In  2  The effects are dependent on, for example, how the long-term interest rate is assumed to move when the repo rate is adjusted. In example 1 the estimates are based on the short- and long-term interest rates moving to the same extent, which has largely been the case in recent years. BIS Review 61/1999  6  such a situation it is therefore reasonable to base policy on an inflation forecast that excludes the direct effects on interest expenditure. 8. Permanent and transitory inflation A schematic account Initial position  4  Economic development stable, underlying inflation UND1X - in line with the target. 3 UND1X  Government and Parliament lower indirect taxes CPI-inflation is lowered for a period of twelve months but underlying inflation, measured with UND1X, remains stable. 2 CPI  1  0 0  1  2  3  Year  Example 2: altered indirect taxes In this example economic activity is stable and inflation in line with the target. Suddenly a cut in indirect taxes, for instance the tobacco tax or the property tax on private houses, is announced and approved. The cut is assumed to have a downward effect on CPI inflation of 0.7 percentage points in the current year. This, however, constitutes a one-off shift in the price level, not an effect that alters inflation’s trend. All else equal, 12 months later the rate of inflation will shift back up to the earlier level.
It is difficult to completely capture a sequence of events where changes in different variables tend to reinforce one another in economic calculations. If the households have also been overly optimistic - irrational - in their expectations, it becomes particularly difficult to capture these effects. It is therefore important for forecasters to make more “qualitative” assessments in addition. Another reason for not trusting solely to formal models based on historical data is that the effects of structural changes that have taken place fairly recently can easily be underestimated. Let me give an example that to some extent captures these problems. During the years from the mid-1980s to the beginning of the 1990s, substantial changes were made in the economic structure and there was a clear correlation between the change in house prices and the change in household borrowing. The decline in house prices during the financial crisis at the beginning of the 1990s was largely due to an unfavourable combination of changes of both a structural and a cyclical nature. In connection with the deregulation of the credit markets during the second half of the 1980s, household borrowing increased substantially and the loans were largely used to buy houses. The fairly high and fluctuating inflation rate contributed to real interest costs after tax often being low, sometimes even negative, which in practice meant that one could at times make a profit from borrowing.