Inflation targeting was chosen as “the best of all bad” alternatives at the time. Such a sudden switch from a fixed exchange rate system to inflation targeting required a radical and fast change in the central bank’s mentality. This was perhaps the biggest challenge that the CNB had to face. Over the past five years it has involved much work on improving our forecasting tools, leading to substantial development in our internal analytical processes. These changes culminated at the beginning of 2002, when the CNB settled on a new forecasting process. This integrates expert judgment and short-term analyses – which were the key pillars of the CNB’s forecasting tool-kit in the first years of inflation targeting – with a small-scale macroeconomic model developed by the CNB’s staff with the assistance of the International Monetary Fund. An important element of this step was a switch from a forecast with a fixed-interest-rate assumption to an unconditional forecast that includes a reaction function of the central bank. The established quarterly projection model was a small-scale model belonging to the first generation of such models. It was thus fairly simple and arguably missed many important links in the economy. Nevertheless, it was already quite close to the state-of-the-art among the inflation-targeting central banks around the world, and intense work has been in progress to build a higher-generation model. We are now just about ready to use regularly our newly developed so-called “third generation” general equilibrium model, which is fully based on micro specifications.

In my view, developments in forecasting over the last 15 years have played a decisive role in that shift. BIS Review 40/2006  1  Simultaneously, the ever-changing world map in terms of monetary policy regimes has also modified the role of forecasting at central banks. In the past, most countries had pegged exchange rates against the major currencies. Indeed, in the 1980s and the first half of the 1990s one could hardly imagine a macroeconomic stabilisation programme without an exchange rate anchor and, of course, under such a system, the role of forecasting is rather small. However, since the early 1990s the number of countries with floating exchange rates has increased dramatically, reflecting numerous currency crises and a growing consensus on the undesirability of conventional currency pegs. Moreover, the inflation targeting regime has gained much more weight among the group of countries with floating rates. Inflation targeting, or following Svensson “inflation forecast targeting”, has placed the forecasting process at the heart of monetary policy decision-making. Under inflation targeting, the forecasting process centres on future price developments. This does not necessarily mean, though, that central bankers are obsessed with inflation. In fact, inflation targeting requires us to assess all the available information, including real economic developments, monetary analysis and the external balance of the economy, in a systematic and complex way. It is hence more demanding from the point of view of consistency than the alternative monetary strategies. Of course, the latter require a consistent system for analysis and forecasting.