The Riksbank’s objective is to maintain CPI inflation at 2 per cent per year. This makes inflation developments an 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 from this perspective is especially important for the Riksbank's interest rate decisions. The two-year time horizon also gives the Riksbank scope to take developments in the real economy into consideration when making interest-rate decisions.
How does the Riksbank forecast developments in inflation and the real economy? 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.
Since the middle of 2005, the Riksbank has based its forecasts on the assumption that the repo rate will follow market expectations, as reflected in what are known as implied forward rates. If inflation according to this assumption is assumed to be close to target two years ahead, market expectations of future monetary policy can usually be regarded as reasonable. However, to determine this more definitely, consideration must be given to how inflation and the real economy will develop throughout the entire forecast period. If, for instance, inflation were to increase very rapidly, at the same time as growth in the real economy remained high, it is possible that the assumed interest rate path might not be considered desirable, even if inflation were to be close to 2 per cent after two years. In this case, the assumed interest rate path probably means that monetary policy is too expansionary. A desirable monetary policy is characterised by inflation under normal circumstances being close to the inflation target in a two-year time perspective while at the same time the paths for inflation and the real economy do not exhibit excessively large fluctuations. Under very special circumstances, when inflation deviates substantially from target, there may be justification for allowing inflation to return to target beyond the normal two-year horizon.
There is no single measure of inflation that at each point in time indicates the desirable stance of monetary policy. The goal of the Riksbank’s monetary policy is to stabilise the rate of increase of CPI at 2 per cent. The Riksbank sometimes chooses to emphasise measures of "underlying" inflation, where certain factors have been excluded. These measures are used as an aid in attaining the target in terms of CPI inflation and in enabling us to explain the way monetary policy is conducted. UND1X has a special status here. UND1X measures inflation adjusted for the direct effects of changes in indirect taxes and subsidies and mortgage interest expenditure. However, the need to emphasise alternative measures of inflation has declined since the Riksbank in 2005 extended the forecast horizon from two to three years. The difference between CPI inflation and the various measures of "underlying" inflation declines with the length of the time horizon.
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.