What factors influence an interest rate decision?
The Riksbank’s target is that the annual change in the consumer price index (CPI) should be 2 per cent. This makes inflation developments an important factor for interest rate decisions. The prospects for the real economy, for example economic growth and employment, are also important for the interest rate decision. In the preparatory works for the Riksbank Act, it was stated that the Riksbank, without prejudice to the price stability target, should furthermore support the objectives of general economic policy with a view to achieving sustainable growth and high employment. Monetary policy is unable to raise growth and employment more permanently but it may affect these quantities in the short term. The best thing monetary policy can do to attain sustainable growth and high employment is therefore to attempt to stabilise production and employment around long-term sustainable paths besides stabilising inflation around the inflation target, The Riksbank therefore conducts what is generally referred to as flexible inflation targeting. This does not mean that the Riksbank neglect the fact that the inflation target is the overriding objective.
How are the forecasts made?
How does the Riksbank forecast developments in inflation and economic growth? First, an assessment is made of economic activity and inflation abroad, with a particular focus on developments in Europe and the United States. Developments in the financial markets are then assessed, including the exchange rate and interest rates. International price developments and the exchange rate are important determinants since they affect price developments for goods and services imported to Sweden. Finally, the Riksbank forecasts economic activity, which is a key determinant of inflation.
Outline of how the Riksbank prepares an inflation forecast
The Riksbank uses a number of different models in its forecasting work. Time series models and indicator models with strong forecasting capabilities are used to produce a first estimate of the future path of economic activity and inflation. Structural models originating in national economic theory are also employed to arrive at an overall assessment of the driving forces in economic development. In addition, the Riksbank uses a large number of smaller models that focus on important relationships in the economy. The advantage of the small models is that they are capable of handling a larger number of details than structural models. The collective information from all these models and other information are finally weighted together to produce an economic and inflation forecast.
At the beginning of 2007, the Riksbank changed over to making forecasts for economic developments in Sweden based on the interest rate path the Executive Board of the Riksbank considers at that point in time to be most appropriate (see the boxed text below). Previously, it was assumed that the repo rate would develop in line with market expectations. Earlier, forecasts were based on the assumption that the repo rate would be unchanged during the forecast period.
The most important reason for publishing the Riksbank’s own assessment of the future development of the repo rate is that it will help the central bank to explain to the general public and the financial markets how the Bank assesses the direction for monetary policy and thereby future interest rate developments. It will become clearer what the Riksbank considers to be a well-balanced monetary policy. This will make monetary policy easier to understand, to predict and to evaluate.
In connection with every monetary policy decision, the Executive Board makes an assessment of the repo-rate path needed for monetary policy to be well-balanced. A well-balanced monetary policy is normally a question of finding an appropriate balance between stabilising inflation around the inflation target and stabilising the real economy. The fact that the Riksbank tries to stabilise both inflation and the real economy does not mean that it disregards the fact that the inflation target takes precedence.
The exact horizon within which the Riksbank aims to ensure inflation is on target depends, for instance, on the reasons why inflation is deviating from the target, the size of the deviation, and the effects on the real economy. It can also depend on how much emphasis the Executive Board members place on stabilising inflation on the one hand, and stabilising the real economy on the other hand. In certain situations there may be reason to allow more time for inflation to return to the target, as a rapid return could have undesirable effects on production and employment. But if the return to the inflation target takes too long, on the other hand, there is a risk that the general public will begin to doubt the Riksbank’s intentions and ability to attain the target even in the long term. It is important to avoid this happening. There is no general answer to the question of how quickly the Riksbank aims to bring the inflation rate back to 2 per cent if it deviates from the target. The Riksbank’s ambition has generally been to adjust the repo rate and the repo rate path so that inflation is expected to be fairly close to the target in two years’ time.
A desirable monetary policy should also be predictable in order to make it easier for households and companies to adapt to new economic conditions. Changes in the repo rate should therefore normally be made gradually and not in large steps. Moreover, changing the interest rate gradually provides an opportunity to await and analyse new economic data. Since it is difficult to know exactly how the economy functions and how monetary policy acts it is also beneficial that one normally proceeds cautiously in changing interest rates.
However, it is important to emphasise that the Riksbank, in presenting its view of what is a suitable path for the repo rate, has not committed itself to any particular future monetary policy. As with all other assessments, the interest rate forecast will need to be revised on the basis of new information received on economic developments in Sweden and abroad and the effects this may have on the prospects for inflation and economic activity in Sweden. Therefore there is always some uncertainty over future interest rate developments in the same way that there is uncertainty over the general future development of the economy.
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