Monetary policy and macro-prudential policy  Taking the role of the financial sector in monetary policy transmission more seriously reveals the macroeconomic consequences of microeconomic behaviour: the impact on inflation, growth and financial stability of the behaviour of financial institutions. As a result, a revised framework has important implications for both the conduct of monetary policy and for policies aimed at maintaining financial stability. Viewing recent experience through this lens demonstrates that the achievement of financial stability relies on more than traditional micro-prudential supervision of individual financial institutions. Clearly, policy needs to take into account the impact of such externalities in order to develop a framework supporting the stability of the financial system as a whole, rather than the individual institutions which constitute it. By the same token, the preceding analysis demonstrates that taking appropriate monetary policy decisions relies on an understanding of the behaviour of financial intermediaries and, in turn, on financial structure and innovation. From a policy perspective, the impact of monetary policy on the behaviour of the financial sector suggests that short-term interest rates are a potentially powerful tool to influence the evolution of systemic risk, and thus to support financial stability. However, as I discussed at the outset, monetary policy should not be overburdened with additional objectives. The primacy of the price stability objective must be retained. The well-known Tinbergen principle makes clear that a single instrument (short-term interest rates) is insufficient to achieve two goals simultaneously. 24 In such a context, additional policy instruments are required.

At the global level, the incorporation of emerging markets into the world economy weighed down on price developments (especially of manufactured goods). In response to the resulting benign inflation developments, the prevailing inflation targeting orthodoxy led to the adoption of an accommodative monetary policy stance. In retrospect, such accommodation was probably inappropriate, at least to the extent that it supported the financial imbalances and asset price bubbles that underlay the recent financial crisis. Failure to take into account financial factors and channels of transmission led to a mis-calibration of the monetary policy response to the impact of globalisation. A simplistic account of the financial sector may have had other, adverse implications for the conduct of monetary policy in recent years. Within the canonical New Keynesian model, financial markets are “perfect”. On the basis of arbitrage considerations, long-term interest rates and other yields and asset returns all derive from the expected path of short-term interest rates determined by the central bank. Such a construct suggests that monetary policy-makers can steer long-term rates closely by simply making pre-commitments about the future path of short rates. No doubt there is an  16  See: E. Fahri and J. Tirole (2009), “Leverage and the central banker’s put”, American Economic Review 99(2), pp. 589–93. 17  See: D.W. Diamond and R.G. Rajan (2009), “Illiquidity and interest rate policy”, NBER working paper no. 15197. 18  See: T. Adrian and H.S. Shin (2009), “Financial intermediaries and monetary economics”, Handbook of Monetary Economics, forthcoming; R.G.