We must always bear in mind that monetary policy is not an “exact science” based on well-defined natural laws. It is not possible to fine-tune the interest rate to attain the objectives with high degree of precision. Irrespective, the criteria for a good interest rate path provide a guide for our interest rate policy. 4. Inflation volatility, deviations from the inflation target and external shocks Inflation adjusted for energy prices and taxes has been low in Norway in recent years. It has risen somewhat, but it is still considerably lower than the target of 2.5 per cent. BIS Review 26/2006  3  Inflation has been and is still being restrained by the fall in prices for imported consumer goods, an unexpected high level of competition in domestic markets and increased cross-border labour flows. The trend in prices for consumer goods and services over the past two or three years is a result of favourable developments in the Norwegian economy. Low inflation is being accompanied by real income growth and a rise in production and is not the result of declining demand, activity or employment. Deviations from the inflation target in Norway have been somewhat higher than in other countries, which may partly reflect the degree of openness of our economy. Chart 12 shows deviations from target and the degree of openness. The higher the columns, the larger the deviations are from target. The lines indicate the degree of openness.
Third, even in the case where the central bank knew that financial imbalances were building up, the size of the interest rate rise needed to reduce the imbalances might be so large that it could lead to a severe economic downturn. In Norway, the central bank is one of the institutions with responsibility for analysing and monitoring the financial system. As a flexible inflation-targeting country, we have chosen to incorporate financial stability considerations into the monetary policy decision-making process, partly because asset prices and debt are important for inflation and output, and partly because it provides focus on potential risks to financial stability. It may also be useful to cross-check by assessing our interest rate policy in the light of simple rules like the Taylor rule, which are less dependent on a specific analytical framework for the Norwegian economy. On the other hand, the rules will not capture all details in the projections, but can provide an indication of whether the current interest rate level is reasonably adapted to the economic situation. As we now publish our own interest rate forecast, market interest rate expectations are one cross check of particular interest. If expectations deviate from our projection, it may indicate that the market has a different view of future economic developments. If we are to influence interest rates in the money market, we must be able to explain such deviations. Of course, it might also be the case that the market’s view is the most accurate.