to the target within a reasonable time horizon, which in our view is normally 1 - 3 years. provided inflation expectations are on target, the inflation gap and the output gap should be in reasonable proportion to each other until they close. looking ahead, the inflation gap and the output gap should normally not be positive or negative at the same time. 2 given the low inflation rate, we have decided to keep interest rates at a low level and have at times considered an even lower interest rate. however, as the norwegian economy has shown solid growth since summer 2003, we decided instead to allow a somewhat longer period for bringing inflation back to target. chart 6 shows our projections of inflation and the output gap from the previous inflation report. the paths reflect our aim of striking a balance between inflation and output stabilisation. the paths also reflect the fact that monetary policy works through the demand side and the capacity utilisation of the economy. therefore, we have to accept a positive output gap in the years ahead as a means of bringing inflation up to target. interest rate developments should result in acceptable developments in inflation and output also under alternative, albeit not unrealistic, assumptions concerning the economic situation and the functioning of the economy. in the inflation reports we analyse developments in inflation, output and the interest rate under alternative scenarios. chart 8 is from the latest inflation report. it shows on the left hand developments in inflation and output under two alternative scenarios, one with lower inflation and one with a wider output gap. consequences for the interest rate are shown on the right hand. in the case of lower inflation, the interest rate path falls below the baseline scenario. in contrast, a wider output gap results in a higher the uncertainty surrounding the forecasts and how we calculate the fan charts are discussed in a box in inflation report 3 / 05 : “ uncertainty surrounding future interest rate developments ”. however, economic theory indicates that under an optimal precommitment policy, it will under some circumstances ( e. g. after a cost push shock ) be optimal to keep both the inflation gap and the output gap negative or positive for some time ahead, see for example walsh, carl ( 2003 ) : monetary theory and policy, second edition, mit press, cambridge, ma. interest rate path. in both scenarios it is assumed that it takes time to identify the causes of developments and to adjust policy. beyond such specific scenario analyses, in the inflation report we also discuss more generally possible consequences of more severe disturbances to the economy.

the interest rate should normally be changed gradually so that we can assess the effects of interest rate changes and other new information. thus, we started increasing the key rate from a low level of 1. 75 per cent last summer. thereafter, the interest rate has been increased in small increments of 25 basis points to 2. 5 per cent. interest rate policy must also be assessed in the light of developments in property prices and credit. a build - up of financial imbalances may influence future inflation and output. in recent years, house prices and household debt have increased sharply in several countries and in our country as well. growth in housing investment moved up further in 2005 from the record - high level in 2004. a gradual normalisation of the interest rate level and a larger supply of new dwellings are expected to curb the rise in resale home prices in the years ahead. the question of whether financial stability considerations should be explicitly included in monetary policy is a subject of widespread debate, both in academia and within central banks. the answers diverge and international consensus has not yet been reached. a flexible inflation targeting regime provides scope for taking into account the impact of potential financial imbalances on future inflation and output. asset prices and household credit and debt are inputs for the analysis of future developments in inflation and the output gap. in this way, the assessment of asset prices and debt levels may influence interest rate policy. furthermore, it is important to keep in mind that the unwinding of financial imbalances may lie many years ahead, well beyond the horizon for the inflation target. it is questionable whether monetary policy today should respond to potential repercussions of possible financial imbalances well beyond the monetary policy horizon. first, it is well documented that asset price bubbles and financial imbalances are very difficult to identify ex ante. second, the appropriate timing of a proactive monetary response is likely to be difficult to determine, given the lags in the impact of monetary policy. third, even in the case where the central bank knew that financial imbalances were building up, the size of the interest rate rise needed to reduce the imbalances might be so large that it could lead to a severe economic downturn. in norway, the central bank is one of the institutions with responsibility for analysing and monitoring the financial system. as a flexible inflation - targeting country, we have chosen to incorporate financial stability considerations into the monetary policy decision - making process, partly because asset prices and