Principles that guide the monetary policy decisions in the new interest rate assumption When our forecasts were based on an unchanged repo rate, monetary policy could be explained by the simple rule of thumb that I described – the repo rate would normally be changed if the forecast showed inflation deviating from target. With the new interest rate assumption, monetary policy can no longer be described by a simple rule of thumb of this kind. How do we then reason instead when we make monetary policy decisions applying inflation forecasts based on our new interest rate assumption? If inflation is expected to be close to target in a two-year time perspective, given the interest rate path on which the inflation forecast is based, this could indicate that the interest rate movements expected by the market are desirable. However, to determine this we must also take into account the consequences for the whole paths of inflation and the real economy that this interest rate policy is expected to give rise to. BIS Review 33/2006  3  Let me illustrate this by explaining how we reasoned at the Executive Board meeting when we chose to raise the repo rate by 25 points in February, despite inflation being low during a large part of the forecast period and close to but still under target in a two-year time perspective 2 .
Let me now go on to how the interest rate assumption is to be used and interpreted in connection with the monetary policy decisions. 2  BIS Review 33/2006  Communication and the interest rate path The interest rate path which the Riksbank uses in the Inflation Reports is based, as I have said, on implied forward rates, and these are calculated on the basis of interest rates on treasury bills and government bonds. The implied forward rate curve on which the forecasts are based is an average of 15 different daily implied forward rate curves. For instance, the interest rate path used in the latest Inflation Report was based on an average of the daily curves between 20 January and 9 February 2006. The reason we have chosen to use an average is because we wanted to exclude temporary movements in the implied forward rates (see Figure 1). At the same time, this means that the implied forward rate curve, as we calculate it, does not reflect market expectations about the future repo rate at a particular point in time but instead the estimated average expectation during the selected 15-day period. Despite the fact that we now base our forecasts on an interest rate assumption that is normally reasonably realistic, it is important to underline that this assumption does not necessarily coincide with the Riksbank’s own expectations about future repo rates. Our assessment of how the economy will develop can differ from that made by market participants.