Low and stable inflation makes it easier for economic agents to distinguish changes in relative prices from changes in the general price level. Prices become a more accurate information vehicle. Alan Greenspan has defined price stability as “a situation in which households and businesses in making their saving and investment decisions can safely ignore the possibility of sustained, generalized price increases or decreases”. 5 This is the aim of monetary policy in all countries. When there is confidence in the inflation target, monetary policy can also contribute to stabilising output and employment. Norges Bank operates a flexible inflation targeting regime, so that weight is given to both variability in inflation and variability in output and employment in interest-rate setting. Past experience indicates that expectations as to future inflation remain stable even if inflation varies somewhat as long as the interest rate is used actively to curb the effects. Monetary policy cannot finetune economic developments, but it can prevent the largest effects from occurring when the economy is exposed to disturbances. In some situations, it may be appropriate to hedge against particularly unfavourable developments. If inflation deviates substantially from the target for a period, the interest rate will be set with a view to gradually returning it to the target, so that we avoid substantial variations in output and employment. Through the 1990s, inflation remained on the whole in the interval 1½ – 3½ per cent. Inflation has varied slightly more in the past few years.
The settlements in 2004 and 2005 resulted in moderate wage growth. There are now signs of higher local pay increases in some industries. Pay increments are probably rising in occupations where pay is directly linked to performance. Municipalities and public entities have recorded a sharp increase in revenues, and this may easily translate into higher labour costs. Nevertheless, the labour market is not so tight that there is a pronounced risk of a marked increase in wage growth in connection with the spring income settlement. Moreover, employee organisations have  6  4  Information from Norges Bank’s regional network, January-February 2006. BIS Review 10/2006  gained acceptance for important changes in labour legislation and regulations. This probably reduces the near-term risk of pay increases that weaken production. A characteristic of the wage formation process in Norway has been that fairly long periods of moderate nominal pay increases and rising employment have culminated in a sharp rise in cost inflation – often as a result of working hour reforms – and a decline in employment. Developments in labour costs and the wage settlements in 1974 and 1975, 1986 and 1987 and in the period between 1998 and 2002 laid the basis for a subsequent decline in output and employment. In our interest-rate setting, we must continuously assess how we should take account of the risk of another sharp rise in cost inflation when the labour market tightens.