The long-term inflation expectations then play an important role. Here we can mainly have an effect by conducting a credible monetary policy. Long-term interest rates are also affected by the economic outlook and by long-term growth. The level of the repo rate is set so that inflation will be close to the target within a couple of years at the same time as inflation and the real economy should not show excessive fluctuations. What is known as the transmission mechanism is often described in terms of the different channels through which the repo rate has an effect on the real economy and inflation; the interest rate channel, the credit channel and the exchange rate channel. According to the “interest rate channel”, higher interest rates normally make it more attractive to save. A higher interest rate also means that it becomes more expensive for companies to finance investments, and for households to borrow for consumption. The “credit channel” describes how monetary policy’s impact on the economy can be reinforced by companies’ and households’ credit ratings declining when interest rates are higher. Households and companies find it more difficult to borrow money. All in all, a higher repo rate dampens household consumption and corporate investment and thereby also total demand in the economy. This in turn means that production growth slackens and resource utilisation is lower. Prices and wages then rise at a slower rate. The “exchange rate channel” describes how monetary policy affects the value of the currency.
2  BIS Review 121/2007  inflation expectations from becoming entrenched below the operational target of 2.5 per cent was one of the main reasons the interest rate was lowered to a very low level in 2003 and 2004, when inflation receded and approached zero. Low interest rates have stimulated demand and output and gradually led to the prospect of higher inflation, which we are addressing by increasing the interest rate. Consumer price inflation is still fairly low, but capacity utilisation is now at such a high level that inflation is projected to move up gradually to 2.5 per cent. Higher interest rates will contribute to a gradual decline in capacity utilisation, thereby preventing inflation from becoming too high. In the long term, monetary policy cannot influence real economic variables such as output and employment; it can only influence nominal variables such as inflation, the nominal interest rate and the nominal exchange rate. When monetary policy serves as an anchor for inflation expectations, it allows the interplay between monetary policy and other components of the economy to function. A good result can be achieved if the social partners take the role of "leader" and the central bank the role of "follower". Wage growth can then be determined in the knowledge of the monetary policy response. Flexible inflation targeting provides a fixed framework for monetary policy and gives a clear indication of how the central bank is to respond in different situations.