Adoption of the inflation target
On 19 November 1992, the Riksbank was forced to abandon the fixed exchange rate against the ECU, the predecessor to the euro. This followed a period of turbulence in the foreign exchange market and speculation against the krona. Since then Sweden has had a floating exchange rate, which means that the value of the krona vis-à-vis other currencies is allowed to fluctuate and is determined in the foreign exchange market.
On 15 January 1993, the Riksbank announced that monetary policy would be conducted in future with a view to achieving price stability (see press release below). When the fixed exchange rate was abandoned the value of the krona against other currencies weakened (depreciated) sharply. At the same time, a number of changes were made to indirect taxes. Both the depreciation and the changes in indirect taxes gave rise to inflationary impulses. For this reason, the Riksbank announced that as of 1995 the objective of monetary policy would be to limit the change in the consumer price index to 2 per cent per year. During 1993 and 1994, monetary policy was aimed at preventing the inflationary impulses from spreading to underlying inflation.
The inflation target has since been defined as keeping the annual rise in the CPI at 2 per cent, with a tolerance range of plus/minus 1 percentage point around this target. The main reasons for defining the target in terms of the CPI are that this is the best known and most frequently used measure of inflation, it comprises a very large proportion of household consumption, and it is published monthly.
But why was 2 per cent chosen as the inflation target? On the one hand, there is an upper limit based on historical experiences of high inflation. Periods of high inflation are most often associated with sharp fluctuations in inflation. In order to avoid this, the target should not be set too high.
On the other hand, it is not good either to have a target that is too low. Since it is difficult to completely exclude the effects of quality improvements from the CPI, there is a tendency for the CPI to overestimate the actual increases in households’ cost of living. Consequently, to avoid deflation, that is a fall in the general price level, there is reason to set the target above zero.
It is also generally accepted in economic theory that a certain low rate of inflation is desirable since it facilitates adjustments of various relative prices. It could be said that a certain low rate of inflation greases the wheels of the economy to facilitate a more efficient use of resources.
On the whole, this suggests that the target should be low but above zero. The reason for choosing 2 per cent was partly that inflation was approximately 2 per cent when the target was introduced. Moreover, this was in line with the inflation rates experienced by other countries or their stated inflation targets.
The purpose of the tolerance range of plus/minus 1 percentage point is mainly to clarify that monetary policy cannot entirely prevent deviations from the target. At the same time, the range is an expression of the Riksbank’s ambition to attempt to limit such deviations.
Below you can find the press release in which the inflation target was announced.