I would say that price stability can be regarded as the bedrock of financial stability, while financial stability is critical to the efficiency of monetary policy. Let me elaborate further on these two points. First, why is price stability the backbone of financial stability ? Financial stability can be achieved on a sustainable basis if financial resources are not misallocated. Past experience, as well as a large number of economic studies provide evidence that inflation brings about distortions in the allocation of resources. For instance, the calculation of returns is biased, due to the fact that the replacement cost of fixed assets is structurally underestimated. This may result in sub-optimal investment decisions, and over-optimistic credit risk assessment. Conversely, in the case of deflation, the solvency of indebted companies may be jeopardized, as the value of cash flows decreases over time, while the face value of debt remains stable. Second, why does financial stability matter for the efficiency of monetary policy? The efficiency of monetary policy relies on the effectiveness of the transmission channels of monetary policy. Central banks have direct control over short-term interest rates only. The impact of monetary policy decisions on prices goes through various channels - acting directly on the anticipations of economic agents, influencing banking credit conditions, the exchange rate and other asset prices. Uncertainty may arise when these channels do not act in a predictable way nor with relatively stable time lags. In this respect, financial instability may affect the transmission channels of monetary policy.

By its nature, trend following amplifies the imbalance that may at some point affect a market, potentially leading to vicious circles of price adjustment and liquidation of positions. Moreover, increasing numbers of participants are able to access financial markets directly, while the expertise to deal with a wide range of technical information is not evenly distributed. This may also reinforce the role of “gurus”. Index management, as a fund management technique, has proven very popular on equity markets and may have contributed to exacerbating fluctuations in financial asset prices. Because their goal is to mimic the performance of indices, “passive managers” constantly strive to match the composition of their benchmark. They thus help to amplify market trends, buying more as the market rises and increasingly liquidating as the market drops. It can be argued that index funds distort the prices of the targeted indices and that, as a result, the indices end up creating rather than measuring performance. The impact of risk management techniques on market dynamics is particularly enlightening with regard to the question of asset price overshooting. Value-at-risk calculations have become a crucial element  13  Leading indicators of currency crisis in emerging countries - BURKART, COUDERT - Notes d’Etude et de Recherche Banque de France - 2000. 6  BIS Review 2/2003  of the standard approach used by market participants to evaluate the risk inherent in their market activities and to set up exposure limits. Of course, central banks and financial institutions should continue to encourage the use of these instruments.