The second view is to “lean–against–the–wind”, i.e. that as price stability may not be sufficient for financial stability, central banks should lean against the emergence of financial imbalances by tightening the monetary policy stance over and above the level necessary to bring inflation back to target over a policy horizon that is generally understood to be around two years. The third view is that “financial stability is price stability”. Proponents of this view advocate a more radical change in the objective of monetary policy, arguing that financial stability and price stability are so intertwined that one cannot distinguish between the two.3 Under this view, both standard and non-standard monetary policies are in the first place attempts at stabilizing the financial system, addressing malfunctioning financial markets and smoothing the monetary transmission process. While all these viewpoints recognise the important interplay between financial stability and monetary policy in pursuit of price stability, their relevance ultimately depends on (i) the weight to be attached to the “risk-taking” channel of monetary policy, (ii) the strength of the macroprudential framework and (iii) the policy strategy of the monetary authority, especially as regards its policy horizon. The risk-taking channel Monetary policy contributes to financial stability by smoothing business cycles and anchoring inflation expectations. Monetary policy works through its effects on intertemporal substitution and risk appetite. By lowering risk-free rates, monetary policy increases the attractiveness of investments projects which would not have been profitable under tighter financing conditions.

Loose monetary policy, in turn, may reinforce the economic momentum that is already under way, further feed optimism and thus favour the build-up of financial imbalances. Empirical evidence indeed suggests that stock market booms usually coincide with atypically low inflation. The run-up to the dotcom bubble in the late 1990s provides one particularly vivid example of this pattern.6  3/5  BIS central bankers' speeches  There are two responses to these sorts of monetary policy pitfalls. First, an appropriate calibration of the monetary policy horizon. Modulating the horizon over which the central bank aims to achieve its price stability objective depending on the shocks hitting the economy is a principle of prudent monetary policy. A demand shock calls for a shorter policy horizon; a costpush shock calls for a longer one. Importantly, this principle holds only if inflation expectations remain firmly anchored. Second, the central bank can minimise the risk of mis-calibrating monetary policy if it broadens the scope of its analysis to an encompassing set of observables, including monetary and financial variables. This also allows policymakers to monitor signs of the emergence of financial imbalances and to calibrate a “leaning against the wind” approach to monetary policy. The effects of the ECB’s monetary policy on the economy and the financial system The monetary policy response to the crisis has been central in restoring the bank lending channel and ensuring very accommodative financing conditions, which has paved the way for the euro area’s recovery and continued expansion.