Now, imagine a highly credible and transparent central bank with an inflation target of 2%. If the credibility of this particular central bank is such that, no matter what it does in the short run, market participants believe that inflation in the long run will remain solidly anchored at 2%, then the 10-year inflation-  7  See, for example, Freedman (1996) and Freedman (2002). BIS Review 30/2006  5  indexed bond will always reflect an expected inflation rate of 2% in ten years time. If the central bank takes excessive comfort from the fact that market expectations reflect stable inflation expectations, it may over time deviate from the optimal policy path. At some point, markets will detect the policy error. In such an admittedly extreme scenario, the likely reaction of the market place would be a sudden adjustment of inflation expectations with a corresponding costly loss of credibility for the central bank. 8 This example illustrates what Alan Blinder (1998) calls the "dog chasing its tail" problem: Financial markets look for guidance from the central bank, the central bank looks for guidance from financial markets, and both parties temporarily lose sight of the underlying factors determining inflation, namely the output gap in the short to medium-run, and money growth in the long-run. To avoid this trap, central banks should exercise due caution when making use of financial market expectations. Financial markets provide useful information for a central bank in search of the optimal monetary policy path.
This means that we believe that there are now, and will be in future, less available resources that can be used without price and wage increases accelerating. Inflation above the target level Looking at inflation, it is primarily the underlying rate that has been surprisingly high. The largest rise has been in prices of services. Here, the relatively high resource utilisation in the services sector has contributed to rising labour costs. In addition, prices of input goods, such as electricity and foodstuffs, have risen. Given the developments in prices and wages over the past year, the Riksbank has gradually altered its view of the inflation propensity in the Swedish economy in a broader sense. A higher resource utilisation, together with rapid wage increases and a weak exchange rate, have led to slightly higher inflationary pressure than in previous assessments. It is this gradual shift that has sometimes been referred to as a total U-turn. Recent events Since the most recent Executive Board meeting, new statistics have been received that largely confirm the picture of the Swedish economy painted by the Riksbank. In my opinion, there is no reason, all in all, to alter significantly the assessment of economic prospects made in the latest Inflation Report, with regard to either the international picture or the Swedish picture.