Norway inflation softens but rate cuts unlikely as NOK extends losses on continued drop in crude prices

We stated last week that the recent oil price slumps kept down Norges bank by rate cuts and in turn NOK has weakened significantly over the summer, driven lower by an extremely dovish Norges Bank as well as renewed weakness in oil, even as data surprises improved over the same period. In fact, the trade weighted NOK, it is currently at historical lows and NOK REER is close to 15% below its long-term average suggesting that some retracement may be in order.

Nevertheless, uncertainty on the oil outlook, recent weakness in employment data and a Central Bank that seems to have its finger on the trigger for another rate cut could keep pressure on NOK in the near term. With oil making up around 20% of Norway's GDP, the importance of oil prices for NOK is undisputed. A sustained drop in oil prices results in less favorable terms of trade which, in isolation, implies a weakening currency. This fortnight will be an important phase for Norges Bank. In essence, today's data is tipping the scales for or against a rate cut in September. Back in June, Norges Bank had hinted that it was tending towards another rate step in order to stimulate the economy, which was increasingly suffering from the low oil prices. Now, however, high inflation is threatening to scupper these plans.

While the July inflation data has been reduced to -0.1% from previous 0.3%, this will probably confirm that the price spike was caused by one-off effects, there is still a risk that inflation will overshoot the target. The July data confirms that underlying price pressures are increasing, Norges Bank is more likely to stay on the sidelines in September.

As oil prices have declined again, the crown has depreciated considerably, too. On the one hand, this depreciation will compensate the effects of the lower oil prices to some extent, on the other, it will boost inflation via higher import prices. If Norges Bank sticks to its goal of price stability, it has less and less room for rate cuts. That means that the NOK will trade firm if inflation data come in on the high side. And the exchange rate will ultimately be an important factor for Norges Bank's rate decision. EUR-NOK is relatively illiquid, the exchange rate will remain volatile as long as there is uncertainty about the rate decision in September.