However, at the same time, transition countries and previously strictly-regulated countries inspired by planned economies such as China and India are playing an increasingly important role in the world economy. While the adjustment towards market conforming economies is moving at a rapid pace, there is still a long way to go until conditions in the domestic markets are the same as those in the old industrial nations. Fixed exchange rates, undeveloped credit markets and a high level of domestic saving in emerging economies can, for instance, delay price adjustments and thereby push down both short-term and long-term interest rates in the international capital markets. Increased competition from low-price imports coupled with low import prices for clothes, for instance, have already kept inflation down for several years in many parts of the world and contributed to the interest rates determined by monetary policy being very low. There is thus some risk that demand for credit and asset prices in many countries have been pushed up by expectations of lower interest rates in the future than is sustainable in the long term. We thus find ourselves in a situation where the inflation rate has been pushed down by increased competition from low-inflation economies at the same time as asset prices and indebtedness have increased rapidly. A dilemma ensues here.
Is it worth accepting slightly weaker demand and thereby inflation over the coming years if the economy develops as we have assumed in our forecasts in order to perhaps reduce the effects of possible corrections following inflated asset prices and loan stocks? Before I get into a discussion of this dilemma, I would like to give a brief reminder of how central banks with price stability as their objective take into account developments in the real economy. Flexible inflation-targeting policy requires openness and clarity In the short term, monetary policy can affect demand in the economy. Most countries with an inflationtargeting policy use this possibility and conduct what is known as flexible inflation-targeting policy, which means that some consideration is given to short-term fluctuations in the real economy. However, in the long term growth is essentially determined by factors outside of the control of monetary policy, such as technology and population growth. As I mentioned earlier, monetary policy’s best contribution is to ensure that inflation is low and stable, which requires confidence in the target. This sets limits as to how much consideration can be given to short-term fluctuations in the real economy, but also limits the uncertain negative effects on inflation and the real economy that in some cases risk arising from a strong growth in asset prices and loans. To be able to maintain confidence, it is necessary that the inflation target has strong support from the general public, the politicians and the financial markets.