Mr. Bäckström explains why price stability ought to be a central bank’s principle monetary policy objective Address by the Governor of the Bank of Sweden, Mr. Urban Bäckström, at Handelsbanken seminar in London on 28/1/97. For most central banks today the primary monetary policy objective is price stability. The situation is thus very different from that which prevailed in the earlier period of high inflation. The reorientation of monetary policy stems from people’s growing awareness of an inflationary economy’s harmful effects. The central banks, which are ultimately accountable to their countries’ citizens and the latter’s representatives, would otherwise not have been mandated to focus policy on price stability. In Sweden, for example, 60 per cent of the population see 2 per cent inflation as an appropriate monetary policy objective and only 12 per cent are against this. In my country a low inflation policy therefore has broad political support. I shall be talking today about why price stability ought to be a central bank’s principal monetary policy objective and what this means for economic growth, employment and unemployment. From there I shall consider development in Sweden, the framework of our monetary policy and the current situation. Why price stability? Why should price stability be singled out as a central bank’s overriding objective? Why not attach equal importance to targets for growth, employment and unemployment, particularly as these factors have high priority for economic policy in general? The answer to these questions calls for an understanding of what monetary policy can and cannot do.

Factors that generate changes in ongoing rate of inflation must be distinguished from temporary effects on inflation due to once-and-for-all shifts in the price level. It is mainly variations in the output gap and in expected inflation which have an impact on the ongoing rate of inflation. Monetary policy accordingly focuses on these factors. Temporary effects on inflation may come, for example, from changes in indirect taxes and subsidies or from shifts in terms of trade. Monetary policy measures as such may likewise have temporary effects on inflation via changes in house mortgage costs, which are included in the measurement of consumer prices. This was the case in 1996, when the average rate of inflation fell below the lower band limit of 1 per cent mainly as a temporary consequence of the Riksbank’s reduction of its instrumental rate. Clearly, monetary policy should not respond to temporary effects on inflation from upward or downward movements in the instrumental rate; to do so would be to make interest rate policy procyclical and thereby destabilising. The monetary policy reaction to other temporary effects depends essentially on how these affect inflation expectations. If a temporary increase in the rate of inflation is taken, for example, to indicate a more lasting upward shift, so that people adjust their inflation expectations, monetary policy would have to respond in order to prevent the ongoing rate of inflation from increasing. If expectations are unaffected, on the other hand, temporary effects may be of secondary importance for monetary policy.