The inflation target

Establishment of the inflation target

On 19 November 1992, the Riksbank was forced to abandon the fixed exchange rate against the ECU, the predecessor to the euro. This followed a period of turbulence in the foreign exchange market and speculation against the krona. Since then Sweden has had a floating exchange rate, which means that the value of the krona vis-à-vis other currencies is allowed to fluctuate and is determined in the foreign exchange market.  

 

On 15 January 1993, the Riksbank announced that monetary policy would be conducted with a view to achieving price stability (see the press release below). When the fixed exchange rate was abandoned the value of the krona against other currencies weakened (depreciated) sharply. At the same time, a number of changes were made to indirect taxes. Both the depreciation and the changes in the indirect taxes gave rise to inflationary impulses. The Riksbank therefore stated that the target for monetary policy would not begin to apply until 1995.

 

When the inflation target of 2 per cent was introduced, it was defined in terms of the annual change in the consumer price index (the CPI). The selection of this measure during the introduction of inflation targeting was largely due to it being a well-known and well-established measure. Other advantages in defining the inflation target in terms of the CPI are that it covers a very large share of household consumption and that it is published every month. From a monetary policy point of view, however, it is a disadvantage that the CPI is directly affected by changes in the policy rate. These changes, through their impact on mortgage rates, have large and direct effects on the CPI which are not connected to underlying inflationary pressures and which also goes in the opposite direction. This means, for example, that interest rate cuts, which are intended to bring inflation up, instead lower CPI inflation further in the short term as the costs for mortgages fall. In recent years, with large adjustments to the policy rate, it has become increasingly difficult to use the CPI as guidance for monetary policy and in monetary policy communication. In practice, therefore, the CPI with a fixed interest rate, the CPIF, has been more important for the shaping of monetary policy than the CPI. As of September 2017, the inflation target is also defined in formal terms by the annual change in the CPIF.

Why 2 per cent?

Too high inflation is harmful to the economy, as inflation usually varies substantially when it is high. Low and stable inflation creates for several reasons good conditions for favourable economic development (see further under the heading Why inflation targeting?).

 

But too low inflation is not good either. A too low inflation target increases the risk of deflation, that is, the general price level falls. Deflation has historically been proved to create problems. When there is deflation, future prices will be lower than today’s prices. As it will be cheaper in the future, households wait until prices have fallen before they consume. Companies postpone investments until prices have fallen. This means that production can fall as long as there is deflation. It may be difficult to break such a deflation process.

 

To avoid deflation there is thus reason to set the target at a positive figure.

 

On the whole, this suggests that the target should be low but above zero. The reason for choosing 2 per cent was that inflation was approximately 2 per cent when the target was introduced. Moreover, this was in line with the inflation targets in other industrial nations.

The variation band illustrates that inflation normally varies around the target

Although the aim is that inflation shall be 2 per cent, outcomes will always vary around the target. To illustrate in a simple manner the fact that monetary policy has little ability to steer inflation in detail, the Riksbank uses a variation band in its monetary policy communication with effect from September 2017. A variation band that stretches between 1 and 3 per cent captures approximately three-quarters of outcomes for CPIF inflation since mid-1995. The variation band does not affect the formulation of monetary policy. The Riksbank always aims for 2 per cent inflation, regardless of whether inflation is initially inside or outside the variation band.

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