2  BIS Review 17/2006  Important components in the assessment of what constitutes a good interest rate path – and which stress the element of judgment in this assessment – are expressed in a set of criteria that should be met. The criteria are included in the Inflation Report. Criteria have been set for robustness and financial stability. It is also appropriate to assess interest-rate setting against cross-checks such as simple monetary policy rules. The central balance is nevertheless between the inflation outlook and the outlook for capacity utilisation in the economy, expressed in the chart as the output gap. The projections are from Inflation Report 3/05. If monetary policy is to anchor inflation at the target, the interest rate must be set so that inflation moves towards the target. Inflation should be stabilised close to the target within a reasonable time horizon, normally 1-3 years. Provided inflation expectations are on target, the inflation gap and the output gap should be in reasonable proportion to each other until they close. Looking ahead, the inflation gap and the output gap should normally not be positive or negative at the same time. Several of the recommendations from Norges Bank Watch can be translated into how we should weigh the outlook for these two variables against each other. According to the report, Norges Bank’s inflation projections through 2005 were fairly accurate. Inflation has risen somewhat but is still very low, even 2½ years after the cyclical change.
Inflation is still being restrained by the fall in prices for imported consumer goods, increased competition in a number of markets and the current period of lower nominal pay increases. The trend in prices for consumer goods over the past two or three years is a result of favourable developments in the Norwegian and global economies. Low inflation is being accompanied by real income growth and a rise in production. It cannot be ruled out that small open economies are particularly vulnerable to fluctuations in international prices. Deviations from the inflation target in Norway are broadly in line with Sweden and New Zealand, but are larger than for example in the UK and Canada. Developments in recent years have also been influenced by the fairly large favourable disturbances to which the Norwegian economy has been exposed. Developments in Norway’s terms of trade provide an illustration of this here. As consumers, we enjoy the benefits of falling prices for many imported goods. As a nation, we benefit from a fall in prices for the goods we import in relation to prices for the goods we export. Norway’s terms of trade are improving. The impact of the rise in oil and gas prices is particularly strong – and the domestic economy is shielded to a certain extent through the oil fund mechanism – but there have also been terms-of-trade gains in the mainland economy. The situation in Norway differs from that of our Nordic neighbours.