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Evaluation of Norges Bank's projections for 2003.

Article Excerpt
Consumer price inflation (1) in 2003 was substantially lower than previously projected by Norges Bank and other forecasters. The difference between actual and projected consumer price inflation can be mainly explained by a sharp fall in prices for imported consumer goods. This in turn is attributable to the krone appreciation in 2002 and the fall in prices for these goods measured in foreign currency. The rise in prices for goods and services produced in Norway was also somewhat lower than expected. Prices fell more than expected in the last part of 2003 in particular. Weaker economic growth, coupled with increased competition and greater efficiency in a number of industries, probably contributed to pressure on prices for both goods and services produced in Norway and imported consumer goods.

Since March 2001, Norges Bank's operational objective for monetary policy has been low and stable inflation. The inflation target is set at 2 1/2 per cent. Monetary policy is forward-looking. Projections for price inflation and economic developments therefore form an important basis for monetary policy decisions.

Analysing forecast error can help us to improve the accuracy of our forecasts in the future and our understanding of the disturbance to which the economy has been subjected. In the light of new, lower projections for externally generated impulses to the Norwegian economy, Norges Bank has revised previous estimates of the exchange rate pass-through to prices for imported consumer goods. Preliminary estimates indicate that the pass-through to these prices may be somewhat weaker, and come later, than previously assumed.

1 Introduction

Like other central banks with an inflation target for monetary policy, Norges Bank uses projections for consumer price inflation as a basis for the setting of interest rates. If monetary policy is to fulfil the operational objective of stable inflation, a thorough understanding of the factors behind price movements is crucial. By analysing forecast error, we gain a better insight into and understanding of economic relationships and price formation. This is important for enabling us to improve the accuracy of our projections.

There may be many reasons why projections do not tally with actual developments. (2)

* The projections in the Inflation Report are based on technical assumptions concerning interest rates and exchange rates. These assumptions do not necessarily reflect the most probable outcome. The purpose of Norges Bank's projections is to provide a basis for monetary policy decisions. Consequently, our projections will not always be the most accurate forecast of economic developments. If, for example, the conditional projection for consumer price inflation two years 'ahead is lower than the inflation target, the interest rate will normally be reduced with a view to achieving the inflation target. In such a situation, the interest rate is changed precisely in order to achieve a different outcome from the projected one. When the projections are evaluated, it is important to bear in mind that they do not necessarily represent Norges Bank's view of the most probable outcome.

* The projections are also based on assumptions concerning international economic developments, oil prices, public expenditure, and direct and indirect taxes. These are factors that monetary policy cannot influence. If developments differ from the assumptions made for these variables, the projections will not be accurate.

* The economy is constantly subjected to unexpected events or shocks that it is not possible to take account of in advance.

* There is uncertainty surrounding the actual state of the economy at the time the projections are published. This is because it takes time for the statistics to be published, and because the statistics are often extensively revised. If the basis for analysing future developments is incorrect, forecast error may result.

* The analytical apparatus that is used may provide an inaccurate or inadequate description of actual economic relationships.

* All projections involve a certain degree of judgement. Forecast error may also arise if this judgement proves to be unsatisfactory.

This article is an evaluation of the inflation projections for 2003. (3) Norges Bank has also provided an account of consumer price inflation in 2003 and the background to the deviation from the inflation target in the Annual Report for 2003 (March 2004).

2 Projected inflation in 2003

Chart 2 shows changes in Norges Bank's inflation projections for 2003 and actual inflation. The projections were gradually revised downwards from the summer of 2001. Other institutions lowered their projections for inflation in 2003 to approximately the same extent as Norges Bank (see Chart 3). On the whole, Norges Bank revised its projections downwards somewhat earlier than most of the other institutions shown in the chart.

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The difference between actual and projected price inflation in 2003 must be assessed in the light of developments in the economic variables that influence price inflation. Inflation is...

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