The inflation target
The Riksbank's target is for inflation, that is, the increase in the general price level, to be low and stable. The target is specified as an annual rate of increase of 2 per cent for the CPIF (consumer price index with a fixed interest rate). The main reason why the Riksbank, like many other central banks around the world, has an inflation target is that stable and predictable price development creates the conditions for favourable economic growth.
The inflation target
The inflation target
The Riksbank can influence inflation via its monetary policy stance, read more on the page What is monetary policy?. The main task of monetary policy is to maintain confidence in the inflation target of 2 per cent. A credible inflation target acts as a benchmark for prices and wages. It stabilises the rate that households and companies expect inflation to be at in the economy.
The inflation target - one of Sweden's economic objectives
The Sveriges Riksbank Act specifies that the Riksbank shall maintain price stability by means of sustainably low and stable inflation. The Act also states that the Riksbank shall decide on the specification of the target - what level the target should be at and what measure of inflation the target should apply to - but that the Riksdag must first approve the Riksbank's proposal. Until further notice, the current specification applies, i.e. that the annual change in the consumer price index with a fixed interest rate (CPIF) shall be 2 per cent. There is broad political support for this inflation target and it can be regarded as one of Sweden’s economic objectives. The inflation target was introduced in 1993 and began to apply from 1995, read more History of the inflation target.
Flexible inflation targeting
It is not possible to keep inflation at 2 per cent all the time, because there are constant changes in the economy that cause inflation to fluctuate in ways that cannot be predicted or counteracted in the short term. Moreover, there may be reasons not to try to bring inflation back to target very quickly by means of substantial adjustments to interest rates, for example when inflation is above target but the economy is still markedly weak. In this way, the Riksbank also takes into account output and employment and conducts what is known as flexible inflation targeting. A prerequisite is for households and companies to be confident that deviations from the target will not last too long as this could affect their expectations as to what level of inflation will be normal in the economy.
Why should inflation be low and stable?
Low and stable inflation creates good conditions for favourable economic development with strong and stable growth. This is because it is easier for economic agents to plan for the long term when inflation does not vary so much and there is a common view of how prices will develop in the future. In this way, the inflation target acts as a benchmark for price- and wage-setting in the economy – it shall constitute what is usually referred to as a nominal anchor.
When instead inflation is high, it also tends to fluctuate substantially from one year to the next. This makes it more difficult for economic agents to make economic decisions about the future. How will wages develop? What price must companies set to cover their costs? These questions are more difficult to answer if inflation is high and fluctuates compared to if it is low and stable. High and fluctuating inflation also has different consequences for different groups in society. For example, when inflation is high, it may be less profitable to save in a bank if the interest rate is lower than inflation, while it may be favourable to invest in a tenant-owned apartment or house if the price of housing increases in line with inflation. The experience of previous historical periods of high inflation, such as those in the 1970s and 1980s, shows that high inflation can be very negative for the economy. It is also difficult and costly to break a trend where households and companies see high inflation as a natural state.
Too low inflation is not good either
But too low inflation can also be problematic because a certain level of inflation acts as a lubricant in the economy. With an inflation rate of 2 per cent, for example, wage formation can more easily ensure that the labour force is well distributed in the economy. It is difficult to reduce wages as this is not considered acceptable. If inflation is low and wages cannot be lowered, it will more difficult to adjust wage conditions – the relative wages among different professions, companies and sectors. This makes it more difficult to attract labour to the parts of the economy where they have the most benefit. This can ultimately lead to both higher unemployment and poorer productivity growth.
Another reason why the inflation target should not be lower than 2 per cent is that this level of the target provides some scope for cutting the interest rate to stimulate demand in economic downturns and bring up inflation, without the policy rate hitting the floor. Some consider that the lower bound for the policy rate is zero, while others believe that it can be negative, as it has been in some countries, including Sweden.
The argument that the inflation target creates scope for monetary policy is somewhat complicated and is described in more detail here Account of monetary policy 2021, Chapter 4. In brief, it means that if normal inflation in the economy is 2 per cent instead of, for example, 0 per cent, all interest rates are higher. This also applies to central bank policy rates. There is therefore more scope to lower these rates and better opportunities to stimulate the economy. It is therefore also less common for the policy rate to be at its lower bound.
Variation band - inflation varies around the target
Since September 2017, the Riksbank has used a variation band of 1–3 per cent for the outcomes for CPIF inflation, to illustrate that monetary policy cannot micromanage inflation. 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.