than 2 % and seek to maintain that over the medium term. in practice, we have a preference for inflation lying within a range between around 1 and 2 %. this reflects potential measurement error in price indices as well as our desire to avoid deflation. having flagged our aversion to persistent deflation, let me turn to the substance of the question. my answer is clear – in the present situation i see no immediate risks of deflation in the euro area, albeit for the wrong reasons. service price inflation accounts for around 40 % of the hicp index and competition in this sector is rather low. in addition, the sizeable government sector has a role in price setting in many areas. both factors tend to put a floor under price increases. our wage and price setting mechanisms are simply not flexible enough to allow widespread or persistent deflation in the absence of a severe or prolonged recession. although formal wage indexation in europe is considerably lower than in earlier decades, we are not at the point where nominal wage cuts are likely to be broadly accepted. similarly, nominal price declines are also rather rare. deflationary risks generally arise from one or more of the following factors – the bursting of an asset price bubble, difficulties in the financial sector or ongoing losses by businesses. clearly these triggers are generally interconnected, and can reinforce each other. these interdependencies make deflation such a difficult problem and its impact widespread and corrosive. turning to a discussion of these triggers, a prolonged or severe recession is not what we are currently experiencing. in fact, we are in a situation where the relatively quick recovery we observed in early 2002 seems to have stalled. part of the reason why we continue to feel that we are in a difficult situation is that we had hoped that the recovery would be rapid. at the beginning of this year we expected that economic growth would be close to trend by the end of this year. in fact, growth will remain substantially below potential this year and the recovery is unlikely to gain much momentum until next year. i do not want to go into the reasons behind that now. my point is simply that the current downturn is not sufficiently severe to generate deflationary pressures. and as i will argue below, the same conclusion holds as regards the other possible triggers for deflation – asset price declines or financial sector fragility. overall, therefore, i am confident that europe will not experience a period of persistent deflation – and the associated problems that this

could cause. i can also assure you that we are aware of the risk. in particular, we are aware that it is difficult to put the deflation genie back in the bottle once it has come out. if signs of widespread problems emerge, we will act swiftly to counter them. an advantage of our measured monetary policy response to date is that we have plenty of policy room available to react if necessary. is there a risk to financial stability closely related to the question of deflation is the issue of financial stability. a period of deflation could be caused by, or contribute to, financial stability problems as real debt burdens rise and borrowers struggle to service their debt commitments. again, i expect that you know more about this than i do. however, let me give you my interpretation of recent developments in europe and their implications for financial stability. asset price declines one concern has been that recent stock price declines could trigger financial instability by weakening balance sheets across the economy. clearly there has been a significant adjustment in stock prices around the world over the past year or so. europe has also been affected. european stock prices are now back around the levels seen in 1998 and have fallen by around 30 % since the beginning of this year. nevertheless, to put this fall in perspective, stock prices remain well above 1996 levels, which was when chairman greenspan made his comments on irrational exuberance. this holds true even when you adjust for inflation. regardless of whether or not stock prices are too high, a decline of the magnitude we have seen is bound to have some impact on the macroeconomy. at the dutch central bank we have estimated that a sustained decline of 30 % would have a cumulative negative impact of just over ½ % on european growth over three years. our model implies that there will be an insignificant impact on prices. however, these estimates are for the direct influence of lower stock prices only and abstract from confidence effects. as an aside, it is interesting to note that the wealth effects from changing share prices are considerably stronger in the united states. for example, a fall of 30 % in us share prices results in a cumulative negative impact of over 3½ percent of gdp over the same three year period. there would also be a negative impact on consumer prices of a little over ½ % over three years. the different impacts stem largely from the lower extent of share ownership in europe than in the us. although direct share ownership is gradually spreading in europe, it remains considerably less widespread than in the