Flexible inflation targeting  The Riksbank and all the other inflation-targeting central banks conduct flexible inflation targeting rather than strict inflation targeting. Flexible inflation targeting means that monetary policy aims at stabilizing both inflation around the inflation target and the real economy, whereas strict inflation targeting aims at stabilizing inflation only, without regard to the stability of the real economy, what Mervyn King (1997) has described as being an “inflation nutter”. By stabilizing the real economy I mean stabilizing resource utilization around a normal level, keeping in mind that monetary policy cannot affect the long-term level of resource utilization. Because of the time lags between monetary-policy actions and their effect on inflation and the real economy, effective flexible inflation targeting has to rely on forecasts of inflation and the real economy. Flexible inflation targeting can be described as “forecast targeting”: The central bank chooses a policy-rate path so that the forecast of inflation and resource utilization “looks good.” By a forecast that looks good I mean a forecast either in which inflation is already on target and resource utilization is already normal, or in which inflation is approaching the target and resource utilization is approaching a normal level at an appropriate pace. More precisely, it means a forecast for inflation and resource utilization that as effectively as possible stabilizes inflation around the inflation target and resource utilization around its normal level.
One important lesson from the financial crisis is that financial factors may have a very strong and deteriorating effect on the transmission mechanism, making standard interest-rate policy much less effective. This motivates more research on how to incorporate financial factors in the standard models of the transmission mechanism used by central banks, and a rapidly increasing volume of such research is now being produced by academic and central-bank researchers and presented at an increasing number of conferences on financial factors and monetary policy. Important questions include how potential output and neutral real interest rates are affected by financial factors and financial distortions (Curdia and Woodford 2009, Walsh 2009), and what impact financial factors have on the general equilibrium effects of  6  BIS Review 112/2009  alternative policy-rate paths on inflation and resource utilization forecasts. 11 Before such extensions to the modelling framework are operational, policymakers and staff have to improvise and apply unusual amounts of judgment on the effects of the financial crisis on the transmission mechanism. Even with much better analytical foundations concerning the role of financial factors in the transmission mechanism, there will of course, as always, be considerable scope for the application of good judgment in monetary policy.