When the build-up of financial imbalances affects a large part of the economy, only monetary policy rates have the ability to reach into all “corners of the economy” (to borrow from Jeremy Stein’s remark).5 And when the build-up of financial imbalances pervades the economy, monetary policy should stand ready to adopt a leaning-against-the-wind posture. The monetary policy horizon In pursuing its price stability mandate, monetary policy can inadvertently exacerbate financial stability risks. As monetary policy operates under uncertainty, there have been episodes of monetary policy mis-calibration throughout economic history, but the consequences for financial stability very much depend on the prevailing financial regulatory regimes. Monetary policy mis-calibration may lead to the build-up of financial imbalances in particular when the central bank is faced with a sequence of positive cost-push shocks that curb domestic price pressures for a prolonged period of time. Think, for instance, of the gradual penetration of new technologies in recent decades – primarily the internet and related digital technologies – which boosted on-the-job productivity, or the emergence of new and cheaper sources of global production, which resulted from the ascent of China as a global manufacturing hub and suppressed import costs for advanced economies. These factors may bring about low inflation conditions which, if not analysed holistically – i.e. taking into account the economic strength and the financial exuberance which typically accompany such conditions – may encourage a looser monetary policy than would be appropriate.

Loose monetary policy, in turn, may reinforce the economic momentum that is already under way, further feed optimism and thus favour the build-up of financial imbalances. Empirical evidence indeed suggests that stock market booms usually coincide with atypically low inflation. The run-up to the dotcom bubble in the late 1990s provides one particularly vivid example of this pattern.6  3/5  BIS central bankers' speeches  There are two responses to these sorts of monetary policy pitfalls. First, an appropriate calibration of the monetary policy horizon. Modulating the horizon over which the central bank aims to achieve its price stability objective depending on the shocks hitting the economy is a principle of prudent monetary policy. A demand shock calls for a shorter policy horizon; a costpush shock calls for a longer one. Importantly, this principle holds only if inflation expectations remain firmly anchored. Second, the central bank can minimise the risk of mis-calibrating monetary policy if it broadens the scope of its analysis to an encompassing set of observables, including monetary and financial variables. This also allows policymakers to monitor signs of the emergence of financial imbalances and to calibrate a “leaning against the wind” approach to monetary policy. The effects of the ECB’s monetary policy on the economy and the financial system The monetary policy response to the crisis has been central in restoring the bank lending channel and ensuring very accommodative financing conditions, which has paved the way for the euro area’s recovery and continued expansion.