The third and final issue I will address today is how to deal with capital flows. Of course, the potential for destabilizing capital flows was well understood even before the crisis. In fact, after the various financial crises of the 1990’s, emerging markets began to accumulate international reserves in order to build a buffer of foreign exchange liquidity. The combination of floating exchange rates and robust foreign reserves, it was hoped, would be sufficient to protect economies and financial systems from destabilizing capital flows. The resort to unconventional monetary policies in the wake of the global financial crisis resulted in an unprecedented level of global liquidity. Emerging markets were buffeted by unusually intense and volatile capital flows. Exchange rate appreciation and FX market intervention were insufficient to maintain financial stability. The policy response in many emerging markets included macroprudential policies to  BIS central bankers’ speeches  3  dampen the effects of capital inflows on domestic credit and capital markets. These policies included both measures that aimed at domestic markets and measures that directly targeted capital inflows. There is currently widespread agreement that a multipronged approach, including macroeconomic, structural, and macroprudential policies may be necessary in order to deal with capital flow surges. More recently, academia, central bank researchers and the IMF have endorsed a judicious combination of capital flow management measures with strong macroeconomic policies, including using exchange rate flexibility as the first shock absorber. However, these measures have costs, including market distortions, administrative burden, and negative market reactions.

Since monetary policy primarily affects the economy through long-term real interest rates, and therefore through agents’ expectations for the future paths of the policy rate and of inflation, the end result would be more accommodative policy during the downturn than recommended under the IT regime. 2  BIS central bankers’ speeches  A more modest proposal was to keep the IT regime, but increase the targeted level of inflation. The crisis and the bubbly period that preceded it convinced many that the modern macroeconomy is more prone to shocks that previously believed, and therefore the 2% target level that prevailed in mature economies before the crisis was perhaps too low to keep the economy from repeatedly hitting the zero lower bound. My take on this debate is that, at the end of the day, inflation targeting emerged even stronger from the crisis. No major central banks abandoned inflation targeting, and some central banks that were not inflation-targeters adopted elements of the framework. There are several reasons for the resilience of the IT regime: •  Central banks found that inflation targets were actually helpful in explaining the need and the room for unconventional policy measures to the general public. •  Furthermore, inflation targets helped anchor inflation expectations, keeping deflation at bay despite the large output gaps prevalent at the height of the crisis. •  The proposed new monetary policy regimes suffer from a number of practical deficiencies. They are too complex for the general public to understand and follow.