This is what has been happening in Chile since the prices of foods and fuels began soaring in an unprecedented way in early 2007. Constraining the monetary policy in the presence of a commodity price hike has its costs, but as we have stated a number of times, failing to tackle the inflationary problem opportunely leads to much higher output costs in the future, because inflation becomes much more entrenched. On the contrary, when facing demand shocks the inflation targeting regimes are particularly useful, and that is the scenario we are seeing today. To rein in inflation, it is necessary to slow down growth via a more contractionary monetary policy. However, if output slowdown is caused by forces outside the monetary policy, the policy rate dosage should be small compared with that where the external scenario does not contribute to the deceleration,  5  For details on the European case, see Berger and Stavrev (2008). In Chile, there is no evidence, either, indicating that monetary aggregates improve inflation forecasts. For discussions on money and monetary policy, see papers in Cuadernos de Economía’s December 2003 issue (De Gregorio, 2003; García and Valdés, 2003; Vergara, 2003). BIS Review 150/2008  3  meaning that monetary policy conduct is countercyclical, reducing inflation and containing the demand slowdown. Financial stability Although more often than not, central banks have an explicit financial stability objective, for many years, and within a context of strong GDP growth and sound balance sheets of banks and firms, this was a second-class issue.

As a matter of fact, whenever accelerated growth in credit and money aggregates occurs simultaneously with soaring asset prices and loose lending standards, increased inflation becomes very likely over the three years that follow (Roffia and Zaghini, 2007). 8 In this context, one can argue that an increase in lending with inflation prospects can be fought with a tightening of monetary policy. However, if the boom was triggered by lack of regulation or supervision, monetary policy tightening by itself could probably be ineffective – or even counterproductive – if the financial system is weakened because of excessive risk taking. Thus, financial regulation plays a major role in granting financial integrity. At the beginning, regulation focused on the strength of individual institutions. However, the tensions we are seeing now exemplify, once again, how individual fragility may quickly evolve into systemic problems. The interrelationships among financial institutions and the proper operation of the markets where liquidity is traded are essential ingredients of a market economy, but these characteristics are also the channels of financial contagion, as recently seen. So it is crucial to have a systemic vision, not only from the perspective of how the different institutions relate to each other, but also how the different types of financial and operating risks are intertwined, creating potential vulnerabilities. The Financial Stability Reports that many central banks put together periodically – including us – seek to evaluate the resiliency of the system as a whole to large disruptions, by carrying out stress tests.