But pure extrapolation from this recent past may not be appropriate due to the possible existence of threshold effects. The persistence of the current inflation shock also entails the serious risk that inflation expectations could become unhinged and that, as a result, our credibility as central bankers could be significantly damaged. It cannot be forgotten that there is a two-way relationship between credibility and effectiveness of monetary policy. Effectiveness depends on the credibility of central banks. But, no less importantly, the credibility of central banks depends critically on the effectiveness of the monetary policy that they have applied. The conduct of monetary policy has also been complicated over the recent period by sharp and abrupt moves in exchange rates, which might signal that the long-awaited correction of global imbalances is not proceeding in as orderly a fashion as we would have hoped. Against this background, the Governing Council is monitoring exchange rate markets closely. And, in this respect, the President of the ECB has repeatedly indicated that excess volatility and disorderly movements of exchange rates are undesirable for economic growth. BIS Review 132/2007  7  In summary, monetary policy is operating in an environment of heightened uncertainty. This is the result of the materialisation of some risks that we have been pointing out for a long time. First, the potential consequences of the turmoil in financial markets, which go beyond a sound reappraisal of risks and a less dynamic economic outlook. Second, renewed inflation pressures associated with the explosion of oil and commodity prices.

The process leading to these broad exercises involves close interaction between staff of the ECB and the national central banks to ensure that the euro area projections draw on all available expertise – both at the country and euro-area levels – and reflect the consensus view of the staff. There are three main steps: First, initial assumptions underlying the exercise and covering interest rates, exchange rates, the international environment and fiscal variables are set, although they are reviewed and can be changed in the course of the exercise; second, the projection numbers are derived and agreed upon, following a process of peer review of the individual country projections, consistency checks and integration within the euro area framework; the third and final step is the preparation of a report for the Governing Council. In addition to the numbers themselves, the staff also produces a number of background analyses on relevant issues. In March and September, the projections are updated by the staff of the ECB. Summary reports of both the Eurosystem’s and ECB Staff’s projections exercises are released on the ECB’s web-site on the same day that the detailed projections are presented to the Governing Council. They are also published later on in the ECB’s Monthly Bulletin. Publication is intended to make clear the information set which is available to the Governing Council when taking its decisions, and not to explain the decisions themselves. Due to the forward-looking orientation of the Eurosystem’s monetary policy, forecasts constitute necessarily a very important input into the decision-making process.