The economy needed a new nominal anchor in order to return to a disinflation path. 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. At the beginning of 2002, 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 macroeconomic model that provides a consistent framework for the policy analysis. 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 initially established quarterly projection model was a small-scale model belonging to the second generation of such models. It was thus relatively simple and arguably missed many important links in the economy. Nevertheless, it was already quite close to the state-of-theart among the inflation-targeting central banks around the world, and intense work has been in progress to build a higher-generation model. As a result from July 2008 the CNB’s forecast is based on latest generation general equilibrium model, which is fully based on micro specifications.

The National Mediation Office also received increased powers of authority to take action in connection with wage bargaining rounds. The National Institute of Economic Research was given the task of annually producing reports on the economic conditions for wage formation. The results of these changes are clear and positive. Since the crisis at the beginning of the 1990s, wage formation has functioned much better than before. The agreements no longer contain flexibility clauses and wage drift is much more limited. The number of labour market conflicts has been lower than before. Real wage increases, which reflect what we can buy for our wages, have been better than before, while the nominal increases have been markedly lower than before (see Figure 6). The social partners have contributed in a constructive manner to this positive development. The positive institutional changes in several areas – e.g. new regulations for fiscal policy, monetary policy and wage formation - are strongly contributing factors to the favourable developments since the crisis in the early 1990s. Conditions for wage bargaining rounds The inflation process has changed in nature in recent years, not only in Sweden but also in many other countries. As the inflation-targeting policy has gained credibility, inflation is increasingly determined by inflation expectations. Inflation has become lower and also appears to be less dependent on variations in capacity utilisation (the short-term Phillips curve has shifted downwards and become flatter). Capacity utilisation mainly affects inflation through wage formation. However, wage costs still play an important role in the inflation process.