The mean squared gap for the inflation forecast is defined as    0 t  ,t   *  / T  1 , where t  ,t denotes the forecast in quarter t for inflation T  2  in quarter t  ,  * denotes the inflation target, and T denotes the forecast horizon (normally 12 quarters). 4  In the Monetary Policy Reports, the following note is also usually attached to the resource utilisation diagram. “These gaps should not necessarily be interpreted as the Riksbank’s overall assessment of resource utilisation.”  4  BIS Review 22/2010  Figure 1 here or Figures 2.13–2.15 in the Monetary Policy Report summarise the essence of the monetary policy decision. What monetary policy alternative shall we choose? Which repo rate path shall we choose: the one in the main scenario, or a higher or lower repo rate path? My firm opinion is that a large part of the monetary policy decision-making process and discussion should centre on monetary policy alternatives and their advantages and disadvantages. I fear that the decision process will otherwise fix too quickly and too uncritically on one particular alternative instead of carefully and meticulously considering several alternatives, choosing the best one, and very clearly describing why one particular interest rate decision was made and not another.
But how can the degree to which monetary policy has succeeded in stabilising inflation and resource utilisation be measured? The mean squared gap for inflation is a natural measure of the stability of inflation around the inflation target. The mean squared gap for output is a natural measure of the stability of the output gap and thus of the stability of resource utilisation around a normal level. Looking at Figure 1, it could be claimed that the mean squared gaps in panels b and c do not tell us anything of significance, as it is obvious from panels d, e and f that the lower repo rate path leads to a better outcome. However, the situation is unusual in that the main scenario is not efficient – that is, that it is possible to find another repo rate path that better stabilises both inflation and resource utilisation. A more normal situation is one in which a balance must be struck between prioritising the stabilisation of either inflation or resource utilisation. Such a situation prevailed for Norges Bank in March 2005, for example. In Figure 4, I present the mean squared gaps calculated on the basis of the alternative policy rate paths and equivalent forecasts for inflation and resource utilisation presented in Norges Bank’s monetary policy report from March 2005. The policy rate path then chosen depends upon the weighting placed by the central bank upon stabilising the output gap, as opposed to stabilising inflation (this weight is usually denoted by  ).