Two possible strategies have been selected by the EMI Council as potential candidates to be recommended to the ECB, namely monetary targeting and direct inflation targeting.2 In the case of direct inflation targeting, the inflation forecast made by the central bank can be viewed as fulfilling the role of the intermediate target.3 Let me dwell a moment on the choice the ECB will have to make between direct inflation targeting and monetary targeting, unless it chooses to combine elements of both strategies. Inflation targeting stresses the responsibility of the ESCB for achieving and maintaining price stability. However, there are some difficulties in the process of forecasting inflation over the medium and longer term. As Mervyn King recently stated, “such a forecast cannot be a single number. It must be presented for what it is, namely a probability distribution”.4 Furthermore, inflation targeting could imply more formal cooperation with the Government since the latter is in a position to influence price developments. Finally, inflation targeting has admittedly proven useful in progressing towards price stability, as the experience of the United Kingdom has shown. Nevertheless, the track record of inflation targeting is fairly short and has mostly taken place in a context of world-wide disinflation. Monetary targeting (in concrete terms, targeting a broad money aggregate such as M3) clearly indicates the responsibility of the central bank for developments that are more directly under its control and would therefore correspond better to the independence of the ECB. Moreover, it is based on observed information, which makes it more transparent.

Future challenges Finally, before I close, I would also like to stress that many challenges will remain for the Basel Committee even after it has completed its current review of the Capital Accord. I have referred at various points to bank provisioning policies. This has traditionally been an area where internationally there has been little attempt at harmonisation (except at the level of very broad principles). But the systematic use of internal ratings by possibly quite a large part of the banking population will arm supervisors with valuable information about expected losses, and ought to focus attention on the adequacy of provisions to cover such losses. Indeed, more generally, the whole question of the appropriate accounting valuation framework for the banking book may have to be re-examined in the light of any recommendations that come from the Joint Working Group of accounting standard setters that is currently looking at accounting for financial instruments. Also looking to the future, the issue of recognising full scale portfolio credit risk modelling will inevitably resurface. The resulting recognition of diversification effects could result in quite a large reduction of capital for well-diversified banks - who are also of course in many cases the largest, most systemically significant banks. At this point we will have to think very hard about what level of capital we really feel comfortable with in our systemic organisations, and in particular whether an individual firm’s capital requirement ought to reflect the systemic externalities it poses.