To further enhance clarity, monetary policy is guided by a principle according to which the aim is normally to bring inflation back to target within two years after a deviation has occurred. The two-year horizon makes it possible to bring back inflation to the target gradually and in this way to avoid excessive fluctuations in the real economy. The target horizon thus allows flexibility in monetary policy, while helping to anchor inflation expectations. BIS Review 51/2008  1  The policy rate’s path to inflation takes time The Riksbank’s target is to maintain a low and stable level of inflation. We can influence inflation by means of our steering interest rate, the repo rate. Through the steering system, the Riksbank aims to keep the shortest market rate, the overnight rate, close to the repo rate. The overnight rate in turn affects the interest rates faced by the general public, and thereby activity and prices in the economy. So, the repo rate expresses the level at which the Riksbank wants the overnight rate to lie. Interest rates with a slightly longer duration, for instance 3 months, are determined in the financial markets, partly by expectations of what the repo rate will be on average during this period. Banks’ lending rates to households and companies and interest rates on securities with different durations are affected therefore by both the actual and expected repo rate. In the slightly longer term there is greater uncertainty and it may be difficult to form an opinion of the future repo rate.
But potential measures must be balanced against the risk that the interbank market will cease functioning more quickly if there are signs of financial turmoil in the future. There is also a risk that a temporary extension of the collateral a central bank accepts can reduce the banks’ incentives to hold sufficient amounts of what are normally considered eligible assets. If the central bank takes over some of the functions of the shortest interbank market, there is also a risk that banks which are essentially creditworthy will suffer liquidity problems as the access to short-term financing in the interbank market will disappear. Although there is still the possibility to borrow from the central bank, collateral is required, while the interbank market usually provides loans without collateral. Even though we have not needed to take a stand in these considerations in an emergency situation, we do of course discuss the issues and monitor developments closely. Conclusion The financial turmoil has meant that several central banks have had problems stabilising the overnight rate at the target levels. The uncertainty has also contributed at times to difficulties for some banks in obtaining funding on the interbank market. Several central banks have therefore taken measures beyond the normal to stabilise the overnight rate and to reduce the pressure on the slightly longer interbank rates. In Sweden there has been no reason to take any extraordinary measures. The Swedish interbank market has on the whole functioned smoothly.