is a parameter that expresses how much weight is given to stable output versus low and stable inflation. If is greater than 0, this is often referred to as flexible inflation targeting. 8  BIS Review 10/2007  Thirty to forty years ago, economic policy was widely regarded as an optimal control problem where the authorities could minimise society’s loss function directly and mechanically. Economic policy could in a sense be viewed as an engineering art. However, in 1977 Finn Kydland and Edward Prescott warned against this approach to economic policy conduct.4 In their work, for which they were later awarded the Nobel Prize, they showed that if the authorities in each period attempt to optimise on a discretionary basis, a suboptimal equilibrium may arise. The reason lies in economic agents’ expectations formation. Kydland and Prescott argued in favour of a rule-based policy, where policymakers commit to a certain pattern of behaviour. They also pointed out that it would generally be tempting to "reoptimise" at a later time and thereby ignore earlier promises. This temptation is often referred to as the "time inconsistency problem". For a rule-based policy to be successful, it must be credible so that economic agents can fairly safely assume that decision-makers will actually follow their announced response pattern. Norway’s experience of various fixed exchange rate regimes during the post-war period provides a good illustration of the difference between discretionary policy and commitment policy. In the period 1946-1971, the krone was pegged to the US dollar.

Given the information at the Bank’s disposal and the assessments made by the Bank at the time the projections are made, the interest rate forecast in the Inflation Report will reflect a monetary policy that provides a reasonable balance between the objectives of stabilising inflation at target and stabilising output and employment. This forecast might in many cases be close to market expectations, but this will not necessarily be the case. When the interest rate forecast reflects a monetary policy that provides a reasonable balance, it contributes to monetary policy predictability. With a predictable monetary policy, market participants can react to new information in a way that contributes to stabilising developments in output and inflation. This makes monetary policy more effective, especially if market participants share the central bank’s analyses and assessments. To be successful, monetary policy must be capable of influencing expectations. This is essential to effective monetary policy. The essence of this argument is that it is primarily through the expectations channel that the central bank can influence economic developments. The expectations channel is the most important channel for monetary policy transmission. 3 The central bank determines the shortest money market rates via the key rate. The shortest rates, however, are of limited importance to economic agents’ consumption and investment decisions. These decisions depend more on agents’ expectations with regard to future developments in the key rate. The key rate is primarily effective because it influences market expectations concerning future interest rates.