The inflation target
The main reason why the Riksbank, like many other central banks around the world, has an inflation target is because this contributes to price stability, which creates the conditions for good, sustainable growth. A credible inflation target functions as a benchmark for inflation expectations in the economy. The Riksbank's target is to hold inflation in terms of the CPIF (the CPI with a fixed interest rate) around 2 per cent a year.
The Riksbank's inflation target was introduced in 1993 and began to apply from 1995 (read more about the history of the inflation target by clicking on the link below). The reason for having an inflation target is so that it will function as a benchmark to guide expectations in the economy regarding future inflation. An inflation target makes it easier for households and companies to make well-founded economic decisions and lays the foundation for efficient price-setting and wage formation. The inflation target thus acts as the economy's "nominal anchor". Since its introduction, the inflation target has contributed to bringing down inflation in Sweden to a low level and remaining much more stable than in the 1970s and 1980s. During that period inflation varied substantially from year to year and was on average almost in double figures. Moreover, since the inflation target was introduced, growth in the economy in general has been higher and real wages have increased more than during the two previous decades. Of course, the fact that the Swedish economy is functioning better is also due to other reforms implemented during the 1990s.
Why should inflation be low and stable?
The Riksbank and most other central banks around the world focus on keeping inflation low and stable, because this creates good conditions for a favourable development in the economy. High and fluctuating inflation leads to uncertainty over how prices will develop going forward, which means that interest rates and thereby borrowing costs will be higher than they would otherwise have been. It also becomes more difficult for households and companies to plan and to take financial decisions, and it affects the distribution of incomes and wealth between different groups in a random manner. All this can mean that willingness and ability to invest in new products and machinery declines and that activity in the economy as a whole is slowed down.
Why 2 per cent?
The important thing is that inflation is low and stable.
- If inflation is too high it is a problem, as this usually means that inflation is fluctuating a lot. This creates uncertainty, which has a negative effect on the economy (see above).
- If inflation is too low, there is a risk of deflation, that is, the general price level falls, which has historically been shown to create major problems in the economy.
There are several reasons why the inflation target was set at 2 per cent when it was introduced:
- Inflation was around 2 per cent when the inflation target was introduced, and this was a common level for inflation targets set by other central banks.
- A target of 2 per cent was also considered to give sufficient room for manoeuvre for monetary policy, that is, there was sufficient scope to cut the interest rate to bring up inflation during a recession without the interest rate hitting the floor (which most people then thought was 0 per cent).
- An inflation rate of 2 per cent also makes it easier for necessary adjustments in relative prices and wages.
Flexible inflation targeting
The Riksbank and other central banks with inflation targets conduct a policy of flexible inflation targeting. This means that at the same time as trying to attain the inflation target, they take into account developments in the real economy.
The variation band – inflation varies around the target
As of September 2017, the Riksbank uses a variation band of 1–3 per cent for the outcomes for CPIF inflation, to illustrate the fact that monetary policy is not able to steer inflation in detail. The variation band is intended to show that inflation varies around the target and will not be exactly 2 per cent every single month. However, the objective of monetary policy is still that inflation shall be 2 per cent, the variation band of 1–3 per cent is not what is known as a target interval.