risk that could stem, for instance, from the potential “ domino effect ” if a participant fails to meet its settlement obligations. central banks are concerned also by financial stability from a monetary policy point of view. i would say that price stability can be regarded as the bedrock of financial stability, while financial stability is critical to the efficiency of monetary policy. let me elaborate further on these two points. first, why is price stability the backbone of financial stability? financial stability can be achieved on a sustainable basis if financial resources are not misallocated. past experience, as well as a large number of economic studies provide evidence that inflation brings about distortions in the allocation of resources. for instance, the calculation of returns is biased, due to the fact that the replacement cost of fixed assets is structurally underestimated. this may result in sub - optimal investment decisions, and over - optimistic credit risk assessment. conversely, in the case of deflation, the solvency of indebted companies may be jeopardized, as the value of cash flows decreases over time, while the face value of debt remains stable. second, why does financial stability matter for the efficiency of monetary policy? the efficiency of monetary policy relies on the effectiveness of the transmission channels of monetary policy. central banks have direct control over short - term interest rates only. the impact of monetary policy decisions on prices goes through various channels – acting directly on the anticipations of economic agents, influencing banking credit conditions, the exchange rate and other asset prices. uncertainty may arise when these channels do not act in a predictable way nor with relatively stable time lags. in this respect, financial instability may affect the transmission channels of monetary policy. for instance, large fluctuations in asset prices may modify the behaviour of agents by decreasing the level of confidence. such fluctuations can also expose bank portfolios to a higher risk of losses, inducing banks to compensate for these risks by restricting credit. let me stress that, although a price stability oriented monetary policy is conducive to financial stability over the long term, episodes of financial instability have been known to take place during periods of low inflation. price stability must be therefore regarded as a necessary but not sufficient condition. other parameters influence financial stability, among which financial integration is of particular interest from the point of view of a central bank in the euro area. 2. 2 the relationship between financial integration and financial stability is twofold : • first, the liquidity redistribution function has taken on a new dimension as participants

federal reserve confronts many challenges when trying to extract relevant information from financial market prices - not least because these prices reflect the market's interpretation of our outlook as well as its independent assessments. third, the market's disciplining of private entities is an important complement to the federal reserve's supervisory and regulatory functions, and the fed can enhance market discipline by improving the flow of information from these regulated entities to the markets. i will begin with a discussion of how markets, in my judgment, inform the monetary policy process, and then turn to the role of markets in the supervisory and regulatory process. financial markets and monetary policy markets affect monetary policy predominantly through the information provided by asset prices. the available menu of prices is extensive, including those of treasury securities ( nominal and real ), corporate debt, equities, and derivatives. these prices embed investors'expectations of the future paths of economic growth, inflation, and financial conditions. at least as important, these prices also can provide some insight into the uncertainty surrounding likely outcomes. monetary policy makers can use economic models and statistical techniques to extract the views of market participants about these key macroeconomic variables. nellie liang, wayne passmore, daniel covitz, and diana hancock, of the board's staff, contributed to these remarks. let me cite a few simple examples of how we interpret asset prices. through open market operations, the fomc sets the target federal funds rate, which is the overnight rate at which depositories lend to each other the balances they hold at the federal reserve. interest rates for periods extending beyond that very short horizon, however, are established by market participants rather than the fomc, although members of the committee may be able to influence these longer - term rates somewhat through what is affectionately described as " open mouth operations. " in this way, market - based interest rates reflect primarily the path investors expect for monetary policy. that expected path is of keen interest to us as policymakers. the market's view of very near term policy is reflected in futures contracts on federal funds. futures on eurodollars provide information on expectations for the period beyond the next six months or so. for longer time horizons, investors'views can be determined from yields on medium - and long - term treasury securities. this determination is based on two estimates incorporated in the yield on a nominal treasury security, such as the ten - year note. the first estimate is essentially a weighted average of the current one - year rate