During an economic boom, rising asset prices facilitate increased borrowing through the higher value of collateral in the form of financial assets, houses and apartments. When the situation then turns, most likely associated with a tightening of monetary policy, the value of these assets falls and households’ financial situation deteriorates. If, in addition, the valuations have been over-optimistic, the price falls can be dramatic. The banks will in any case respond to the deterioration of both their own balance sheet and that of their borrowers by contracting their lending. During the following period of consolidation, inflation and economic activity will decrease. In a worst case scenario the banks’ loan losses will be large enough to threaten financial stability. Apart from the risk that expectations have been irrational, however, this kind of credit cycle is considered to be part of a normal adjustment process, which should be a component of forecasters’ informal and formal models. However, as the theory of credit cycles is not especially well-developed in the standard models that are taught in the field of economics, there is reason to suspect that the relationships are underestimated by forecasters. Other economists have pointed out that rises in asset prices that initially are justified by fundamentals, also attract short-term investors who contribute to pushing up prices. The longer the price rises continue, the greater the significance the speculators will have for price developments since investors with a longer investment horizon will no longer buy the assets.
According to these theories there is some scope for monetary policy to take account of the output gap without necessarily threatening price stability in the slightly longer term. An important condition for this, however, is that there is considerable confidence in the central bank’s aim to focus on long-term price stability. In the long run, monetary policy cannot determine the real interest rate but in the short term the real interest rate can be influenced and deviate from its long-term equilibrium position. An increasing number of central banks have adopted inflation targets during the 1990s. The introduction of statutory price-stability objectives, independent central banks, transparency and - not least - regulations that give long-term sustainability in the public finances have also been important means for increasing credibility for the ability of economic policy to maintain price stability. 1  2  E.g. Woodford, Claridas  BIS Review 40/2004  In Sweden, the Riksbank adopted an inflation target as early as 1993. According to this target, inflation measured in terms of the change in consumer prices should be 2 per cent per year, with a tolerance for deviations of +/- 1 percentage point. As monetary policy does not have an immediate impact, interest rate decisions are normally governed by forecasts of inflation one to two years ahead. To avoid the economic costs of excessively sharp fluctuations in economic activity, the Riksbank many decide not to take account of price effects that are judged to be temporary.