The policy rate must always be decided on the basis of the best available information at any given time. Experience shows that paths change sharply from one forecast to the next and the central banks explain the assumptions behind such changes thoroughly. Above all, these central banks aim to exert a specific effect on expectations, which is the principle behind a successful monetary policy. This appears to have produced results in New Zealand and Norway. Another option is for the baseline forecast to assume a policy rate path calculated from a monetary policy rule that steers inflation to target within the forecast horizon. This was done in the alternative scenario published in the November 2006 Monetary Bulletin. Other inflation-targeting central banks take different approaches, including the assumption of an unchanged policy rate as the Central Bank of Iceland initially did after moving onto an inflation target. The choice of assumptions for the Central Bank’s next macroeconomic and inflation forecast has yet to be decided. It is still under consideration and discussion in-house. What is crucial for the Central Bank is the credibility of its forecasting and the ability to exert the impact on expectations that it deems necessary. 4  BIS Review 16/2007  Conclusion It is not the Central Bank of Iceland’s policy to maintain high interest rates. However, this is necessary for as long as the recent macroeconomic conditions prevail. High interest rates subdue private consumption and investment.
The Central Bank incorporated these expectations into its baseline forecast, even though it considered them unrealistic. They assumed rapid cuts in the policy rate commencing early this year. The Central Bank considered neither assumption to be compatible with the inflation outlook. Thus the forecast lacked credibility, in the Bank’s own opinion. This prompts the question of what assumptions it is natural for the Central Bank to make about the policy rate in its baseline macroeconomic and inflation forecasts. Iceland is not the only country whose central bank has faced such a challenge. Several years ago, the Reserve Bank of New Zealand responded by using its own policy rate forecast as an assumption. The Bank of Norway followed suit two years ago and now uses a future interest rate path forecast by its Executive Board for its baseline forecast. Sweden’s Riksbank recently announced that it will use its own forecast for the repo rate path as an assumption in its inflation forecast. These banks have followed a similar course to the Central Bank of Iceland in developing the interest rate assumptions behind their forecasts. They have now opted to use the path that is forecast by those who actually determine the policy rate, partly because they did not consider market agents’ forecasts and expectations sufficiently credible. At the same time, these central banks have firmly stated that their policy rate forecasts entail no commitment to hold their rates to that path.