Monetary policy and asset prices It is worth mentioning the role of asset prices in the conduct of monetary policy. A long series of booms and busts over the past four decades have demonstrated that asset price developments can pose serious threats to macroeconomic and price stability, and that, therefore, central banks cannot simply neglect them. In this respect, it appears that a comprehensive monetary policy strategy, which also gives prominence to money and credit developments, might be better able to “lean against the wind” of financial exuberance. Central banks should be equipped with a broad-based analytical framework for monitoring and analysing in detail such developments. At the ECB, this approach is underpinned by the monetary analysis, the second pillar of our monetary policy strategy. Fiscal policy For many commentators, the financial crisis has underlined the need for a return of the State in managing macroeconomic developments. Of course, together with central bank liquidity support, discretionary government intervention has been key in forestalling a repeat of a 1930s-style depression. However, we are observing a drift in public liabilities that will prove hard to correct with the usual stabilisers. In some countries, this drift actually has nothing to do with the financial crisis. It is rooted in the policy hyper-activism that was already in place before the crisis. And this despite the obvious dangers of an overreactive fiscal stance, which cannot be decided and implemented without long lags. Here, fiscal rules, such as the Stability and Growth Pact in the European Union can help.

It is an irrefutable empirical fact that inflation variability rises with the level of inflation, which in turn increases uncertainty for investors and long-term interest rates through a rise in the inflation risk premium. A permanent increase in inflation curtails, rather than stimulates, long-term growth. A considerable body of empirical research finds that the Phillips curve has a negative bent in the long run: inflation and inflation volatility penalise capital formation and thus detract from the economy’s growth potential. Empirical evidence confirms this negative relationship, with a 100 basis point permanent increase in inflation being associated with a 10–30 basis point decrease in trend output  2  BIS Review 22/2010  growth. Hence, if this is applied to the euro area, a 4% inflation target would shave no less than half a percentage point per year off trend growth! As for using monetary policy to manage macroeconomic risk, it should be recognised that this would introduce harmful asymmetries. It avoids policy restriction when positive supplyside shocks reduce inflation, fuelling asset price booms; and when the asset price boom finally turns into a bust, it leads central banks to overreact to negative demand-side shocks. So, financial instability meets two formidable multipliers, the first being a pro-cyclical monetary response to expansionary disinflations in good times and the second being moral hazard in financial markets, namely the expectation that the central bank will aggressively protect the markets from “tail events” in bad times. These expectations encourage markets to tend towards risky strategies, over-exposures and exuberance.