Against this background, most central banks aim for a reasonable compromise between these two extremes. They strive to fulfil the inflation target in the medium run by being forward-looking and accept the occurrence of limited deviations (downwards as well as upwards) in the short term. A monetary policy that acts on current inflation is by definition not forward-looking. Similar arguments apply to a strategy whereby the central bank is guided by nominal GDP outcomes, a question that was discussed last year in this Association. Besides the disadvantages I just mentioned from not looking ahead, a nominal GDP strategy has the drawback that the national accounts frequently have to be revised. Whereas the CPI figures are mostly definitive when they are first published, the GDP outcome data are often changed substantially, sometimes after an interval of several years. The relatively long time lag before monetary policy affects the economy makes it necessary to accept that inflation will sometimes deviate from the target. The alternative would be marked fluctuations in employment and output. This is clear from what happens when one of the Riksbank’s models is run with a monetary policy for correcting inflation quickly. We assume that the rate of inflation suddenly rises from 2 to 3 per cent and the Riksbank immediately tries to counter this by raising the repo rate in a single step of between 4 and 5 percentage points.
It is intuitively hard to see why a central bank would prefer to stabilise the money supply, which does not directly affect public prosperity, rather than stabilising price movements and output more directly. If the relationship between the money supply and inflation is not exact and stable over time, the significance of the money supply should be demoted to that of one of several indicators in an inflation targeting strategy based on forecasts. While the money supply is an important indicator of inflationary pressure, it is not the only one. There may be grounds, on the other hand, for highlighting the significance of the money supply (or rather perhaps its mirror image of the loan stocks in bank balance-sheets) as a source of information about the financial system’s future stability. In the past, the build-up of a sizeable financial bubble has nearly always coincided with a major expansion of credit in the financial system. Sweden’s bank crisis about a decade ago is a case in point. Against this background, the money supply and credit flows should belong to the arsenal of indicators of both monetary and financial stability that a central bank ought to follow closely. Inflation and the output gap Yet another alternative way of conducting monetary policy is to set the interest rate as a function of the rate of price increases and some measure of the difference between actual and potential growth.