Mr. Bernanke’s quote recognises the channel between the stock-market boom and incipient inflationary pressures.7 Mr. Issing focuses attention on financial imbalances on the grounds that strains in the financial system may conflict with price stability in the long run.8 Mr. Heikensten calls attention to the possible repercussions of financial imbalances on the real economy in a situation where the household debt burden is high and interest rates are increasing rapidly.9 Seen from an institutional perspective, flexible inflation targeting is becoming an increasingly common monetary policy regime. With a target horizon that is forward-looking and sufficiently flexible, it is possible to take into account the impact of potential financial imbalances on future inflation and output. However, it is important to keep in mind that the unwinding of financial imbalances may lay many years ahead, well outside the horizon for the inflation target. Some situations may require a careful weighting of the probabilities and costs of not reaching the inflation target within a medium-term horizon against possible economic turbulence further ahead. In the worst case, this turbulence may result in the actuation of a financial crisis. Another interpretation of the role of monetary policy is that it demands that financial instability is taken into account beyond its impact on inflation and output. For instance, structural costs may arise as a result of incorrect decisions by economic agents, based on incorrect information in the period characterised by financial imbalances.

The increased complexity of the financial system is illustrated by the rapidly expanding market of credit derivatives. This is a relatively new financial instrument that comes in many and complicated forms. While contributing positively to greater flexibility in risk management, there is also the possibility that risk is more easily concentrated, and that economic agents can take on risks without being fully aware of their ramifications. Analysing risk originating inside the financial system, it can be useful to divide the approach into two areas.3 The microprudential analysis focuses on the developments within individual institutions, and is concerned with limiting the distress of individual institutions, thereby protecting depositors. The macroprudential analysis focuses on the financial system as a whole, and aims at limiting system-wide distress and avoiding output costs. An important concept here is systemic risk; the risk that liquidity or solvency problems in a bank may cause liquidity problems or insolvency in other institutions. Thus, correlation and common exposures across institutions are important in the macroprudential approach. The second approach deals with risks originating from outside the financial system. This field has increasingly been recognized by researchers and policymakers in later years. Strong growth in debt and asset prices, as well as macroeconomic disturbances like a surge in commodity prices or the unwinding of large imbalances in the world economy, can ultimately affect financial stability in a negative way. To identify potential sources of instability, we need indicators that contain useful information.