The Norwegian economy has been flourishing of late, enjoying substantial real income growth with low inflation and very low unemployment. Benefiting from rising world energy prices and favourable supply shocks in the wake of globalisation, this good performance also reflects fiscal restraint, broadly successful monetary policy and the economy’s capacity to attract foreign labour. Macroeconomic policy is nevertheless facing a number of difficult challenges, both in the short and medium terms.

The inflation targeting framework used by Norges Bank has worked well but faces a difficult period. Although financial market conditions had tightened, the spring of 2008 saw core inflation rising close to the central bank’s inflation target, while headline inflation was high and fluctuating. The monetary stance may need to tighten further if demand pressure continues and cost-inflation accelerates or import prices pick up. But with downside risks from high household debt and the still uncertain resolution of the sub prime crisis and ensuing financial turmoil, a cautious approach is required.

The authorities have managed well the accumulation of buoyant petroleum revenues in a fund invested abroad, but long term challenges remain. Despite room in the short term within the confines of the budget rule, current government projections show a long-term financing gap that the expected returns from the Pension Fund are insufficient to close. On this basis, long-term fiscal consolidation is needed, and necessary structural reforms to increase working hours and reduce future pension and health spending will contribute to this adjustment. In the short term, while the 2008 budget plans to undershoot the fiscal rule, in practice it now appears that the budget is quite expansionary. Budgetary plans for 2009 should avoid an increase in the structural deficit, unless the output gap were to narrow significantly.

Strong demand has reduced unemployment and maintained high participation rates, but further efforts to reform disability and sickness leave schemes are required. Immigration has helped manage demand pressure, probably contributing to both higher growth and lower wage inflation than would have otherwise occurred. But, while immigration may be helpful for short term stabilisation, it cannot be a remedy for disincentives to labour market participation.

Norway is not making the most of education expenditure: the compulsory education system appears to be cost inefficient by international standards. Considering the large amount of public resources invested in education, improving educational outcomes is both possible and necessary: high educational achievement is essential for future productivity growth, innovation potential and high labour force participation. A number of measures must be taken to improve teaching quality, such as increasing qualification standards for new teachers, and increasing teachers’ use of appropriate professional training. Cost consolidation measures, increasing the size of schools or classes, would help to contain high unit costs, freeing resources that might be used for improving teaching quality. Finally, the increased resources the government is intending to put into education will not achieve their aim, in the highly decentralised Norwegian system, if accountability is not improved through provision of better performance information at all levels, with appropriate incentives for the various partners in education to work together to improve results.