time lag. this means that the riksbank cannot control inflation in the very short term and that monetary policy decisions must be based on forecasts of future inflation. monetary policy is normally aimed at achieving the inflation target within two years to avoid the deviations from target from being too large and too protracted. the two - year horizon can be regarded as a restriction the riksbank has taken upon itself to give credibility to the inflation target. at the same time, it provides an opportunity to show consideration for the real economy. if, for instance, there is a shock that leads to inflation being pushed upwards despite weak demand, a very rapid return to the inflation target could lead to a more severe slowdown in the already weak demand, than would be the case if the recovery was allowed to occur at a slower pace. if inflation is instead held back despite good growth in demand, attempts to quickly return it to target through very expansionary monetary policy could lead to the economy overheating. over time a policy that quickly subdues inflationary impulses would probably result in more stable inflation, but there would be a risk of substantial fluctuations in the real economy. we have chosen a two - year horizon for monetary policy because this is considered to give sufficient scope in most cases to ensure a good and stable development of the real economy. however, the rate at which it is desirable to bring inflation back on target in an individual case depends on what shocks the economy has suffered and how substantial they are. sometimes the deviations from target can be so large that there is reason to allow inflation to return to target beyond the normal two - year horizon. in these cases, we shall explain this in connection with our decisions. back when the new sveriges riksbank act came into force in 1999 and a new executive board entered office, the riksbank published a clarification of monetary policy, where it was pointed out that the horizon might need to be longer when the economy was subjected to large shocks 1. the new element is that we are clearer on the point that the choice of time horizon concerns a desire to alleviate the consequences for the real economy. another new element since last year is that we make forecasts under the assumption that the repo rate will develop in line with market expectations, as these are reflected in implied forward rates. previously, forecasts were instead based on the assumption that the repo rate would remain unchanged during the forecast period. what consequences does this change have

stabilisation of both inflation and resource utilisation is confirmed by the mean squared gaps in figure 4. the mean squared gap for inflation is the mean squared deviation between the inflation forecast and the inflation target during the forecast period. a lower mean squared gap for inflation entails a better stabilisation of inflation around the target and thus a better attainment of the inflation target. the mean squared gap for output and for hours worked is the mean squared gap for resource utilisation measured in two ways, that is using the output gap and the hours - worked gap during the forecast period. a lower mean squared gap for output or hours worked entails a better stabilisation of resource utilisation around a normal level measured as the output gap or the hours - worked gap. the closer to origo the mean squared gap for inflation and resource utilisation is, the better the stabilisation of inflation and resource utilisation. this case is special as there is no conflict between stabilising inflation and resource utilisation ; the extended repo - rate path stabilises both better than the main scenario. this is of course already obvious in figure 2, so the mean squared gap does not add much new information here. however, the normal situation is considered to be that there is a conflict between stabilising inflation and resource utilisation. in such a situation, the mean squared gap in figure 3 would lie in a north - west to south - west direction and determining monetary policy would entail weighing up whether to stabilise one more or less than the other. figure 4. the mean squared gap for cpif inflation and output and hours worked respectively. source : the riksbank figure 5 : the decision - making situation for norges bank in 2005 figure 5 shows the policy decision facing norges bank in march 2005, which is an example of a case where there was a conflict between stabilising inflation and stabilising resource utilisation. 5 the problem at that time was that the inflation forecast was under the inflation target of 2. 5 per cent, so that the gap between the forecast and the target was negative, while the forecast for the output gap was positive. in such a situation, a lower repo - rate path stabilises inflation around the target better but the output gap less well, and vice versa for a higher repo - rate path. the mean squared gap then lies in a north - west to south - west direction. this