Second, the need for accountability and credibility may encourage a central bank to target average inflation over a number of years, offsetting a period of above-target inflation with a subsequent period of below-target inflation. And in some countries, such as Australia, the objective is explicitly defined as being “over the cycle”. But, as already noted, average inflation targeting approaches price-level targeting as the horizon extends to infinity. Third, optimal policy under uncertainty may lead to some correction of price-level deviations. For instance, suppose that a shock has caused inflation to move above target. As time passes and the central bank seeks to return inflation to target, it is possible that further shocks push inflation away from the intended path or that tighter monetary policy fails to return inflation to target as quickly as expected. With the usual concave objective function, the policymaker should prefer to err on the side of inflation undershooting its intended path, rather than risk departing even further above target. Consequently, in the presence of uncertainty, the monetary authority will seek to return inflation to target more rapidly and may even aim to keep inflation below target for a period. For more on this, see Kamenik et al (2008). Whatever the explanation for the trend-stationarity of the price level, these results suggest that existing policy frameworks have delivered something quite close to price-level targeting in practice. That suggests the welfare gains from making the extra step may be limited, particularly when there are costs to changing the framework.

Consequently an increase in the value of a bank’s equity resulting from, say, a rise in the value of its (risky) assets will lead it to expand its debt (through deposit or wholesale funding) and a corresponding increase in its assets, either through extending new loans or acquiring additional securities. So as looser monetary policy boosts asset prices, it encourages an expansion in banks’ balance sheets, putting further upward pressure on asset prices. Leverage targets therefore act as an amplification mechanism. But the number of relatively safe borrowers/projects is limited. So the extension in the volume of loans is also likely to involve moving along the risk spectrum towards more risky borrowers. Looser monetary policy is not the only factor operating through these channels. Two other macroeconomic factors are potentially relevant. First, a number of authors have focussed on the role of international payments flows in the crisis, with capital flowing “uphill” from emerging economies, such as China, into the United States and some other advanced BIS Review 111/2010  3  economies (see, for instance, Obstfeld and Rogoff, 2009, and the references therein). Bernanke (2005) attributes this to a “savings glut” in the surplus countries. Possible drivers include: an inadequate household safety net and restricted capital market access for enterprises in China; the accumulation of precautionary holdings of international reserves by emerging economies following the Asia crisis; and rational savings of the windfall gains from higher oil prices on the part of oil producers.