After the deregulation of the 1980s, the upswing was so strong, the financial imbalances were so large and the high level of inflation had gained such a firm foothold that a downturn was almost impossible to avoid. 2  For a more detailed description of the Norwegian crises see Gerdrup (2003): Three episodes of financial fragility in Norway since the 1890s, a forthcoming article in BIS Working Papers. BIS Review 25/2003  3  Monetary policy and financial stability Norges Bank’s operational objective for monetary policy is inflation over time of 2½ per cent. This objective can normally be achieved by applying different interest rate paths. The choice of path may have an impact on developments in output and employment in the short term. It may also affect how quickly we achieve the inflation target. Choosing between the different strategies involves balancing fluctuations in output and employment against deviations from the inflation target in the short term. A rapid and pronounced change in the interest rate would be appropriate in cases where there is a risk that inflation may deviate considerably from the target over a longer period, or where heightening turbulence in financial markets or a cost-push shock resulting from wage negotiations indicate that confidence in monetary policy is in jeopardy. Financial market confidence in the inflation target provides Norges Bank with greater opportunities for promoting stability in the real economy, even more so as inflation targeting is incorporated as an anchor for wage determination. The impact of monetary policy occurs with a lag.
The IMF also finds that the probability of bubbles bursting in the housing market is greater than is the case for stock markets. A decline in the housing market also has a greater impact on output and employment. Housing wealth has a greater impact on consumption than other assets. The contagion effects via the banking system are stronger because housing and property loans normally account for a substantial share of banks’ loans. A sharp rise in asset prices and debt build-up may pose a risk to economic stability. To minimise this risk, there may be situations when it is appropriate to apply a somewhat longer horizon than the normal two-year horizon for achieving the inflation target. A precondition for this is that financial market participants are confident that inflation will be low and stable over time. The current situation Today, private sector debt and house prices are at a historically high level. Banks’ loan losses will probably rise. However, our assessment is that the banking sector is reasonably well equipped to cope with the increase. For a long time, household debt in Norway has risen at a far higher rate than income growth. The debt burden has therefore risen rapidly and is high in a historical context. Partly as a result of the reduction in interest rates, interest expenses are moderate. High and growing debt means, however, that households are vulnerable to sharp increases in interest rates or a substantial rise in unemployment. Some groups of households are particularly at risk.