12  Interpreting these trends is not straightforward. Household surveys may reflect consumers’ assessments of the most frequently purchased items, for example, rather than the whole CPI basket. And financial market measures reflect not only expectations about future inflation, but also investors’ required compensation for inflation risk – the inflation risk premium – and, in the UK, the wedge between CPI and RPI inflation rates. BIS central bankers’ speeches  5  4. What if inflation is slow to return to target abroad? Protracted global weakness could heighten the challenge of returning inflation quickly to target in the UK. That’s because weak global conditions would tend to push down on the equilibrium interest rate that would maintain demand in line with supply and inflation at the target. This equilibrium rate has likely been falling for the last three decades and turned sharply negative in the downturn.13 This meant central banks had to turn to unconventional policy tools to stimulate their economies in order to return inflation to target. In the cases of the UK and the US, these measures have been effective in supporting domestically generated inflation. Although the equilibrium rate might be turning positive in the UK as domestic headwinds have abated, it’s likely still to be negative in many countries, reflecting an excess of saving over investment, in particular in the euro area.
BIS Review 28/2007  7  The experience of previous business cycles has shown that wage and price inflation may increase markedly in a late phase of the upturn. Higher interest rates will counter such a development. However, we must also prevent inflation from becoming entrenched well below 2.5 per cent. We will therefore be mindful of the effects of higher interest rates on the krone exchange rate when inflation is low. Positive supply-side conditions that have held down inflation so far suggest a gradual approach, so that we can assess the effects of interest rate increases and other new information on economic developments. At the meeting on 15 March, Norges Bank’s Executive Board presented the interest rate path shown in the chart. The Board decided that the key policy rate should lie in the interval 4-5 per cent in the period to the publication of the next Monetary Policy Report on 27 June, conditional on economic developments that are broadly in line with projections. Furthermore, the key policy rate is expected to move up to about 5 per cent around the end of 2007. Economic developments are uncertain. The uncertainty surrounding the interest rate ahead is illustrated by the shaded area in the chart, which is intended to capture the outcome with a 70 per cent probability. Long-term interest rates, income growth and house prices Favourable economic developments in Norway have had an impact on developments in our property markets. House prices have risen sharply over the past 14 years.