behalf of the public and the authorities, and the bank is required to wield the weapons in its arsenal whether people like it or not. the bank attempts to carry out that task as well as it possibly can. in the service of that task, the bank is granted more independence than are most government - owned institutions. one could ask why this is so. what makes it necessary? the explanation lies not least in the fact that the legislature – in iceland as elsewhere – has realised that the battle against the disease called inflation could be lengthy and uncomfortable. as time passes, the treatment of the disease could generate unpleasant side effects, and it might be tempting to do away with those side effects in the vain hope that the illness will somehow cure itself. indeed, we have heard this irresponsible notion expressed in various quarters recently. anyone who has come down with a persistent illness is familiar with the physician ’ s demand that the patient complete the course of treatment prescribed to him. if he does not, he runs the risk that the bacteria attacking him will become resistant to the medicine best suited to fight them, with the result that the medicine will work poorly or not at all the next time it is needed. the tactic of last resort under such circumstances is to prescribe a much stronger dose, which inevitably produces much more dire side effects. if a central bank, either the one located in this building or another one, should change its course in mid - stream because of escalating pressure stemming from painful side effects, it is hardly likely that such a bank would be taken seriously when it next attempted to mount a campaign against inflation. the independence of the central bank exists not least to guarantee that those wishing to take the line of least resistance, hoping that the illness will cure itself, cannot bring undue pressure to bear. the central bank ’ s independence also provides the government a buffer against such pressure. the fact is that the central bank neither can nor wants to ignore the figures that tell us that it is far from having achieved its goal of bringing inflation down to targeted levels. there are many explanations for this – or excuses, perhaps – but as has always been the case, many excuses are usually worse than one. and of course, the main explanation is that growth, and demand have been greater and more enduring than economic indicators – and therefore the bank ’ s forecasts – suggested. this has required lengthier and more invasive treatment than was previously intended. and while the central bank does not consider this

rate and interest rate over the forecast horizon. in december 2005 the same baseline forecast was used, but in the alternative scenarios, the policy rate path followed financial market analysts ’ forecasts and the exchange rate was extrapolated from uncovered interest rate parities. these approaches were developed further in 2006 and the baseline forecast in july and november was based on a policy rate path calculated from forward interest rates and analysts ’ expectations. the alternative scenarios assumed, respectively, an unchanged policy rate and a policy rate path that would bring inflation to target within the forecast horizon. earlier forecasts based on an unchanged policy rate across the horizon, in an environment where there was an obvious need for a sharp hike, produced a misleading picture. they presented developments that the bank had to explain would never materialise. the baseline forecast in monetary bulletin in november 2006 represented an enhancement insofar as it was based on market expectations about policy rate changes. the central bank incorporated these expectations into its baseline forecast, even though it considered them unrealistic. they assumed rapid cuts in the policy rate commencing early this year. the central bank considered neither assumption to be compatible with the inflation outlook. thus the forecast lacked credibility, in the bank ’ s own opinion. this prompts the question of what assumptions it is natural for the central bank to make about the policy rate in its baseline macroeconomic and inflation forecasts. iceland is not the only country whose central bank has faced such a challenge. several years ago, the reserve bank of new zealand responded by using its own policy rate forecast as an assumption. the bank of norway followed suit two years ago and now uses a future interest rate path forecast by its executive board for its baseline forecast. sweden ’ s riksbank recently announced that it will use its own forecast for the repo rate path as an assumption in its inflation forecast. these banks have followed a similar course to the central bank of iceland in developing the interest rate assumptions behind their forecasts. they have now opted to use the path that is forecast by those who actually determine the policy rate, partly because they did not consider market agents ’ forecasts and expectations sufficiently credible. at the same time, these central banks have firmly stated that their policy rate forecasts entail no commitment to hold their rates to that path. the policy rate must always be decided on the basis of the best available information at any given time. experience shows that paths change sharply from one forecast to the next and the central banks explain the assumptions behind such changes thoroughly