Successive boom-bust financial cycles have made it clear that unsustainable buildups of credit and leverage lies at the heart of financial fragility. It is hard to deny the critical role that monetary policy plays in this. Monetary policy sets the price of leverage and hence has first order implications for the pricing of all financial assets and the evolution of the financial cycle. A framework in which monetary policy reacts systematically to the financial cycle, in addition to traditional inflation and output developments, will help to keep the economy on an even keel. This differs from an approach in which policy leans against the wind only when financial stability risks become evident. Given the long and drawn-out nature of financial cycles, such an approach would inevitably lead to doing too little too late, as the cumulative impact of policy over the whole financial cycle is ignored. 8  Just as the proliferation of inflation targeting frameworks starting in the 1990s helped to bring down the level and volatility of inflation rates worldwide, a general trend towards a more systematic leaning against the financial cycle approach to monetary policy, especially among advanced economies, could yield significant benefits. I believe that if central banks coordinate on such a framework, and thereby adopt a longer through-the-cycle perspective in policymaking, the problems from cross-border spillovers and perceptions of competitive devaluations will be significantly diminished. The key challenge will be one of communication.

Finally, the ultra-accommodative monetary policy stances of advanced economies have contributed towards greater global asset price co-movements and increased cross-border financial spillovers. In the context of a highly globalized financial system, extreme monetary easing has ‘pushed’ capital to other parts of the world, particularly emerging market economies where yields are higher, and boosted asset prices globally. The exceptionally long period of zero interest rates has also led to a buildup of financial positions that are attractive or justified only if yields remain low. As a result, global bond yields and exchange rates have become acutely sensitive to shifting expectations about monetary policy 5  changes in advanced economies. Such excessive sensitivity has put global markets on a knife edge with frequent bouts of volatility. These developments have critical implications for the transmission mechanism of monetary policy and its conduct. On the one hand, the greater influence of global factors and structural growth headwinds may have made inflation and output less responsive to monetary policy. On the other hand, financial markets and asset prices globally have become more sensitive to monetary policy actions and communication. This raises a dilemma. With inflation and output below targets, monetary policy is eased. Against the tide of global factors and growth headwinds, inflation and output fail to respond, and the temptation is to do more and more. In the meantime, financial markets respond vigorously to low interest rates and the search for yield accumulates in the form of greater financial fragility over time. Something will eventually have to give.