At the same time, monetary policy can be used to smooth fluctuations in activity around the growth trend. But I should emphasise that this presupposes that the central bank is committed to price stability and that its policy is perceived as credible. With low inflation, moreover, the economy will function more efficiently. It is important, I believe, to realise that price stability’s status as the monetary policy objective does not imply a lower priority for growth and employment as economic policy’s overall objectives. Rather than being an impediment, low inflation creates good conditions for growth. In order for this to be combined with low unemployment, the labour market must also function properly. Monetary policy with an explicit inflation target Since the move to a flexible exchange rate in the autumn of 1992, monetary policy in Sweden has been conducted with an explicit inflation target. The Swedish target for the rate of inflation, which is appraised in an annual perspective and expressed in terms of the consumer price index, is 2 per cent. The target is surrounded by a band of ±1 percentage point, which serves among other things as a buffer for temporary effects on inflation. I should like to mention some factors which illustrate how the Riksbank works on the construction of monetary policy with an inflation target. As monetary policy is characterised by long and variable lags, the policy needs to be forward-looking and based on an inflation forecast.
Factors that generate changes in ongoing rate of inflation must be distinguished from temporary effects on inflation due to once-and-for-all shifts in the price level. It is mainly variations in the output gap and in expected inflation which have an impact on the ongoing rate of inflation. Monetary policy accordingly focuses on these factors. Temporary effects on inflation may come, for example, from changes in indirect taxes and subsidies or from shifts in terms of trade. Monetary policy measures as such may likewise have temporary effects on inflation via changes in house mortgage costs, which are included in the measurement of consumer prices. This was the case in 1996, when the average rate of inflation fell below the lower band limit of 1 per cent mainly as a temporary consequence of the Riksbank’s reduction of its instrumental rate. Clearly, monetary policy should not respond to temporary effects on inflation from upward or downward movements in the instrumental rate; to do so would be to make interest rate policy procyclical and thereby destabilising. The monetary policy reaction to other temporary effects depends essentially on how these affect inflation expectations. If a temporary increase in the rate of inflation is taken, for example, to indicate a more lasting upward shift, so that people adjust their inflation expectations, monetary policy would have to respond in order to prevent the ongoing rate of inflation from increasing. If expectations are unaffected, on the other hand, temporary effects may be of secondary importance for monetary policy.