Doing so may enable the central bank to take into consideration the longer-run  BIS Review 96/2007  3  consequences on inflation and production of potentially large movements in asset prices and levels of indebtedness that have been built up over long periods of time. From a theoretical perspective, central banks should always look at inflation and growth over the indefinite future, and thus this seems a reasonable proposal. At the same time one must remember that in practice it is difficult to construct forecasts for longer horizons that actually contain more information than that which is contained in the forecast for the coming two to three years. Also, the horizon may in fact have to be very long to illustrate the issues at hand. The Riksbank view The monetary policy strategy followed by the Riksbank is that of flexible inflation targeting. When setting interest rates we consider not only the outlook for inflation but also the development of the real economy. In most situations, monetary policy is focused on bringing inflation back to target within a two-year horizon, which is deemed as providing enough time to allow consideration to be given to developments in the real economy. In certain circumstances, if inflation has deviated substantially from the target, it is reasonable to let inflation return to target at a slower pace, provided this does not undermine the credibility of the inflation target.
In short, there are two arguments for this: (i) engaging in such behaviour – let’s call it “leaning against the wind” – in situations when an asset price is changing due to non-fundamentals can dampen the effects of the unmotivated price change on the real economy and thereby prevent an inefficient allocation of resources; (ii) if the market knows that the central bank engages in “leaning against the wind” activities the probability will fall of non-fundamental price changes arising in the first place. The key issue here is, of course, identifying price changes that are driven by nonfundamentals. This problem cannot be overly emphasized. But difficult or not, it is an issue that central banks cannot ignore. If prices of houses or other assets are partly driven by factors that are hard to explain and that are believed to give rise to inefficient allocations and risks of large fluctuations in real economic activity and inflation, such events will, in one way or another, find their way into our thinking about monetary policy. Extending the forecasting horizon In practice, most inflation targeting central banks have chosen to adopt forecast horizons of two to three years, at least in external communication and official documents. In this environment, the idea that a central bank can need to extend the horizon over which it constructs inflation and output forecasts is one that has been heard from many central banks.