Control of the money supply
In recent years inflation has surged to levels not seen in decades in Norway. Some people claim that this is due to factors beyond the control of the central bank such as supply chain disruptions, the war in Ukraine or soaring global energy prices. While these events undoubtedly has had an efffect on prices, they are of temporary nature and they don't create a permanent uptick in the price level. To find the main driving force of the inflation it instead makes sense to take a closer look at monetary policy and understand its effect on the money supply.
Monetary policy response to Covid-19
Economies around the world came to a standstill when the COVID-19 pandemic hit in early 2020. To combat the unprecedented economic fallout, central banks took extraordinary measures to stabilize financial markets and support economic activity. One of the most significant moves was the rapid reduction of interest rates to near-zero, and in some cases, negative levels. The goal was to make borrowing cheap and to encourage spending and investment, in order to prevent deeper economic contractions.
With interest rates set so low, borrowing became essentially free for the governments, businesses and household alike. The government borrowed money to finance various initiatives to support the economy, while businesses and households took advantage of low mortgage rates or other forms of credit. As a result, credit growth soared, and the overall money supply in the economy began to expand rapidly.
Norway was no exception, and in the period from early 2020 to 2022 the money supply expanded by more than 25%.
Source: Statistical Bureau of Norway
Link between money supply and inflation
The economist Milton Friedman once famously stated that “Inflation is always and everywhere a monetary phenomenon, in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output." He went on to popularize the quantum theory of money. According to this theory, if the amount of money in an economy doubles, all else equal, price levels will also double.
This dynamic played out clearly in Norway during the COVID-19 years. Norges Bank, like many central banks globally, allowed the money supply to expand rapidly while the overall economic output did not keep pace. As lockdowns and restrictions slowed production and disrupted global supply chains, the Norwegian economy’s ability to produce goods and services was constrained. This mismatch between a rapidly expanding money supply and stagnant or even declining economic output created fertile ground for inflation. With more money circulating in the economy, but fewer goods and services available to purchase, price levels inevitably began to rise. The inflationary pressures that followed are a direct reflection of this imbalance, highlighting the critical role that monetary policy plays in managing inflation risks.
Source: Statistical Bureau of Norway
Monetary policy response
Norges Bank started raising interest rates gradually from zero in September 2021 to address mounting inflationary pressures. They proceeded to raise rates slowly and incrementally to 4,5% over a two year period. This has reduced the growth in the money supply, but it hasn't been enough to curb inflation. In their latest monetary policy report (3/2024) they expect inflation to remain above the 2% target for several more years.
This slow progress in achieving inflation control reflects both the time-lagged nature of monetary policy and the difficulty of reining in inflation once it has taken hold. The persistence of high inflation suggests that previous expansions in the money supply are still exerting upward pressure on prices, with excess liquidity circulating throughout the economy. Unfortunately by not managing to curb inflation sooner, the central bank has sparked debate over whether its commitment to the inflation target is robust enough to inspire confidence. Maintaining interest rates that allow inflation to linger above target signals that Norges Bank may be prioritizing other factors over strict inflation control. If this perception grows, it could erode trust in the inflation target itself, potentially complicating future efforts to bring inflation in line with long-term goals.
