Banerjee, A., Dolado, J.J., Galbraith, J.W., and Hendry, D.F., 1993, Co-integration, Error Correction and Econometric Analysis of Non-Stationary Data. (Oxford: Oxford University Press).

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  • International Monetary Fund, 1999, “The Choice of a Nominal Anchor for Norway,” Chapter III of Norway Selected Issues Paper, IMF Country Report No.98/34, pp. 2436, December 16, 1998.

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  • Johansen S. 1992, “An I(2) Cointegration Analysis of the Purchasing Power Parity Between Australia and the United States,” Chapter 9 in C.P. Hargreaves (ed.) Macroeconomic Modeling in the Long Run, Aldershot, Hants., England, Edward Elgar, pp. 229248.

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  • Norges Bank Inflation Report 1/05, March 2005.

  • Soikkeli, Jarkko, 2002, “The Inflation Targeting Framework in Norway,” IMF Working Paper WP/02/184, (Washington: International Monetary Fund)

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  • Svensson, Lars E.O., Kjetil Houg, Haakon O. Aa. Solheim, and Erling Steigum, 2002, Norges Bank Watch 2002, “An Independent Review of Monetary Policy and Institutions in Norway” (Oslo, Norway: Norwegian School of Management, Center for Monetary Economics), September 2002. Available also on the web at http://www.princeton.edu/~svensson/norway/nbw.htm.

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1

Prepared by Etibar Jafarov

3

When the inflation targeting framework was adopted, this time horizon was deemed to be long enough to avoid unnecessary output costs of returning inflation to the target in too short a period of time. Even so, Norges Bank reserved the option to extend the time horizon beyond two years if necessary. In mid-2004, with the aim of reducing variability in interest rates and output, Norwegian authorities changed the time horizon for achieving the inflation goal from 2 years to 1–3 years.

4

For example, Norges Bank estimates the share of import prices in the consumer price index (CPI) at more than one-fourth. Moreover, import prices influence CPI indirectly through prices for domestic goods with significant imported inputs and components.

5

Energy prices are not included as this paper models core inflation, which excludes energy prices.

6

Henceforth, CPI means CPI-ATE and inflation means core inflation, unless otherwise noted.

7

Strictly, CPI-IP (provided by Norges Bank) and IP (from the OECD) are not fully comparable. The former excludes the impact of taxes and tariffs while the latter does not; and the latter includes, in addition to consumer goods, imports not sold directly to consumers.

8

See Norges Bank Inflation Report 1/05.

9

See Johansen (1992) for an analysis of the cointegrating properties of I(2) series.

10

If there is, in fact, a cointegrating relationship among these variables, excluding the error-correction term derived from the cointegrating relationship, would introduce inefficiency and bias (see Banerjee, Dolado, Galbraith, and Hendry, 1993). Such bias, however, may not be very large if feedback from long-run relationships among explanatory variables to short-term relationships is slow.

11

The procedure began with 10 lags of the relevant variables, then non-significant variables, based on F-tests, were dropped.

12

This lack of significance of the inflation targeting dummy indicates that the underlying relationship between headline inflation and explanatory variables did not significantly change with the formal introduction of inflation targeting. However, both the mean and standard deviation of headline inflation have declined since 1999, suggesting that the de facto introduction of the inflation targeting framework may have affected inflation through its impact on explanatory variables in equation (6). See Chapter 2 of this selected issues paper, which closely examines the central bank reaction function.

13

The authorities refer to these factors as structural factors.

Norway: Selected Issues
Author: International Monetary Fund