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The following OECD assessment and recommendations summarise chapter 2 of the Economic survey of Norway published on 20 August 2008.
Progressive monetary tightening has been vindicated
The policy interest rate is now at or perhaps above its neutral level. But with the spread between the policy rate and market rates having widened in the wake of financial turmoil, effective financial conditions are certainly somewhat tighter than the level of the policy rate would normally imply. At the time of its latest interest rate increase in June, the central bank was projecting a decline of headline inflation only after some further increase over the summer, and underlying inflation was also expected to rise for some time before beginning to fall back by the end of 2008. The bank still expects that headline inflation at the end of 2009 is equally likely to be above the 2.5% target as below. Although growth is moderating, rising core inflation and wage pressure, and the need to anchor inflation expectations led the Norges Bank to increase its policy rate in June, in line with OECD projections published in the June Economic Outlook, and it left open the possibility of a further increase later. In view of ongoing inflationary pressures, it is too early to say whether monetary policy has been successful in stabilising inflation close to the target.
Monetary policy is approaching the end of the tightening phase
As always, the authorities need to monitor economic developments continuously and be ready to modify their projections as new information comes in. The possibility of a slowing economy, but continuing inflation pressure, will present different challenges from the environment of the last few years, in which Norges Bank has developed its techniques of flexible inflation targeting using innovative methods – including an informative method of publishing forecasts of the policy interest rate. For the moment, however, the continuing strength of the economy in early 2008 is certainly a reminder that the danger of overheating will not recede immediately and interest rates may need to go higher. It is also difficult to gauge the strength of the underlying supply response, but the OECD, Norges Bank and the Norwegian Ministry of Finance estimate output to have been substantially above potential by the end of 2007. Part of the supply response in recent years has been a much higher than expected increase in the working age population and labour force as flows of immigrant labour, attracted by Norway’s low unemployment and high wages, have allowed the economy to grow at rates well above what potential would otherwise have been. Since Taylor rules are themselves based on estimates of the output gap, and the sensitivity of inflation to the measures of the output gap is uncertain, it is more important than ever for Norges Bank to continue to use a wide range of indicators in making its policy decisions.
Key policy interest rate
Intelligent policy design insulates the economy from oil market fluctuations
Oil and gas exports accounted for over 20% of total GDP in 2007, helping to make Norwegian per capita GDP the highest in the OECD apart from Luxembourg. But public and private consumption together account for only about 60% of GDP, compared with between 80 and 85% in G7 countries (except Canada, another important per capita oil producer, at 75%). This difference is due to the policy of transferring petroleum revenues directly into an offshore fund, known as the Government Pension Fund, Global (hereafter referred to as the Pension Fund).
The purpose of the Pension Fund is to support long–term management of petroleum revenues. Proceeds from the fund are used to finance the non–oil budget deficit and are not earmarked for pension expenditures. Since 2001 this framework has been supplemented by the fiscal guideline stating that only the expected long run real returns can be channelled into the budget; long run returns are estimated using a 4% real rate of return, and over time the non–oil structural deficit should correspond to these returns. Taken together, the Pension Fund and the 4% guideline have had a major, highly favourable impact on both the economy and public finances. The benefits to the economy are twofold: first that the potentially destabilising impact of highly variable export revenues on the exchange rate and demand pressure on the mainland economy is almost entirely eliminated; secondly, what could have been a major aggregate demand shock for the mainland economy is spread over a number of years. It is important that this approach be maintained.
But oil wealth puts continuous long–term pressure on “mainland” supply
Although the Pension Fund and the “4% rule” bring some stability and make for a rational way to spread the benefits of petroleum wealth over a number of generations, the underlying challenge of adapting the economy to a trend increase in demand cannot easily be avoided. In a sense, fiscal policy is now always “expansionary” since it is the vehicle for transmitting the trend increase in income into demand. A drastic cut in petroleum production or a decision to consistently save much of the financial income from the Pension Fund would make a significant difference; while this might only postpone the challenge, it could smooth the impact of the fiscal impulse if it came at a time when the Pension Fund were growing more slowly, owing to declining production.
Meanwhile, the application of the 4% rule to the structural budget deficit rather than the actual deficit is a sensible way to ensure that automatic stabilisers work fully, around this expansionary trend. The rule allows some latitude for active demand management in specifying that the constraint on the non–oil structural deficit be met over the cycle. The planned structural deficit in 2007 was about in line with the 4% guideline, but the actual outcome was smaller. Given the size of the output gap and continuing though moderating growth, it would have been appropriate to maintain this tighter fiscal policy into 2008, rather than the quite large increase in the structural deficit in the revised budget; such tightness could also be thought of as continuing to compensate for structural budget deficits that exceeded the 4% rule in the earlier phase of the cycle. On current OECD projections, the excess of total demand over supply will diminish substantially by 2009. But fiscal restraint – avoiding an increase in the structural deficit – would still be wise. Also, a strong case can be made for undershooting the 4% per cent rule in the medium term, when the oil price is high and the Fund is growing rapidly. Such a policy would have a number of advantages: it would provide support to monetary policy in a period of inflationary levels of excess demand in the economy and upward pressure on interest rates and the exchange rate; it would reduce the risk of short term relaxation in, for example, already generous welfare spending programmes with long term fiscal costs and potential adverse incentive effects; and it would build up a greater cushion of pre–funding for the long–term fiscal gap that can be seen under current projections.
The fiscal rule over the cycle
Despite oil wealth, long–term fiscal challenges persist
In the medium term, over the next 10 to 20 years, public finances in Norway are in relatively good shape, partly because of increasing Pension Fund revenues, but also because the effects of the ageing of the population are coming somewhat later in Norway than in most countries. One measure of this, the level of taxation required to balance the budget while funding expected expenditures under current policies, is calculated to decline for the next few years, before turning up again only after 2015. From then onwards, however, Ministry of Finance projections made in the autumn of 2007 suggest that the situation will get quite significantly worse: they foresee a financing “gap” of 7% of GDP for the year 2060. While the size of this gap is sensitive to assumptions such as the oil price, and those projections assumed an oil price well below current levels, it seems likely that there will still be a shortfall even if oil prices remain high. The main contributors to the gap are old age pensions and age–related health expenditures.
Long term fiscal gap
The pension reform, due to be implemented as from 2010, will convert the state pension system into a notional defined contribution (and still unfunded) scheme, i.e. the expected value of retirees’ pensions will be equivalent to the notional accumulated value of their lifetime pension contributions. The new pension accrual rules will be phased in over time, with full effect from the 1963 cohort onwards, while the other reform elements (life expectancy adjustment and transition to wage/price indexation of benefits after retirement) are planned to take effect from 2010.
At present, by agreement between the social partners, a supplementary pension scheme (AFP), subsidised by the government, significantly reduces incentives to work after age 62 for a large majority of the workforce. In the 2008 wage round covering the private sector, it was agreed to reform the AFP as from 2010, making it an income supplement for people over age 62, thereby restoring work incentives. The wage round negotiations resulted in an increase in the AFP subsidy for the benefit of the oldest cohorts. At the same time the government agreed to a partial deferment of the life expectancy adjustment for pension benefits accumulated under the present pension system. The government estimates the total cost of these concessions as having a present value of about 6% of GDP, with a maximum yearly cost of 0.2% of mainland GDP in the late 2020s. In current expenditure terms this may seem small, but the principle of buying short–term industrial peace towards the peak of a cycle, with concessions that have long–term effects is a poor one (it was in such conditions that the original AFP scheme was introduced).With these measures, the government has gone a considerable way to shelter older cohorts from the full effect of the pension reform. Such concessions should not be extended further, or given to younger cohorts. Furthermore, the remaining elements of the pension reform, notably concerning disability and public sector pensions, should be implemented in line with the key elements of the reformed main pension system.
How to obtain this publication
The Policy Brief (pdf format) can be downloaded in English. It contains the OECD assessment and recommendations.The complete edition of the Economic survey of Norway 2008 is available from:
For further information please contact the Norway Desk at the OECD Economics Department at email@example.com. The OECD Secretariat's report was prepared by Paul O’Brien and Romina Boarini under the supervision of Patrick Lenain. Research assistance was provided by Ane-Kathrine Christensen, Elke Lüdemann and Thai-Thanh Dang.