5 it is a brave central banker who would deliberately induce a recession in order to head off the mere risk of a future financial correction. for instance, william white ( 2006 ), “ is price stability enough? ”, bank for international settlements working paper 205. alan greenspan ( 2002 ), “ opening remarks ” in rethinking stabilization policy, federal reserve bank of kansas. charles bean, matthias paustian, adrian penalver and tim taylor ( 2010 ), “ monetary policy after the fall ” in macroeconomic challenges : the decade ahead, federal reserve bank of kansas. bis central bankers ’ speeches that explains the interest in deploying additional policy instruments that are better suited to restraining the build - up of dangerous financial imbalances and contributing to the maintenance of financial stability – so - called macroprudential tools. with two targets – price and financial stability – one really wants another instrument, or set of instruments, to complement monetary policy. in the new arrangements established following the crisis, the deployment of such instruments falls to the bank ’ s financial policy committee. there are several potential macroprudential tools to deal with such cyclical risks, but they are of broadly two types : those that increase the resilience of the system ; and those that work pre - emptively against a build - up of leverage. in addition, measures may be targeted or more general in impact. to give some examples, first consider the basel iii counter - cyclical capital buffer, implemented in the european union under the capital requirements directive. by forcing banks to hold extra high - quality loss - absorbing capacity during a credit boom that can be released during a subsequent downturn, this primarily improves resilience. but because it raises the marginal cost of bank funds, the counter - cyclical capital buffer should also inhibit the build - up of leverage in the first place. there are several reasons why debt finance is cheaper than equity finance, including the implicit subsidy from being too big to fail, and the advantageous tax treatment of debt. moreover, debt pays the same return in all states of the world except when default takes place, while the return on equity will vary ; that makes debt more attractive for some investors, especially during financial booms when the probability of default appears low. raising the capital requirements on particular components of banks ’ balance sheets by varying sectoral risk weights is different in that it alters the relative attractiveness of different sorts of lending. assuming that the increase in capital requirements is

that cannot be avoided. indeed, such an adjustment was seen in response to the rise in energy prices in 2004 - 06. over that period, nominal wage growth was broadly stable, and there was a relatively smooth adjustment to real wages in response to the rise in energy prices. a key risk to the outlook is whether a similar, benign adjustment will occur in response to the latest price rises. with inflation having been above target for much of the past three years, and set to rise further in the near term, there is a risk that households and businesses may start to expect cpi inflation to be persistently above 2 %. if that happened, and those expectations were built into higher wages and prices, the benign adjustment would not be repeated. so we are closely monitoring developments in inflation expectations. unfortunately inflation expectations can ’ t be observed directly. but a number of measures, including household surveys and financial market instruments, can act as a guide ( chart 6 ). while all these measures have their drawbacks, most have risen – in some cases markedly – over the past year. it is unclear to what extent these measures contain information about the medium - term – the horizon over which the mpc aim to bring inflation back to target. and it is comforting that other measures – such as money spending remain stable and in line with the average rate of increase since 1997. and the committee ’ s commitment to ensuring inflation returns to the 2 % target should give those setting prices and wages some confidence that inflation will be close to target in the future. conclusion there is no doubt that the current climate is the most challenging the mpc has ever had to face. balancing the downside risk to demand associated with tighter credit conditions against the inflationary pressures emanating from the rest of the world is an enormous challenge. and the immediate prospect is for a deterioration in both output growth and inflation. monetary policy cannot prevent the economy being buffeted by developments in the wider world economy but the experience of the past 10 years has shown that the economy is now more flexible in responding to events. crucially we now have a credible framework for setting monetary policy to meet the inflation target in the medium term. monetary policy cannot prevent the short - run ups and downs of economic cycles. in the current climate, the committee believes that, if bank rate were set to bring inflation back to target too quickly, the result would be unnecessary volatility in output and employment. instead we are focused on returning cpi inflation to the 2 % target in