In these situations of moderate and fundamental-driven capital flows, the prevention of financial vulnerabilities resulting from exchange rate volatility should be addressed through financial regulation and financial development. In fact, this has been the case of Chile, where the regulation of currency mismatches has prevented banks from excessive risk taking, and the deepening of the financial system has provided an increasing hedging capacity of the private sector. Nonetheless, this approach is not free of situations like those experienced in some emerging market economies like Mexico, Brazil and South Korea after the Lehmann bankruptcy, where the un-regulated corporate sector became systemically important after the misuse of hedge instruments increased dramatically their exposure to exchange-rate risk. In this regard, strict rules for addressing excessive risktaking from financial intermediaries that fund these positions should be implemented. On the other hand, when a country is subject to a sudden surge of capital inflows due to the incentives associated with temporary macroeconomic and financial conditions, or due to sudden changes in the international investors’ portfolio decisions, the inflation-targeting framework may be subject to important challenges. These challenges are particularly important when episodes of capital flows also result in inflationary pressures. Under these circumstances, dealing with inflationary risk through interest-rate policy may generate further incentives for capitals inflows, exacerbating exchange rate volatility and even creating an over-appreciated currency. From the point of view of macroeconomic policies, this requires to ensure that fiscal policy is not what is inducing capital inflows.

José De Gregorio: Capital flows and the interaction between macroprudential policy and monetary policy Keynote speech by Mr José De Gregorio, Governor of the Central Bank of Chile, at the Central Bank of Chile Annual Conference on “Capital Mobility and Monetary Policy”, Santiago, 17 November 2011. *  *  *  I am very grateful for comments and suggestions from Rodrigo Cifuentes, Kevin Cowan, Luis Oscar Herrera, Alejandro Jara, Ernesto Pastén and Claudio Raddatz. Welcome to the 15th annual Conference of the Central Bank of Chile, this time focusing on “Capital Mobility and Monetary Policy”. In this address, I will discuss the challenges of dealing with macroeconomic and financial instability in the context of inflation targeting in emerging economies and analyze the special case of capital inflows as a source of such macroeconomic and financial instability. The monetary policy framework based on inflation targeting and exchange rate flexibility has been successful in providing price stability and the conduction of countercyclical monetary policy over the last decades. Perhaps precisely because of this success, the “separability view”, that takes price stability and financial stability as independent goals, was the preferred policy framework before the global crisis in those countries that explicitly pursue financial stability as a policy goal.1 Nevertheless, the recent crisis and financial turmoil resulted in increasing awareness of the linkages (spillovers) between macro and financial stability, both at the national and the international level.