Examples of such intermediate variables could be current price tendencies, the money supply or resource utilisation. I intend to discuss such possibilities and then conclude by harking back to the Riksbank’s current monetary policy strategy. Alternatives to basing monetary policy on forecasts Actual price movements One alternative to the present rule of thumb could be to set the interest rate in the light of the prevailing rate of inflation. The Riksbank would then adjust the instrumental rate every time Statistics Sweden publishes a CPI outcome that is above or below the 2 per cent target. The primary argument against such an arrangement is perhaps that, compared with the present rule of thumb, it would lead to larger fluctuations in real economic activity. This is because the repo rate and inflation are not directly linked. The Riksbank’s possibility of influencing price movements is more indirect and works, in simple terms, via market interest rates, credit flows and asset prices before impinging on demand in the real economy and such variables as employment, profits, investment, consumption and net exports. Demand’s impact on prices depends in turn on potential output and resource utilisation. We still do not know exactly how this complex transmission mechanism functions, how quickly it works or how it varies both over time and in its effects on the economy. Concerning the time lag, the view adopted by most central banks is that most of the effect materialises after an interval of one to two years.
The fact that the variables to which monetary policy responds are assumed to be known at the time of decisions contributes to this. The conceivable objections to basing monetary policy on simple rules of this type concern their very simplicity. An economy is constantly being hit by shocks of different types. Neither firms nor households behave mechanically. It is therefore not to be expected that economic policy can be boiled down to some kind of auto-pilot. Allow me to illustrate this with a couple of examples. A first objection to basing monetary policy on a simple Taylor rule is that the rule assigns too much weight to a particular indicator of the output gap. The output gap is a central concept in macro theory and economic policy but that does not lessen its complexity. Potential output tends to vary over time. Changes in such factors as demography, technology, tax and transfer systems or other important components temporarily or permanently affect productivity growth and labour supply, with an impact in turn on potential output. Although considerable progress has been made in real business cycle theory when it comes to the importance of supply shocks, we unfortunately do not have a clear intellectual framework for the forces behind potential output’s variations in the short and medium term. Changes in the output gap are therefore difficult to pin down exactly in stable measurements. The methods used to estimate potential growth and the output gap from econometric models tend to yield conflicting results that are also unstable over time.