The economic outlook and monetary policy in the euro area I will start by discussing the current state of the euro area economy and the medium-term economic outlook. The performance of the euro area economy this year is characterised by the ongoing recovery of economic activity at a pace somewhat faster than previously envisaged. Inflation, however, has remained above (though relatively close to) 2%. This outcome is not in line with our notion of price stability and is higher than the average inflation expected a year ago for 2004. The sharp rise in oil prices since the beginning of this year, by about 60% (in US dollar terms), has been the main reason for the higher than earlier expected inflation. Let me elaborate a bit on the pace of the economic recovery, the factors that have contributed so far to the pick-up in growth, and the conditions and basic factors that are expected to influence the mediumterm economic prospects. Since the start of the economic recovery in the second half of 2003, we have seen robust growth rates in the first half of 2004, with real GDP increasing by 0.7% and 0.5% in the first and second quarters, respectively. The recovery in growth has so far been driven partly by buoyant external demand and partly by domestic demand. Private consumption increased moderately but investment was subdued. Although short-term indicators have become more mixed over the past couple of months, the underlying determinants of economic activity remain favourable, and growth is expected to continue in 2005.
At the same time, what was presented then was by no means an extremely tight monetary policy – despite the fact that inflation was at its highest in over a decade and inflation expectations were clearly above the target level. As usual we looked both at how inflation and the real economy would develop. And the forecast for the repo rate presented was such that inflation was expected to be back on target within two years and GDP growth was expected to fall initially but to then rise to a good long-term level. We know what happened next; the Lehman Brothers investment bank went bankrupt in midSeptember, the financial markets ground to a halt and this changed the game rules. The circumstances for monetary policy changed and we were given an example of a different decision-making situation where both developments in inflation and developments in the real economy called for the same decision. During the autumn we cut the repo rate in three stages by a total of 2.75 percentage points. This meant a departure from the monetary policy we have normally conducted and which is characterised by more gradual changes in the interest rate. Before I talk about our most recent interest rate decision I shall discuss in slightly more detail how the financial crisis has affected monetary policy and how other measures by the Riksbank have been activated.