##rona not slipping much from its level over the past few months, at least for as long as pronounced macroeconomic imbalances remain. confidence in the exchange rate will be a crucial factor over the coming months. it should also be pointed out that exchange rate movements can be the result of external events or changes beyond our control, such as a sudden shift in international investors ’ risk perceptions or global credit supply. the exchange rate of the krona is closely linked to developments in capital markets elsewhere in the world, especially while the current account deficit is as large as at present. inflation and macroeconomic forecasting the central bank bases its monetary policy formulation and implementation on the inflation and macroeconomic forecast that it prepares three times a year and publishes in monetary bulletin. forecasts are always uncertain and by definition can never state precisely what will happen over the forecast horizon. the central bank forecasts are based on extensive research and analysis, and on models that have been developed to simulate how events are likely to unfold. a major advance was made in 2006 with the introduction of a new macroeconomic model designed by central bank economists. the central bank has always expressed qualifications about the accuracy of its forecasts, and readers of monetary bulletin will be familiar with the risk profiles that draw attention to forecasting uncertainties. another uncertainty is the output gap at any time, which is an important determinant of the inflation outlook. however, the economic laws are known and are the same as everywhere. forecasts are prepared on the basis of the best available information and known correlations between changes in aggregates. they therefore provide a sufficiently good indication about future developments to enable the board of governors to make decisions on the basis of them. better forecasts have not been available. nonetheless, the central bank has frequently been criticised for the quality of its forecasting and the allegedly incorrect monetary policy decisions based on them. for example, the bank came under harsh fire for raising the policy rate in the second half of 2006. it was claimed that the forecasts were wrong and the hikes therefore unnecessary. in some cases, critics selected limited and minor areas of central bank forecasts which they considered to be based on incorrect assumptions, and dismissed the entire forecast as a result. now that the year is over, it is obvious, of course, that the bank ’ s forecasts did not fully hold. for instance, in july 2006 the bank forecast higher second - half inflation than proved to be the case. explanations for the deviation include the

the impact of the appreciation of the krona since the middle of the year, less - thanexpected wage drift and a slowdown in house price inflation. domestic demand in q3 was broadly in line with the central bank ’ s november forecast. it was also known that the current account deficit was wider than expected in q3 and would significantly overshoot the forecast for the year as a whole. no indications of easing labour market pressures could be seen. unemployment was negligible and there was a large influx of foreign labour. despite lower inflation than in the bank ’ s july forecast, there was still no sign that the target would be attained within two years if the effect of indirect tax cuts on headline cpi in the first half of 2007 was ignored. furthermore, the wide current account deficit and tight labour market aroused suspicions that pressures in the economy were underestimated, and thereby inflationary pressures as well. as mentioned earlier, policy rate hikes primarily impact the exchange rate. the krona appreciated substantially until near the end of 2005. by then it was considerably stronger than was compatible with external balance in the economy, as the central bank had explained in detail, among other things in its december monetary bulletin that year. so it was not surprising that the krona depreciated. what was unexpected was how soon and how fast the krona fell. it depreciated by 19 % against the exchange rate index over 2006 as a whole and all the weakening was confined to the first half of the year. so far in 2007 the krona has been roughly 15 % weaker on average than at the beginning of 2006. by comparison, the us dollar depreciated against the euro by almost 11 %. for most of the period since the middle of 2006, the krona has fluctuated within a fairly modest range. since the end of the sharp depreciation in the first half of last year the krona can be described as relatively stable and marginally above its long - term average value. at present, the real effective exchange rate is slightly stronger than on average over the last quarter of a century. a wide current account deficit could potentially erode confidence in the krona. the central bank has underlined the importance of restoring macroeconomic balance by realigning domestic demand with output capacity, and of establishing a sustainable external balance by such means rather than through a sharp currency depreciation that would fuel inflation and other instabilities. inflation developments depend heavily on the k