The illustration is from our third Monetary Policy Report in 2012. If monetary policy at that time had given weight only to the low level of inflation, the key policy rate should have been lowered sharply and kept close to zero for some time, as indicated by the red dotted line in the upper left panel. Inflation would then have been predicted to pick up relatively fast, partly owing to a weaker exchange rate. Taking into account our second criterion for an appropriate interest rate path, the key policy rate would have been somewhat higher in the short term, as indicated by the blue dotted line. Inflation would have been predicted to take somewhat longer to rise towards the target, but developments in output and employment would have been more stable. Finally, taking into account considerations of robustness (criterion 3), we reached the interest rate forecast indicated by the black dotted line. [Chart: Decomposition of change in the interest rate path] Our communication of interest rate decisions is aided by a decomposition of changes in the interest rate path. This is a model-based illustration of how the change in the interest rate forecast from one report to the next can be decomposed into contributions from exogenous disturbances. The intention is to communicate the driving forces behind any changes in the interest rate path. The chart illustrates the different forces behind the change in the interest rate path from the last report in 2012 to the last report in 2013.
4  BIS central bankers’ speeches  our inflation targeting regime should be flexible. Hence, the interest rate path should provide a reasonable balance between the path for inflation and the path for overall capacity utilisation in the economy. We have learned that stabilising inflation involves important trade-offs in a small open economy. Let me elaborate a bit on this point: Shortly after we adopted inflation targeting in 2002–2003, efforts to dampen inflationary pressures resulted in a strong krone appreciation, with strong impacts on the economy. Later, in the mid-2000s, when inflation was low while at the same time growth was strong, low interest rates at home and abroad contributed to amplifying the cyclical upturn in Norway. In the light of our experience, it is fair to say that our inflation targeting regime has become more flexible over time. The third criterion is that the interest rate path should reflect a robust monetary policy. By this we mean that the interest rate should be set so that monetary policy mitigates the risk of a build-up of financial imbalances. Moreover, acceptable developments in inflation and output should be likely under alternative assumptions about the functioning of the economy. Implementing these concerns analytically is not straightforward, however. We are working intensively to refine our approach to these concerns in our analytical framework. [Chart: Criteria for an appropriate interest rate path] This chart illustrates how the forecasts for the key policy rate, output and inflation evolve when the various criteria are taken into account.