Temporary price level target Yellen's predecessor as chairman of the Federal Reserve, Ben Bernanke, has proposed a solution that can be regarded as a special application of a makeup strategy. 24 This is based on the central bank under certain circumstances not having a target for inflation, but instead for the development of the price level. The difference may appear subtle, as inflation is the change in the price level, but it is potentially quite important. Let us assume that both the inflation target and the target increase for the price level is 2 per cent. If, in an inflation-targeting regime, one has an inflation rate that undershoots the 2 per cent target for a period of time, it is the central bank's task to bring it back on target. The fact that inflation has deviated from the target before is not important – “bygones are bygones”. But if it is instead the development of the price level that is the target and inflation deviates from 2 per cent, then this must be “made up for”. The principle is thus the same as Yellen's makeup strategy, but here one has clarified in advance that the target refers to the price level rather than inflation. The differences between a price level target and an inflation target is illustrated in Figure 7. 25 If something unexpected occurs in an inflation-targeting regime that causes inflation to be lower than the target, it is enough to bring inflation back to 2 per cent again (the bottom right figure).
The current inflation rate does not provide sufficient information to determine the level at which interest rates should be set now. Our analyses indicate that a substantial share of the effects of an interest rate change will occur within two years. Frequent and marked interest rate changes can keep inflation under tight control, but will lead to wide variations in output and employment. This can be called a strict inflation target. Theoretically, we could also have chosen to stabilise output without taking into account variability in inflation. This can be called a strict output target. In Norway, as in a many other countries, we have chosen an intermediate solution. Interest rates are changed more gradually with less impact on output than under a strict inflation target, and inflation is allowed to deviate from the target over a somewhat longer period. This is called flexible inflation targeting.44 A two-year horizon in interest rate setting will also contribute to smoothing fluctuations in output and employment. Two years is therefore normally a reasonable time horizon for achieving the inflation target. The most important monetary policy instrument is the interest rate on banks’ sight deposits in Norges Bank. Short money market rates will shadow changes in Norges Bank sight deposit rate. The shortterm nominal interest rate in Norway is now very low historically. With reduced pressures in the economy and the prospect of an inflation rate below target at the twoyear horizon, Norges Bank has over the past year reduced the key rate on a number of occasions.