Past episodes of persistent negative price growth, such as those seen in Japan over the last decade, have shown us that in those conditions monetary policy loses much of its potential to exert a decisive influence on the price path and on the level of output. In that regard, most central banks, such as the ECB, recognise that their price stability objective should be made compatible with a low probability of deflation. Moreover, in the current setting of low inflation and interest rates, we have witnessed episodes of rapid increases in some asset prices that have led analysts to suspect important deviations between fundamental and observed values. Some notorious recent examples include the overvaluation in the real-estate sector in several East Asian countries in the 90s, and the surge and subsequent correction of the wave of excessive optimism in some equity markets around the turn of the millennium. Currently, the extreme increases in housing prices and households’ level of indebtedness witnessed in some western countries is attracting some attention and concern in view of the potentially adverse consequences on the stability of the whole economy. Looking back, one can indeed find in unbalanced developments in asset and debt markets the seeds of some of the major financial crises that ultimately led to persistent negative output and price growth. Therefore, conditions such as low inflation and interest rates may sometimes conceal risks capable of bringing a phase of price and economic stability to its end.

It is about establishing an incentive-based approach to risk management and capital adequacy, within a framework of the three mutually-supporting pillars The new comprehensive framework provides at least four transmission channels for influencing financial stability and the overall economy: first, by setting more risk-sensitive minimum regulatory capital requirements, so that regulatory capital is both adequate and closer to economic capital; second, by providing incentives to encourage improvements in banks’ internal risk management processes; third, the enhanced mechanisms to encourage the marketplace to exert external discipline on banks and the banking sector; and fourth, the necessary greater co-operation among supervisors across jurisdictions. The effects of each of these channels will be different in terms of time and in terms of final influence, some of them having the capacity to bring significant long-term positive changes to the financial markets. In my view, perhaps too much attention is placed on the minimum capital rules of Pillar 1 and not enough on the effects of the other three channels. 3. Implications of Basel II for monetary policy  Let me therefore turn to the issue of how the main elements of Basel II may affect the ability of the monetary authority to fulfil its objectives. I believe that the achievement of price stability as a desirable medium to long-term target is, by now, a non-controversial objective of primary importance whose foundations are well known. On one hand, the proposition that labels inflation largely as a pure monetary phenomenon within long time-horizons can hardly be contested either conceptually or empirically.