Since it takes time – we allow for a time horizon of one to two years before the transmission mechanism has worked through the economic system – we have to form an opinion of the state of the economy in the long run. Predicting the future is difficult for many reasons, not just due to statistical shortcomings but also because the economy is changing all the time. The economy can be hit by different kinds of shocks, e.g. the increased electricity prices when there was a shortage of water in Sweden’s reservoirs, and  BIS Review 10/2005  3  the price of meat and other food when cows in Europe were affected by a number of diseases. It is difficult to determine early on what changes in the economy are temporary and what are permanent. Another factor complicating the picture is that inflation expectations in society greatly influence price and wage formation, and thereby inflation. In other words the car – to continue with the analogy – has a fogged windscreen, a speedometer that is very difficult to read and pedals that sometimes are sluggish and sometimes easy to push down. How can we make the economy go at an appropriate speed?
So inflation expectations play a key role for monetary policy and for that reason we keep a close eye on how they are developing.3 Perhaps the most important task of monetary policy is to influence inflation expectations since it is via market rates, and not the repo rate itself, that demand in the economy is affected. That is why communication and credibility are so significant. If we can get our message across we increase the chances of a successful monetary policy. Monetary policy in a low-inflation economy The Riksbank’s rule of action, which says that the policy rate should be adjusted when inflation is above or below target one to two years ahead, is not at all as mechanical as is sometimes perceived. The Executive Board’s clarification in 1999 made it clear that the practical formulation of monetary policy takes account of developments in the real economy. According to the clarification there may be reason for the Riksbank to deviate from the target if inflation is being affected by a temporary shock that will not fully dissipate during the coming two-year period but that is nonetheless not deemed to have any lasting influence on inflation developments. Another reason is when a bigger shock makes a return to the target one to two years ahead associated with excessive undesirable effects on the real economy. There are many examples in recent years of when we have taken such factors into account. At the turn of the year 2002-2003, for example, rising energy prices were pushing up inflation quickly.