Use of instruments that diminish the risk associated with floating exchange rates is also gaining ground in Norway. The operational target of monetary policy in Norway is low and stable inflation. Developments in the krone exchange rate are nonetheless important when Norges Bank sets the interest rate. There are several reasons for this. First, changes in the krone exchange rate affect prices in krone terms for imported consumer goods and services. Second, exchange rate changes have an impact on competitiveness in Norwegian business and industry and on market opportunities at home and abroad. This affects the level of activity in the economy and, in turn, price and cost developments. In the period between Inflation Report 3/06, presented in November 2006, and Monetary Policy Report 1/07, presented in March this year, the krone appreciated more markedly than we had assumed. As a result, Monetary Policy Report 1/07 was based on the assumption that the krone would be somewhat stronger throughout the projection period. The exchange rate assumption in Inflation Report 3/06 is shown by the broken blue line in the chart on the left, while the broken red line denotes the exchange rate assumption in Monetary Policy Report 1/07. The isolated effect on the interest rate path of a stronger krone is illustrated in a box in Monetary Policy Report 1/07. As shown in the chart on the right, the stronger krone pointed to a somewhat lower path for the interest rate.
“Papa Bear” - Inflation Let me start with “papa bear” inflation. On conventional wisdom, he should be making an appearance by now. Historically, inflation comes from high wage growth in a tight labour market during the late stages of the business cycle – a relationship economists describe as the Phillips Curve. Cyclical conditions are now tight in major economies, especially in the US. US unemployment rate has fallen to 4.1%, well below the Fed’s estimated Non2/7  BIS central bankers' speeches  Accelerating Inflation Rate of Unemployment (NAIRU) of 4.6%. Yet, wage growth has remained at around 2.5%, below the pre-crisis average of 3.5%. Whenever central bankers gather these days, this phenomenon of “missing inflation” is often the main topic of discussion. Many wonder whether the Philips Curve has permanently flattened – meaning whether the negative relationship between the unemployment rate and wage growth has fundamentally weakened. Some even ask if the Philips Curve is dead – if the relationship no longer exists. Why has “papa bear” inflation been missing to-date? The first and simplest explanation is that the headline measure of unemployment may be understating the level of slack in the economy. In the US, the IMF estimates that the output gap between actual and potential GDP has only just closed. The output gaps in the EU and Japan are still some way off from closing. There may also be quite some slack in the labour market that may not be fully apparent.