has frequently been necessary for the central bank to show that expectations of high inflation are unfounded. besides monetary policy, expectations are affected by other factors. one of these is the budget. unsustainably large budget deficits are liable to undermine confidence in long - term price stability. our inflation forecast serves as a foundation for decisions about monetary conditions. if monetary policy is directed at stabilising inflation at 2 per cent, it will over time help to stabilise demand so that this is in line with the economy ’ s available capacity. in order to clarify our line of reasoning and our inflation assessments, the riksbank publishes an inflation report four times a year. a range of indicators is reviewed in these reports, accompanied by a discussion of risks and opportunities in the field of inflation. the present situation in the latest inflation report, published this march, gdp growth in 1997 and 1998 was expected to be around 2 and 3 per cent, respectively. it was also argued that sizeable capacity restrictions should not arise in the course of the period. given that, and inflation expectations being low, underlying domestic inflation ( measured with the cpi excluding transitory effects on inflation ) in the coming two years was put at between 1. 5 and 2 per cent. as we all know, to forecast inflation is a complicated task. in view of the shortcomings in such estimates, it is more a matter of assessing the balance of risks. our latest inflation report therefore includes a discussion of two alternatives in which future inflation might be either lower or higher than in the main scenario. one alternative is that inflation could be lower than in the main scenario, mainly if private consumption were to be weak. the other envisages the opposite - higher inflation - on account of a weaker exchange rate that stimulates a stronger growth of exports and gdp, leading to increased inflationary pressure. what are the economic tendencies that have appeared during the last months? during winter there were signs of a slowdown in manufacturing. the december survey from the national institute of economic research showed an unchanged inflow of orders and expectations of subdued production. the order statistics from statistics sweden, which fluctuate fairly widely from month to month, gave the impression of relatively weak orders in the fourth quarter of 1996. in december and january, however, the order inflow has picked up and more recent survey data likewise paint a brighter picture of activity in manufacturing. the improvement mainly applies to production for export but even the domestic market is somewhat optimistic about the

to absorb temporary deviations from trend inflation. such deviations may arise, for instance, from political decisions to alter indirect taxes and subsidies, changes in interest rates as well as from international price shocks. for march 1997 the consumer price index showed a twelve - month fall of 0. 4 per cent. however, this figure was to a large extent influenced by last year ’ s sharp repo rate cuts. when home owners renew mortgage loans at lower interest rates we get a transitory downward effect on inflation. it is important to distinguish between cpi changes and underlying inflation. transitory effects, for example changes in interest rates or in indirect taxes and subsidies, may cause the general price level to jump up and down. in the conduct of monetary policy it is therefore important to keep an eye on underlying inflation ; the transitory effects are of secondary significance as long as they do not affect inflation expectations and thereby trend inflation. given the time lag that applies to monetary policy, a central bank that targets inflation has to monitor the various factors which determine inflation one to two years ahead. in a simple analysis of inflation ’ s determinants one can start from the familiar augmented phillips curve. the rate of inflation is determined by two factors : the relationship between supply and demand in the economy - the output gap - and inflation ’ s expected rate. note, however, that while the output gap is a useful starting point for an inflation analysis, there is no simple way of measuring it. this makes it necessary to go into more detail and study a variety of indicators in order to analyse any tensions between demand and supply. still, the output gap is a suitable starting point for my present purpose. the simple model tells us that when the output gap is closed, inflation is constant and equal to the expected rate. this means that, with normal capacity utilisation and given a low level of inflation expectations, actual gdp can follow potential output. in such a situation some form of external shock is needed to shift inflation upwards or downwards. this can mean either that production falls below or rises above the level for normal capacity utilisation or that inflation expectations move up or down. the latter case is ultimately a matter of confidence in economic policy ’ s consistency and its future reactions. the ability of monetary policy to influence inflation has to do with the impact of the instrumental rate on the path of gdp and thereby on the degree of capacity utilisation, together with its effect on inflation expectations. in practice a period of restricted demand