The monetary policy response to an exchange rate shift also depends on the underlying cause, the perceived duration of the shift and the economic situation in other respects. • •  If the krona weakens on account of portfolio shifts that stem in turn from fears of rising inflation, for example, it is natural for this to elicit a tighter monetary stance. That was in fact a major argument for the Riksbank’s policy from 1993 to 1995. If, on the other hand, the exchange rate weakens at a time when overall inflationary pressure is low, for example in connection with declining international demand, this does not necessarily imply a threat from inflation. The weaker exchange rate is then rather a part of a real economic adjustment. Such mechanisms were presumably involved last autumn. Monetary policy therefore has to be based on an assessment of inflation prospects that is as comprehensive as circumstances permit. The exchange rate is one important factor in this assessment but normally it should not play an isolated role. That is why the Riksbank has chosen not to use a monetary index—a weighted combination of interest rates and the exchange rate—as an intermediate target. The Riksbank’s view of the exchange rate has altered a good deal since 1992. We have gradually placed more emphasis on the krona’s forecast path and been less concerned about its occasional fluctuations. As I see it, a number of things have contributed to this.
And many market participants were also expecting a correction at some point; but they generally felt they were well placed to handle it. In fact the severity and breadth of the downswing has surprised markets, commentators, and policymakers alike. In the light of subsequent developments, a number of commentators have concluded that the problem was simply a lack of attention and short memories. I don’t think it was quite as simple as that. I am with Mark Twain who said "History doesn't repeat itself, but it does rhyme." While the current crisis has some similarities to previous downswings – in the early 90s or of the 70s for example – there are some significant differences too. For example the last three recessions in the UK (in the 70s, 80s and early 90s) were preceded by sharp rises in consumption and activity and earnings to well above sustainable rates. As Chart 2 shows that was not true of the last few years when consumption, output and earnings all seemed unusually stable. Again in previous recessions, stress in the banking sector has tended to follow on from defaults and losses on domestic loans as interest rates rise and the economy slows down. But this time the downturn started in the banking sector – last summer when losses in the US property market not only led to losses in UK banks trading and treasury books but closed important sources of finance to them. The downturn in the housing market and then the wider economy followed.