So inflation expectations play a key role for monetary policy and for that reason we keep a close eye on how they are developing.3 Perhaps the most important task of monetary policy is to influence inflation expectations since it is via market rates, and not the repo rate itself, that demand in the economy is affected. That is why communication and credibility are so significant. If we can get our message across we increase the chances of a successful monetary policy. Monetary policy in a low-inflation economy The Riksbank’s rule of action, which says that the policy rate should be adjusted when inflation is above or below target one to two years ahead, is not at all as mechanical as is sometimes perceived. The Executive Board’s clarification in 1999 made it clear that the practical formulation of monetary policy takes account of developments in the real economy. According to the clarification there may be reason for the Riksbank to deviate from the target if inflation is being affected by a temporary shock that will not fully dissipate during the coming two-year period but that is nonetheless not deemed to have any lasting influence on inflation developments. Another reason is when a bigger shock makes a return to the target one to two years ahead associated with excessive undesirable effects on the real economy. There are many examples in recent years of when we have taken such factors into account. At the turn of the year 2002-2003, for example, rising energy prices were pushing up inflation quickly.
In other words the policy rate is normally adjusted so that inflation 1-2 years ahead, taking into account the balance of risks, is in line with the target. The Riksbank introduced the current regime of a floating exchange rate and inflation target in 1993, after a number of decades with a fixed exchange rate. The new regime has meant a new way of working whereby we attempt, with the aid of monetary policy, to adjust economic growth to what the inflation target allows. A common analogy is that the economy is like a car with certain characteristics that enable it to drive at certain speeds but not at others. In that case we in the Executive Board are the driver, using the policy rate to accelerate or slow down. If the car is going too fast, its tyres will start to overheat and we risk driving off the road, i.e. prices will rise and we have to raise the policy rate to slow down. Conversely, when the car is going too slowly we accelerate by lowering the policy rate. In reality the analogy with a car is somewhat misleading. First, it is difficult to know exactly the speed at which the economy is actually growing. The statistics that we use when forecasting economic growth contain errors, do not provide a comprehensive picture of the economic situation and furthermore are produced with a lag. Another problem is the difficulty in knowing exactly how long it takes before a rate adjustment has the desired effect.