speculation in the first episode or on house price increases in the second. and larger adjustments would incur greater incremental costs. as a consequence, using monetary policy to damp asset price movements could lead to more variability in output and inflation around their objectives, at least in the medium term. among other things, greater variability in inflation could lead inflation expectations to become less well anchored, diminishing the ability of the central bank to counter economic fluctuations. we simply do not have good theories or empirical evidence to guide policymakers in using short - term interest rates to limit financial speculation. given our current state of knowledge, my preference at this time would be to use regulation and supervision to strengthen the financial system and lean against developing problems. monetary policy would be used only if imbalances were building and regulatory policies either were unavailable or had proven ineffective. the homework assignment is to improve our ability to identify incipient financial imbalances and understand their interactions with changes in policy interest rates. a related issue, which i ’ ll assign for extra credit, is critical for the conduct of policy in the future. some observers have attributed the bubbles observed in some asset prices in recent years to a decades - long downward trend in real interest rates. in this view, the decline in interest rates has caused investors to reach for yield by purchasing riskier assets with higher returns, driving the prices on riskier assets above fundamental values. many critics of central banks ascribe the drop in real rates to monetary policy decisions that kept rates unusually low, on average, over the business cycle from my perspective, the decisions the central banks were making about their policy rates were shaped by the underlying determinants of the balance of saving and investment, including, in the past decade or so, the high saving propensities of the newly emerging asian economies and the sluggish rebound in investment globally after the recession early last decade. nonetheless, it is important that we understand the reasons for the decline in average real rates and whether low rates are likely to persist – and that very tough problem is the extra credit assignment. for one thing, as the economic expansion gains traction and central banks back off the current highly accommodative stance of policy, policymakers will need to understand how the longer - term trend in real rates has influenced the point at which the policy rate becomes restrictive. for another, if rates are going to continue to be low by historical standards, regulators will need to be especially alert to any signs that a

reach for yield by investors is contributing to excessive risk - taking. inflation objectives the final homework assignment concerns the inflation objectives of central banks. central banks have widely chosen to target inflation rates near 2 percent. the federal reserve is required by law to conduct monetary policy to achieve maximum employment and stable prices. we haven ’ t announced an explicit inflation rate target consistent with that dual mandate, but the federal reserve governors and reserve bank presidents publish our individual forecasts for inflation over the longer run, conditional on our individual views of appropriate monetary policy. those forecasts indicate that most of the fomc participants believe that inflation should converge to 1 – 3 / 4 to 2 percent over time. recently, some prominent economists have called for central banks to raise their inflation targets to about 4 percent. shifting inflation targets up would tend to raise the average level of nominal interest rates and thus give central banks more room to lower interest rates in response to a bad shock to the economy before running against the zero bound. although i agree that hitting the zero bound presents challenges to monetary policy, i do not believe central banks should raise their inflation targets. central banks around the world have been working for 30 years to get inflation down to levels where it can largely be ignored by businesses and households when making decisions about the future. moreover, inflation expectations are well anchored at those low levels. increasing our inflation targets could result in more - variable inflation and worse economic outcomes over time. first of all, inflation expectations would necessarily have to become unanchored as inflation moved up. i doubt households and businesses would immediately adjust their expectations up to the new targets and that expectations would then be well anchored at the new higher levels. instead, i fear there could be a long learning process, just as there was as inflation trended down over recent decades. second, 4 percent inflation may be higher than can be ignored, and businesses and households may take inflation more into account when writing contracts and making investments, increasing the odds that otherwise transitory inflation would become more persistent. for both these reasons, raising the longer - term objective for inflation could make expectations more sensitive to recent realized inflation, to central bank actions, and to other economic conditions. that greater sensitivity would reduce the ability of central banks to buffer the economy from bad shocks. it could also lead to more - volatile inflation over the longer run and therefore higher inflation risk premiums in nominal interest rates. it is notable that while the economic arguments for raising inflation targets are well understood, no major central bank