The current inflation rate does not provide sufficient information to determine the level at which interest rates should be set now. Our analyses indicate that a substantial share of the effects of an interest rate change will occur within two years. Frequent and marked interest rate changes can keep inflation under tight control, but will lead to wide variations in output and employment. This can be called a strict inflation target. Theoretically, we could also have chosen to stabilise output without taking into account variability in inflation. This can be called a strict output target. In Norway, as in a many other countries, we have chosen an intermediate solution. Interest rates are changed more gradually with less impact on output than under a strict inflation target, and inflation is allowed to deviate from the target over a somewhat longer period. This is called flexible inflation targeting.44 A two-year horizon in interest rate setting will also contribute to smoothing fluctuations in output and employment. Two years is therefore normally a reasonable time horizon for achieving the inflation target. The most important monetary policy instrument is the interest rate on banks’ sight deposits in Norges Bank. Short money market rates will shadow changes in Norges Bank sight deposit rate. The shortterm nominal interest rate in Norway is now very low historically. With reduced pressures in the economy and the prospect of an inflation rate below target at the twoyear horizon, Norges Bank has over the past year reduced the key rate on a number of occasions.

Those who experienced the banking crisis in the 1990s have a clear perception of this. Financial instability is characterised by wide fluctuations in prices for assets, such as dwellings, commercial property and securities or failure in the functioning of financial institutions (a “run” on banks) or financial markets. Financial instability is also characterised by disturbances in credit availability or the flow of capital. This may have consequences for output, employment and for inflation. Financial stability therefore promotes price stability. In tandem with the trend towards lower inflation since the mid-1980s, asset prices have shown wider variations and financial crises have become more frequent. In the short term, a conflict may arise between achieving the inflation target and financial stability. In Japan, equity and property prices increased sharply in the 1980s, while inflation was subdued. In the US, household and corporate debt rose fairly sharply and equity prices trebled between 1994 and 1999, while inflation was moderate. This has prompted a debate as to whether monetary policy must take financial stability into account to a greater extent. Low interest rates and low inflation may contribute to a rise in asset prices and debt build-up (financial bubbles) through several channels. With confidence in the inflation target, inflation may be less affected by changes in the economic situation. Increased international competition and imports from low-cost countries can keep inflation at a low level even during a period of strong expansion in the domestic economy. High productivity growth contributes to low inflation, but also to high earnings.