The Riksbank’s target is that the annual change in the consumer price index (CPI) should be 2 per cent. This makes inflation developments an important factor for interest rate decisions. Monetary policy is normally focused on achieving the inflation target within two years. One reason for this is that the effects of monetary policy appear with a time lag. Another reason is that the Riksbank, by aiming at this horizon, can contribute to dampening fluctuations in the real economy while at the same time maintaining the credibility of the inflation target.
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, e.g. 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, 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 an inflation forecast.
At the beginning of 2007, the Riksbank changed over to making forecasts for economic developments in Sweden based on the interest rate path the Executive Board of the Riksbank considers at that point in time to be most appropriate. During 2005 and 2006, the Riksbank made its forecasts under the assumption that the repo rate would develop in accordance with market expectations (as reflected in implied forward rates). Previously, forecasts were based on the assumption that the repo rate would be unchanged during the forecast period.
The most important reason for publishing the Riksbank’s own assessment of the future development of the repo rate is that it will help the central bank to explain to the general public and the financial markets how the Bank sees interest rate developments and how it reasons when making monetary policy decisions. It will become clearer what the Riksbank considers to be a well-balanced monetary policy. This will make monetary policy easier to understand, to predict and to evaluate.
Normally, a well-balanced monetary policy means that inflation is close to the inflation target two years ahead while inflation and the real economy do not show excessive fluctuations. An interest rate path that leads to inflation rising rapidly, at the same time as growth in the real economy is high and capacity utilisation is strained, is probably not a desirable monetary policy, even if inflation is close to 2 per cent two years ahead. In this case the interest rate path may entail an overly expansionary monetary policy that leads to unacceptably large fluctuations in inflation and real economic activity. A well-balanced monetary policy may here be to instead allow slightly longer than two years for inflation to reach the target, while the real economy can develop more smoothly. Similarly, a longer period of time than two years may be needed to bring inflation back on target if inflation has been pushed up at the same time as growth is weak (which may, for instance, result from sudden energy price rises).
A desirable monetary policy should also be predictable in order to make it easier for households and companies to adapt to new economic conditions. Changes in the repo rate should therefore normally be made gradually and not in large steps. Moreover, changing the interest rate gradually provides an opportunity to await and analyse new economic data. The fact that it is difficult to know exactly how the economy functions and how monetary policy acts also means that one normally proceeds cautiously in changing interest rates.
However, it is important to emphasise that the Riksbank, in presenting its view of a suitable path for the repo rate, has not committed itself to any particular future monetary policy. As with all other assessments, the interest rate forecast will need to be revised on the basis of new information received on economic developments in Sweden and abroad and the effects this may have on the prospects for inflation and economic activity in Sweden. There is thus uncertainty over future interest rate developments in the same way that there is uncertainty over the general future development of the economy.
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.