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Since mid-2003, mainland Norway has experienced a robust cyclical upswing. After booming at nearly 4% in 2005 thanks to strong domestic demand, mainland real GDP growth is projected to slow towards potential in 2006 and ease further in 2007 in response to the withdrawal of monetary stimulus.

With oil revenues surging and pressures for higher public spending rising in 2006, it will become increasingly important to adhere to strict budgetary discipline so as to preserve the credibility of the fiscal rule, following up on declarations of the new government. Gathering inflationary pressures call for a return to a neutral monetary stance.
Strong domestic demand is boosting growth

The Norwegian mainland economy expanded at an annual rate of 3% in the first half of 2005, with no sign of imminent weakening. The upturn is now broadly based, with strong activity in services and in manufacturing alike. Non-oil business investment has recently picked up and the housing market has remained buoyant. Strong private consumption and record high oil investment should bring growth to 3 3/4 per cent for the year. So far, the recovery has led to an increase in working hours per employee rather than a rise in employment levels. Yet, there are encouraging signs that the Norwegian economy will start creating new jobs. The unemployment rate, still at a relatively high 4 1/2 per cent, should thus begin to turn down soon. Core inflation remains subdued because of low import prices and strong competition pressures. However, some statistical indicators of underlying inflation as well as accelerating domestic prices support the picture of mounting inflationary pressures.

Macro policies are moving towards a neutral stance

Mainland Norway is showing some signs of mild imbalances. Fuelled by low real interest rates, household credit growth is running at a 12% annual rate and housing price-rent ratios have reached historical highs. The Norges Bank is thus expected to continue a gradual removal of stimulus that started in July 2005 with a cautious hike of a 1/4 per cent. Short term interest rates are assumed to rise faster than expected by the market, from a very low level, nonetheless leaving monetary conditions supportive in the near term. On the fiscal side, public spending growth has remained strong up to now despite favourable cyclical developments. However, the budget from the newly elected government implies a stabilisation of the non-oil structural deficit as a share of mainland GDP in its revised budget for 2006. As a result, the excess spending compared to the fiscal rule is significantly reduced following three years of substantial deviations. The proposed introduction of a dividend tax in 2006 could lead to a fall in household disposable income, which consumers are expected to offset through a lowering of their saving ratio.

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The cyclical upturn is expected to continue

Mainland GDP is projected to expand by 2 3/4 per cent in 2006, close to the potential growth rate, then slow somewhat toward 2 1/2 per cent in 2007. Private consumption and non-oil investment should be the main growth drivers next year. Oil related investments should reach record-high levels in early 2006 leading to strong spillovers in the mainland economy. But business investment projects are expected to slow a bit over the next two years, allowing growth to converge toward its potential rate. The gradual removal of fiscal and monetary stimulus should also limit buoyant domestic demand in 2007. Over the next two years, a slowing productivity per head should translate into the creation of new jobs, pulling the unemployment rate down to slightly below 4%, close to the estimated level of the structural unemployment rate. Because of high profits and fairly good conditions in the exposed sector, which leads the wage round, wages might accelerate somewhat in 2006.

Risk of tensions on the domestic front

The new government has promised higher public spending on education, long term care and municipal infrastructure. There are thus substantial risks of new deviations from the fiscal rule, especially in light of higher oil prices and surging oil revenues. Excessive wage claims could also rise due to a faster than expected fall in unemployment, and fuel inflationary pressures.


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