Chart 2 shows a measure of excess volatility in these series over time (a moving average of the ratio of actual to fundamentals-based volatility), while Chart 3 shows a measure of price misalignment (the absolute deviation of prices from fundamentals, expressed as a percentage of prices). Chart 2 suggests that, on average over the past century, US stock prices have been over three times more volatile than fundamentals, confirming the excess volatility hypothesis. But the trend in the degree of excess volatility is also telling. Up until the 1960s, prices were around twice as volatile as fundamentals. Since 1990, they have been anywhere between six and ten times more volatile. Excess volatility in equity prices has risen as financial innovation has taken off. The pattern is much the same with measures of misalignment. Up until 1960s, the average absolute deviation of US equity prices from fundamentals was just over 20%. Since 1990s, the average absolute deviation has been well over 100%. Charts 4–6 present the same evidence for UK equity prices since 1920. While less dramatic, the patterns are much the same. Misalignment correlates with innovation and liquidity. Patience and profits To bring these market inefficiencies to life, consider a simple experiment to gauge the relative performance of momentum and long-term investors. Both are assumed to follow a simple strategy: the speculator buys (sells) when prices have risen (fallen) in the previous period; the fundamentalist buys (sells) when prices are low (high) relative to fundamentals.

In the first half of 2008, strong increases in commodity prices accompanied by signs of rising wage pressures and an upward drift of inflation expectations implied that risks to price stability over the medium term were increasingly on the upside. To counteract these upside risks and ensure the solid anchoring of inflation expectations, the Governing Council of the ECB raised its key interest rates by 25 basis points in July 2008. With the intensification of the financial turmoil from mid-September last year, the macroeconomic situation and outlook changed fundamentally and suddenly. As the financial crisis deepened and broadened, global demand and economic activity weakened substantially, commodity prices declined markedly and, as a result, inflationary pressures and risks in the euro area diminished. Monetary growth and the expansion of credit to the private sector decelerated, confirming that upside risks to price stability were abating. In response, the Governing Council lowered the key ECB interest rates decisively, by an unprecedented 300 basis points between October 2008 and April 2009. The Governing Council will continue to do what is necessary to preserve price stability and ensure the firm anchoring of inflation expectations over medium to longer-term horizons. Such anchoring is indispensable to supporting sustainable growth and employment and also contributes to financial stability. Let me also stress that, from the onset of the financial market tensions, the ECB has taken forceful action in its liquidity management, also through non-conventional measures, to make sure that banks are able to refinance themselves.