Adoption of the inflation target
Establishment 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 with a view to achieving price stability (see the 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 the indirect taxes gave rise to inflationary impulses. The Riksbank therefore stated that the target for monetary policy would not begin to apply until 1995.
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.
Why 2 per cent?
Too high inflation is harmful to the economy, as inflation usually varies substantially when it is high. Low and stable inflation creates for several reasons good conditions for favourable economic development (see further under the heading Why inflation targeting?).
But too low inflation is not good either. A too low inflation target increases the risk of deflation, that is, the general price level falls. Deflation has historically been proved to create problems. When there is deflation, future prices will be lower than today’s prices. As it will be cheaper in the future, households wait until prices have fallen before they consume. Companies postpone investments until prices have fallen. This means that production can fall as long as there is deflation. It may be difficult to break such a deflation process.
There is a tendency for the CPI to overestimate the actual rate of increase in the general price level. This is because it is difficult to entirely exclude the effects of quality changes in the CPI. To avoid deflation there is thus reason to set the target at a positive figure.
On the whole, this suggests that the target should be low but above zero. The reason for choosing 2 per cent was that inflation was approximately 2 per cent when the target was introduced. Moreover, this was in line with the inflation targets in other industrial nations.
Below you can find the press release from 1993 in which the inflation target was announced.
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