higher assumed set of policy interest rates is associated with lower growth and lower than target inflation over the standard two - year horizon, but also with reduced risk of the really big fall in inflation and activity in year 4. graph 4 would we automatically select the first of these two possibilities purely on the basis that inflation is at target in two years'time? there would be a fair proportion of people who might select the second alternative, given the choice. of course, life is not quite as simple as the hypothetical choice i have concocted here. we don't know enough about the behaviour of asset prices, much less their linkages to the economy through the financial sector, to make such forecasts with any confidence. nor do we know much about how the dynamics might respond to monetary policy. so we cannot easily identify the optimal response to the situation. there would, as well, be significant communication issues associated with a policy which sought to reduce the risks associated with asset price developments, but which carried the side effect of slowing the economy. but despite the difficulties, it seems to me that thinking through the nature of risks posed by these asset price swings is helpful. policy should not rush to respond to every asset price movement that comes along. but a case might be made, on rare occasions, to adopt a policy of'least regret'so far as asset prices are concerned, if financial and macroeconomic stability were thought to be at risk. to do so would probably require an acceptance of a longer time horizon for inflation targets, and an acceptance of a bit more short - term deviation from the central point of the target. these issues remain unresolved among theorists and practitioners of monetary policy. there will be a good deal of further discussion about them in the period ahead. conclusion inflation targeting has been a successful model for monetary policy in australia. it has been associated with lower, less variable inflation, and better and less variable economic growth. while i would not claim that improved overall economic performance has been entirely due to the adoption of inflation targeting, i do claim that this approach to policy has made a significant contribution. for discussion of these issues in more detail, see claudio borio and philip lowe ( 2002 ),'asset prices, financial and monetary stability : exploring the nexus ', bis working paper no. 114, july – available at http : / / www. bis. org / publ / work114. htm. inflation targeting allows a considerable degree of short - term flexibility for

in that final phase of this asset price cycle, monetary policy will need to be easy. the question, however, is whether during the earlier phase it should be tighter than normal, in order to try to lessen the probability of a bust, at the expense of having somewhat lesser short - term growth and inflation lower than the announced target. put another way, should policy accept a mild short - term undershoot of the inflation target in order to lessen the likelihood of a much bigger undershoot in three or four years'time? here there is less agreement. some people argue that there is a strong case for this additional response, particularly on the grounds that if the costs of the bust are large it is worth paying some cost to avoid it if at all possible. others argue that a modest response of policy to the asset price problem would be ineffective in dampening the asset price dynamics, and that an aggressive response would bring on the problems that policymakers are setting out to avoid. in this view, policy should stick to its usual macroeconomic concerns, responding to any after - effects of the asset price cycle when they emerge. does inflation targeting allow scope for responding to asset price concerns, if that is thought to be sensible? i think it does, provided we are prepared to adopt a sufficiently long time horizon. inflation targeting is often presented, for expositional purposes, as a commitment to vary the instrument so as to keep the forecast inflation rate at the target at some particular horizon – two years, for example. but surely policymakers care, in principle at least, not just about the inflation rate two years from now, but the whole path of future prices. we care not only about where inflation will be two years from now, but where it might be heading at that time and how quickly. consider two hypothetical outlooks. in one, a given set of policy interest rates assumed for the forecast is associated with inflation in two years'time at the target, but also with an asset price boom and increasing leverage, which means that there is an uncomfortably high probability that, beyond the two - year horizon, perhaps in year 4, there will be a crash which could impair the financial system, take the economy into recession and reduce inflation well below the target. in the alternative outlook, a for example, lars svensson ( 1997 ),'inflation forecast targeting : implementing and monitoring inflation targets ', european economic review, 41 ( 6 ), pp. 1111 – 1146.