As its influence on the economy is subject to a time-lag, monetary policy has to be conducted in a forward-looking manner. Consequently, forecasts play a decisive role in analyses and decision-making. At the same time, the exchange rate, like other prices set on financial markets, is very difficult to forecast.11 Nevertheless, due to its significance for the development of small, open economies such as Sweden’s, it is important to form an understanding of exchange rate developments. The Riksbank tries to analyse and forecast the development of the trade-weighted exchange rate, which is to say the value of the Swedish krona against a basket of the currencies of Sweden’s most important trading partners. Due to the volatile nature of the exchange rate, no attempts are made to capture short-term variations in it. Instead, the focus lies on the more long-term trend. The starting point for this a statistical model in which the real exchange rate is related to relative GDP, the terms of trade and net foreign assets.12 However, the final forecast for the exchange rate considers the fact that the exchange rate both influences and is influenced by a multitude of other variables, including the interest rate differential in relation to other countries.13  10  See, for example, Ekholm et al. (2008). Pressure on firms to improve productivity can be seen as a positive aspect of a strong real exchange rate. A weak real exchange rate is otherwise frequently seen as being advantageous for a country as it benefits its exporting firms.
This is probably ascribable to cyclical divergence more so than a divergence in assessments and response patterns. In recent years, many of our trading partners have pursued an accommodative monetary policy with the aim of preventing the downturn from becoming deeper and longer and staving off falling inflation expectations. In the euro area and the US, low interest rates have probably contributed to improving the balance sheets of banks, households and firms. Financial stability considerations have thus pulled in the same direction as inflation and employment considerations. This may change as the economic outlook changes. As the Chair of the Federal Reserve, Janet L. Yellen, put it: “There may be times when an adjustment in monetary policy may be appropriate to ameliorate emerging risk to financial stability.”6 The quote reflects to a large extent the assessments we have made in Norway in recent years. In order to illustrate this, we can construct a simple analytical framework. Chart: Framework The point of departure is a central bank with a flexible inflation targeting regime. The central bank weighs deviation from the inflation target against deviations from potential output. The future paths for inflation and output are included in the assessment. We have included a variable that captures the transmission of financial stress to the wider economy. This framework thus differs from the normal one presented in the monetary policy literature. In the stylised model, we have called this stress impulse zt. First, the size of the effect on the real economy depends on the level of financial stress.