At the same time, Norges Bank - which had maintained its rate since March 2012 - said the Norwegian krone currency had depreciated markedly, helping dampen some of the negative economic impact of the weaker oil prices and underpin inflation, which is expected to be close to 2.5 percent in coming years.
In addition to its rate cut, the central bank said its key policy rate should lie between 0.75 percent and 1.75 percent until March 2015, unless the economy is exposed to new major shocks.
In September the central bank said it expected its policy rate to remain at 1.5 percent until the end of 2015 but in October it omitted that guidance due to uncertainty surrounding the outlook.
Norway's headline inflation rate eased to 1.9 percent in November from 2.0 percent in October while Gross Domestic Product expanded by 0.5 percent in the third quarter from the second for annual growth of 2.1 percent, up from stagnation in the second quarter.
In its latest forecast, the central bank projected average consumer price inflation of 2.0 percent this year, rising to 2.50 percent in 2015 and 2.75 percent in 2016.
Total GDP by Western Europe's largest crude oil producer is forecast to expand by 2.0 percent this year, up from 0.7 percent in 2013, and 1.25 percent in 2015 and 1.75 percent in 2016.
The Norwegian krone has been hit hard by the decline in oil prices, falling to around 7.22 today - a level that has not been seen since December 2008 - and a drop of almost 16 percent this year.
Norges Bank issued the following statement:
"Norges Bank's Executive Board decided to lower the key policy rate by 0.25 percentage point to 1.25 percent.
The upturn in the world economy remains moderate and there is considerable uncertainty surrounding developments ahead. Growth prospects for the Norwegian economy have weakened. Activity in the petroleum industry is softening and the sharp fall in oil prices is likely to amplify this tendency. This will have spillover effects on the wider economy and unemployment may edge up ahead. At the same time, the krone has depreciated markedly, which is helping to dampen the effects on the Norwegian economy and underpin inflation.
"The analysis in the Monetary Policy Report presented today implies a key policy rate of 1¼ percent, or somewhat lower, in the period towards the end of 2016", says Governor Øystein Olsen.
Capacity utilisation in the mainland economy will probably decline to a further extent than projected earlier, but is expected to increase again towards the end of the projection period. Inflation is projected to lie close to 2.5 percent in the coming years.
The Executive Board decided at its meeting that the key policy rate should lie in the interval ¾–1¾ percent in the period to the publication of the next Report on 19 March 2015, unless the Norwegian economy is exposed to new major shocks."
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