Let me give you just two examples. First, different liquidity categories were introduced in February 2004 to better mirror the risks associated with different asset classes. More liquid central government debt instruments are in category 1, while less liquid asset-backed securities are in category 4 to reflect the limited secondary market liquidity of those instruments. The second example is the establishment of the previously mentioned specific eligibility criteria regarding asset-backed securities, which were inter alia introduced in 2006 to exclude instruments such as synthetic CDOs and cash CDOs containing other synthetic tranches of ABSs. Due to the opaqueness of the market and the product complexity, those instruments were not deemed suitable as collateral for central bank credit operations. The current developments confirm the appropriateness of the measure. The currently ongoing market turmoil has presented us with a wealth of information both on how our collateral framework interacts with financial markets and financial market participants and on the appropriateness of our risk control framework. We will continue to  6  BIS Review 68/2008  assess carefully the collateral we receive and make sure that the rules outlined in the collateral framework are strictly applied, as well as to study whether there are elements in our collateral framework that may need to be refined to make it even more effective. 6. Going forward: transparency  The recent events have highlighted a number of weaknesses in the financial system, namely in the areas of transparency, valuation, risk management practices, the current prudential framework and market functioning.

Similarly, the changes in the composition of labour contracts that I mentioned earlier are likely to imply that inflationary pressures might take longer than usual to build up. We need to factor this information into our policy deliberations. At the same time, we need to monitor carefully developments in long-term unemployment, labour force participation rates and hours worked with a view to informing our assessment on the likely evolution of structural unemployment. Should the share of long-term unemployed stabilise at one point, with no convincing signs of further likely downward adjustments, the risks of inflationary pressures starting to emerge at higher levels of unemployment would increase. At this point – when scratches indeed become scars – the level of slack relevant for determining medium-term price stability would decline. Policymakers would therefore need to start tightening policy earlier to remain faithful to their primary mandate. As I mentioned in my introduction, however, there are some who argue that such a response would be premature, since if hysteresis effects can be caused by lack of demand, then they can equally be reversed by excess demand. In a high-pressure economy, for example, firms might be encouraged to dig deeper into the labour market to find recruits, thereby reactivating and retraining some of those workers who were previously thought to be unemployable. Glenn Rudebusch and John Williams therefore conclude that optimal monetary policy would allow inflation to overshoot its target.13 I have some doubts about this view, mainly for two reasons.