Moreover, market participants continuously review and update their own assessment of future economic and monetary policy developments. Financial market prices therefore reflect a realtime and continuous update of market expectations about future economic and monetary policy developments. 3. How do financial markets affect monetary policy? As I mentioned at the outset, the link between monetary policy and financial markets is not a one way street. Financial market prices reflect market expectations about future economic developments, such as inflation, output, and the likely course of monetary policy. It is therefore natural and appropriate for central banks to evaluate closely the information contained in market prices. In other words, market expectations can and should influence the setting of monetary policy. However, central banks must exercise caution in using the information extracted from market expectations as an input to formulating monetary policy. My previous comments illustrate that the more credible and the more transparent a central bank is, the more market prices will reflect the central bank’s own expectations about the future. In other words, the information value of financial market prices for monetary policy purposes decreases to the extent that they no longer reflect an independent evaluation by millions of market participants about probable future developments in the economy and in financial markets. An example may illustrate the potential pitfalls of a central bank relying excessively on market expectations in formulating policy. Consider a country with a liquid inflation-indexed bond market. In principle, these bonds reflect what the market expects inflation to be in, say, ten years time.

In practice, only a small number of central banks can draw on a sustained history of successful monetary policy, amongst them, the Federal Reserve, the Bundesbank and the Swiss National Bank. Fortunately, in recent years, an increasing number of central banks are rapidly accruing credibility in that painstaking process referred to by Alan Blinder. 6 When we think about expectations, transparency and credibility in the context of monetary policy, it is important to remember that they cannot and should not be substitutes for action. It is often said that a  4  See for example McKinsey (2005), where it is shown that the ratio of the global financial stock (including equity, debt securities and deposits, but excluding real estate) was roughly three times the size of world GDP in 2003, while it was about equal to world GDP in 1980. 5  The growing importance of balance sheet considerations in monetary policy was noted by Alan Greenspan in his reflections on central banking at the Jackson Hole Symposium 2005. "In particular, our analysis of economic developments almost surely will need to deal in greater detail with balance sheet considerations than was the case in the earlier decades of the postwar period. The determination of global economic activity in recent years has been influenced importantly by capital gains on various types of assets, and the liabilities that finance them. Our forecasts and hence policy are becoming increasingly driven by asset price changes."