BIS Review 18/2005  1  It takes time for an interest rate reduction to have an impact on inflation. We are now seeing the effects of monetary policy decisions some of which were taken two years ago. The interest rate has affected inflation via the krone exchange rate and via demand for goods and services. In particular, the rise in prices for domestically produced goods and services has picked up. In addition, the reduction in the interest rate has probably contributed to holding up expectations of future inflation even when inflation is low. If there is confidence in monetary policy, economic agents will expect inflation to be close to target over time. This will provide a basis for company budgets. This will then contribute to stabilising inflation. Many companies change their prices only once or twice a year. When they change prices, they probably take into account the expected rise in other prices. It has been important to prevent inflation expectations from falling and becoming entrenched at a low level. Surveys of inflation expectations indicate that expectations are well anchored around the inflation target in the long term. The first signs of the effects of the interest rate cuts appeared in the foreign exchange market. The interest rate differential against other countries narrowed. It became more attractive to borrow and less profitable to invest in the Norwegian krone. The movement in the krone exchange rate was reversed and it depreciated through 2003 and into 2004.
As the interest rate gradually increases to a more normal level, growth in private demand will probably ease, and capacity utilisation may be brought down and stabilise. There is uncertainty associated with developments in demand and output in the near term, partly because the interest rate has been low for a long period. Higher growth may rapidly trigger stronger pressures in the economy. Output growth in Norway is high, and capacity utilisation is rising. It may appear that growth has become more self-driven. The low interest rate will probably contribute to an increase in the output gap and inflation ahead. The operational objective of monetary policy is inflation of close to 2.5 per cent over time. In the conduct of monetary policy, emphasis is also placed on curbing fluctuations in output and employment. The objective of stabilising developments in output and employment implies, in isolation, a higher interest rate. This will reduce the risk that capacity utilisation in the Norwegian economy will become too high. High capacity utilisation could give rise to bottlenecks in some sectors of the economy and lead to a higher rise in property prices and household borrowing. This could be a source of instability in demand and output in the somewhat longer run. The objective of bringing inflation back to target and anchoring inflation expectations nevertheless implies a continued expansionary monetary policy. International interest rates are rising, albeit slowly and from a low level. There are prospects of continued low inflation for a period ahead.