The model exercises I have presented so far build on the assumption that inflation expectations are anchored. As long as households and firms assume that inflation will return to target over time, neither small nor large cost shocks will have a lasting effect on inflation. The central bank can then put relatively large weight on the aim of high and stable output and employment. Chart: Greater attention to inflation? In Norway inflation has been low and stable for a long period, until recently. Inflation expectations, as we measure them, have been close to the inflation target. Short-term fluctuations in inflation have had little impact on inflation expectations ahead. Since winter, inflation expectations have increased, particularly one-year-ahead expectations. Inflation has also attracted substantial media attention. In 2003, a theory called rational inattention was advanced by the Nobel Laureate Christopher A. Sims. [13] In periods of low and stable inflation, it may be rational not to pay much attention to inflation and it would be reasonable to assume that inflation remains relatively constant. Once inflation reaches a high level, agents start paying attention to it and find it worthwhile to spend time and resources on factoring future inflation into their economic decisions. If economic agents expect high inflation to persist, the high inflation numbers may become a source of persistently high inflation. Both inflation and inflation expectations become entrenched at a higher level, and it becomes more difficult to bring inflation down. Chart: From one expectations regime to another This can also be illustrated in a model exercise.

A smaller rate increase is then needed to stabilise the economy than if the cost shock had only affected inflation. In the model exercises, it is assumed that the hand-to-mouth households do not have debt, but if we had introduced debt for this group, an interest rate increase would have reduced disposable income to a further extent. In most New Keynesian models, monetary policy primarily works  through the real interest rate, which is also the case in the model simulations I have shown. But, in practice, the nominal interest rate probably has a greater effect than the real interest rate on the cash flow of indebted households, at least in the short run. Chart: Decomposition of main drivers behind rate path When we make forecasts for the purpose of interest rate setting, we incorporate that an increase in prices and costs influences household real disposable income and firms’ profits. [12] We also incorporate that the effect of interest rate changes has likely increased over time due to higher debt ratios. We also assume that both real and nominal interest rates have a bearing on demand. The decomposition chart in our Monetary Policy Report shows the contribution from different types of shocks to changes in the policy rate path from the previous Report. In the latest Report, the decomposition showed a negative contribution from demand, represented by the dark blue bars. These negative contributions reflect, among other things, the fact that we take into consideration many other conditions than those included in the simplest models.