The Riksbank’s objective is to maintain CPI inflation at 2 per cent per year. This makes inflation the most important factor for interest rate decisions. But it takes time for a change in the repo rate to have an effect on inflation. As a result of this time lag in monetary policy, the Riksbank must adopt a forward-looking approach and base its decisions on a forecast of future inflation. Most of the effect of an interest rate change is assumed to occur after one to two years. For this reason, inflation in this time-frame is especially important for the Riksbank's interest rate decisions.
So how does the Riksbank forecast inflation one to two years ahead? First, an assessment is made of economic activity and inflation abroad, with a particular focus on developments in Europe and the United States. This is followed by an assessment of the financial markets, for example the exchange rate and bond yields. International price developments and the exchange rate are important determinants of imported inflation. Finally, the Riksbank forecasts Swedish economic activity, which is a key determinant of domestic inflation. Coupled with an assessment of various temporary disturbances to inflation - so-called transitory effects – the assessments of imported and domestic inflation result in a forecast of Swedish inflation.
Outline of how the Riksbank prepares an inflation forecast
The Riksbank uses a number of different models in its forecasting work. Time series models and indicator models with strong forecasting capabilities are used to produce a first estimate of the future path of economic activity and inflation. Structural models are also employed to arrive at an overall assessment and to gain an understanding of why certain events happen. In addition, the Riksbank uses a large number of partial models of important relationships in the economy. These are capable of handling a larger number of details than structural models. At a number of meetings, the results of the various models are combined to produce a single inflation forecast.
To illustrate the consequences for monetary policy, the Riksbank’s forecasts assume that the repo rate will remain unchanged. In other words, the forecasts answer the question of what will happen if the Riksbank does not change its key interest rate. If the forecast of inflation exceeds the Bank’s target one to two years ahead, the repo rate is normally raised. Correspondingly, the repo rate is usually lowered when the forecast of inflation one to two years ahead is below target.
The Riksbank normally aims to attain its target of 2 per cent CPI inflation one to two years ahead. But there are situations when the Bank may deviate from this simple rule of monetary policy. First, disturbances can occur that indeed only have a temporary effect on CPI inflation, but that nevertheless have an impact on inflation one to two years ahead. In such circumstances, the Riksbank may decide not to counter the disturbance through monetary policy if CPI inflation is affected by certain factors that are not judged to have any significant permanent effect on inflation or the inflation process. Second, disturbances may have occurred and caused inflation to deviate substantially from the target. In this case, the Riksbank may decide to bring inflation back to the target over a slightly longer period than the usual one to two years. More information about transitory effects and target deviations can be found in the clarification at the bottom of the page.
One complicating factor associated with the CPI is how housing costs are calculated. These costs include households’ mortgage interest expenditure. Normally, this expenditure will rise when the Riksbank raises the repo rate and fall when the Riksbank lowers the repo rate. So if the Riksbank follows its rule and raises the repo rate because its forecast of inflation one to two years ahead is above target, households' mortgage interest expenditure will rise. This contributes to higher CPI inflation in the short term. In the same way, a rate cut based on a below-target forecast of inflation one to two years ahead leads to even lower CPI inflation in the short term. This effect does not have any impact on the inflation measure UND1X, since the measure does not include households’ mortgage interest expenditure. As a result, UND1X is an important complement to the official target variable CPI in the Bank’s monetary policy analysis.
To deal with the uncertainty under which decisions are always made, the inflation forecast is supplemented by an assessment of the risk situation at the time. For example, if the risk of higher inflation in the main scenario is greater than the risk of it being lower, there is said to be an upside risk. These risks are included in the risk-adjusted forecast, which forms the basis of the Bank’s monetary policy. Risk-adjusted forecasts of inflation have been published in the Inflation Report since the end of 1999. The below article describes how the Riksbank derives the uncertainty intervals that are incorporated into its inflation forecasts.