In countries where GDP is more volatile, bank leverage is lower, and banks (by either choice or regulation) put more capital aside to deal with uncertainty. 4 This being the case, it is not hard to imagine that a period of declining volatility in prices and output leads to increased risk taking across several economies. By stating this, I am not suggesting that we should aim at higher volatility. However, we need to recognize the impact that price stability has on financial vulnerabilities (financial fragility), and adjust financial regulation accordingly. Let me now turn to a second source of conflict between interest rate policies that target PS and FS: an innovation that simultaneously leads to increased aggregate demand becoming a risk for FS that coincides with a positive aggregate supply shock. Two examples come to mind. The first is the current concern regarding capital inflows and financial stability. Many have argued – rightly, I think – that large capital inflows could simultaneously lead to increasing financial vulnerabilities without posing an inflationary problem because of the appreciation of the local currency. The correct reaction for PS – keeping loose monetary conditions – is not necessarily the correct reaction from an FS standpoint. The second is the build up to the global financial crisis in the US and Europe. One of the reasons that monetary policy did not react to rising household debt, was that global supply factors had been contributing to drive prices down. Central banks need to oversee price stability and financial stability.

One instrument (namely, the interest rate) is often not enough for pursuing two objectives. More generally, the two objectives should be addressed with more than one instrument. The choice of instrument will depend on both the cause of the financial fragility and the institutional setting of each country. For a start, central banks should work closely with “micro-prudential” supervisors, communicating potential risks so that these can be incorporated into the supervision process or into changes in regulation. A regional house bubble would be a good example of this kind of coordination, with supervisors adjusting provisions accordingly. In addition, central banks  4  Chapter V, Financial Stability Report 1st half 2009, Central Bank of Chile. http://www.bcentral.cl/publicaciones/politicas/pdf/ief2009_1.pdf  BIS Review 76/2010  5  should consider macro-prudential regulation that adjusts capital, liquidity or asset quality regulation through the cycle or in periods of higher risk taking. Finally, central banks should not discard using their balance sheet to “correct” the prices of financial assets when these asset prices are leading to increased vulnerabilities in the financial system. In EMEs this is typically the case of a boom where there are signs that the currency may be strengthening beyond its fundamentals, in which case a mechanism of selfinsurance, such as accumulation of reserves, may help to smooth the transition and to have the economy well-prepared for potential reversals of capital flows. In the case of Chile, we have intervened three times in the exchange rate market since the currency was allowed to float in 1999.