BIS Review 81/2009  3  movements in various measures of economic slack have played a fairly modest role in the inflation process in the euro area in recent years. 6 The same Phillips curve analysis suggests that changes in inflation expectations play a major role in shaping inflation developments, anchoring inflation and potentially mitigating the harmful outcomes resulting from temporary shocks. In such a setting, expectations pin down the level of inflation in the long run, while changes in the output gap lead to short-run accelerations or decelerations of inflation around that level. There are many caveats to using a Phillips curve framework to relate inflation developments to economic slack – for instance, measures of both inflation expectations and the output gap are subject to considerable uncertainty, non-linearities may arise, and the relationship may change over time. Moreover, the actual impact of slowing real economic activity on inflation depends crucially on the nature of the economic downturn, the types of shock hitting the economy, their magnitude and duration. Wage and price rigidities may also contribute to help to moderate inflationary responses to changing economic conditions in the short run. Overall, the current weakness in real economic activity would be expected to dampen inflationary pressures in the euro area but not to lead to outright deflation. The approach underscores that while economic slack may contribute to movements of inflation in the short run, well-anchored inflation expectations are a crucial determinant in the inflation process. 2.

In contrast to developments in M3, the growth rate of the narrow monetary aggregate M1 has – after a trough in the third quarter of 2008 – started to rise again, and reached 5.3% in the first quarter of 2009. While M1 developments usually prove inferior to M3 developments in terms of their information content about future inflation, in the case of the euro area they have traditionally exhibited good leading indicator properties for future real GDP growth. Taken per se, such a development would also speak against a deflationary scenario and might offer valuable insights into the timing of the recovery. To conclude, monetary indicators provide important information to try understanding the likelihood of different scenarios ahead. In this respect, the real-time problem which is always prevalent in monetary analysis – but also in other types of analysis – becomes more serious in a financial crisis. 4. Short and long term policy responses to the crisis  There are inevitable challenges associated with policy actions in times of crisis. Central banks around the world have embarked on untested areas of monetary policy-making. Expansionary fiscal policies and government interventions to stabilise the financial sector are expected to dramatically increase public debt. This could pose a severe threat to the sustainability of public finances and eventually to macroeconomic stability. To preserve macroeconomic stability over the medium term, there is a need for careful monitoring of the policy stimulus over the policy-relevant horizon, combined with well-designed exit strategies from non-standard policy-making.