On the basis of the deviation between actual price inflation and Norges Bank's projections over the last few years, an uncertainty interval for price inflation can be calculated. How can monetary policy be credible when it is so difficult to control price inflation? The answer is to be found in two factors. First, economic agents base their decisions on the probable inflation outcome. Although there is considerable uncertainty, monetary policy will be credible if the outcome they consider most probable, and thus base their decisions on, is consistent with the nominal anchor. Second, confidence is linked to the response pattern. If price inflation in Norway is higher than that aimed at by the ECB as a result of shocks, there must be confidence that monetary policy instruments are oriented towards bringing price inflation down towards the level implied by the nominal anchor. Thus temporary deviations do not necessarily lead to a loss of credibility. Confidence in low and stable inflation contributes to greater stability in the krone exchange rate than would otherwise be the case. However, this cannot prevent changes in the krone exchange rate if the  BIS Review 7/2001  3  Norwegian economy is subjected to substantial disturbances in the real economy other than those in the euro area and such disturbances are not countered by fiscal or incomes policy. Monetary policy cannot function effectively without good interplay with fiscal policy.
Low oil prices amplified the fall in investment in the petroleum sector. At the beginning of 1999, the outlook for the Norwegian economy seemed fairly bleak. In this situation, the possibility that Norway would enter a recession of a type that would further reduce confidence in the krone was considered a definite risk. This is why Norges Bank decided at the beginning of 1999 to reduce interest rates. Owing to the uncertainty associated with economic developments and the effects of interest rate changes, Norges Bank adopts a gradual approach to the setting of interest rates. Interest rates were therefore reduced in five steps by a total of 2.50 percentage points in the period from 28 January to 23 September 1999. The lowering of interest rates contributed to strengthening the krone. 6  BIS Review 7/2001  In mid-1999, Norges Bank considered the risk of a recession of a type that would reduce confidence in the krone to be substantially reduced. In addition to the reduction in interest rates, this was partly due to brighter prospects for international growth and higher commodity prices. However, we still envisaged a growth pause in the Norwegian economy. The projections for price and cost inflation in the next few years were then in accord with the corresponding aim for inflation for the ECB.