Eva Srejber: Inflation targeting and bubbles Speech by Ms Eva Srejber, Second Deputy Governor of Sveriges Riksbank, at the Adam Smith seminars, Paris, 9 July 2002. *  *  *  Since the mid-1990s, inflation has stabilised at very low levels in the industrial nations. From an average inflation rate of 6 per cent during the period 1975 to 1994, the rate of price increase has been slightly below 2 per cent over the past 6 years. This entails a return to the same low inflation rate as prior to 1970. Inflation has also been reduced considerably in most other countries in, for instance, Asia and Latin America. There are many factors that have contributed to this. Firstly, price stability has become an explicit objective for monetary policy in many countries. An increasing number of central banks are orienting their monetary policy towards a fixed inflation target. This includes the Riksbank, which, after the fixed exchange rate was abandoned in November 1992, established an inflation target of 2 per cent with a deviation interval of plus/minus one percentage point. The orientation of monetary policy has in many countries been supported by a fiscal policy aimed at budget consolidation. Independence for the central banks in Europe, convergence criteria for EMU membership, the stability pact in Europe and the ban on financing budget deficits through printing new banknotes are all examples of measures that have helped increase confidence in the price stability target. Increased competition in the wake of globalisation has probably also subdued inflation temporarily.
However, first and foremost I would like to point out that monetary policy aimed at stabilising the inflation rate should basically reduce the risk of over-valued asset prices leading to an exaggerated real demand. Fluctuations in the level of resource utilisation and in the output gap are traditionally assumed to be reflected in the inflation rate. If inflated asset prices stimulate demand in the economy, without a corresponding increase in the potential growth rate, inflation will rise. If the central bank anticipates this, monetary policy will normally be tightened to ensure that demand is compatible with long-term sustainable growth. And as long as demand in the economy increases at a rate compatible with long-term growth, there is less risk of exaggerated indebtedness. Inflation targeting should thus, at least in theory, reduce the risk of extensive financial imbalances accumulating. However, even with an otherwise successful inflation target policy, real and financial imbalances created by exaggerated asset prices can build up. If there are exaggerated expectations regarding growth in productivity and profits in a particular country, this can lead to a strong inflow of capital and strengthening of the currency. The increase in real demand, which is caused by exaggerated increases in asset prices, can thus be partly met by increased imports, while the currency strengthens and domestic inflationary pressure is reduced.