why are expectations so important for monetary policy? but the first question is : why are expectations so important to monetary policy? economic outcomes are the result of people ’ s collective decisions and these decisions depend on how people think and what they expect the future to bring. for example, a decision to buy a house will depend on expectations of future income, what interest rates might be, and whether one thinks the real estate will increase or decrease in value. the price a firm sets and the wages it negotiates with employees are influenced by its expectations about the rate of inflation in the coming quarters. the future is inherently uncertain. firms, individuals, families and policy - makers – all of us – form best guesses, or expectations, regarding events we are uncertain about. bis central bankers ’ speeches this means that current economic outcomes are determined by what people think the future will be, not necessarily by what the future will actually be. people will be right or wrong about the future, but what matters to their decision today is their perception of it. this perception can be fast changing, as recent developments in financial markets have once again made clear. a reassessment of the global economic outlook and a heightened degree of uncertainty contributed to the significant fall in equity prices and increase in overall market volatility of the past few weeks. but keynes coined the term “ animal spirits ” to describe the emotional, non - purely logical state that influences our decision - making. 1 with the unusual sequence of large drops and rebounds in capital markets in recent weeks, 2 it is difficult to argue that fear and animal spirits were not also at play. obviously, given that expectations determine the evolution of the economy, they matter for monetary policy. but it works both ways. monetary policy also influences expectations. in fact, expectations management – or the expectations channel – is a powerful tool through which monetary policy can influence and stabilize the economy. what people think future policy will be influences their decisions and can have an important impact today. through the adjustment of expectations, the monetary authority has the opportunity to better offset fluctuations in the level of output or inflation. this expectations channel of monetary policy has always been at work, but as its existence has become better appreciated, its influence might have become greater as well. 3 we can see a clear illustration of its importance in the conditional commitment the bank of canada used during the financial crisis – one of three types of potential unconventional monetary policy tools at its disposal. 4 in april 2009, the bank stated that it

) tripled in the three years to 2007, and credit default swaps grew sixfold. following the sudden reappraisal of the creditworthiness of these instruments, assetbacked commercial paper ( abcp ) markets froze, sivs failed, and money market funds experienced runs. the feedback to the regulated sector was immediate and devastating. money market mutual funds pulled short - term funding from the banking sector. other core financial markets, such as repo and over - the - counter derivatives markets, seized up. virtually all american investment banks and many commercial banks could not roll over their funding positions. during this time, the canadian non - bank abcp sector – a classic shadow banking activity – also collapsed. 7 only the herculean efforts of the public and private sector through the montreal accord could resolve this debacle. we should all hope that the lessons of these sorry episodes remain fresh in the minds of investors, banks and regulators for some time. however, experience suggests it would be foolish to rely on memory alone. that is why the fsb and g - 20 are acting. our core objective is to address bank - like risks to financial stability that emerge outside the regular banking system. at the same time, we want to preserve sustainable non - bank financing models that do not pose such risks but provide needed competition to banks and credit to the real economy. as a result, the fsb ’ s approach, outlined this week in mexico, is proportionate to financial stability risks and starts with those activities that were sources of problems during the crisis. it also provides a process for monitoring the shadow banking system so that any rapidly growing new activities that pose bank - like risks can be identified early and, where needed, addressed. these vehicles were part of a complex chain that transformed short - term investments in commercial paper into long - term loans. as confidence that this paper could be rolled over faltered, there was indiscriminate selling of structured assets. bis central bankers ’ speeches there are five work streams to address vulnerabilities. they seek to : • mitigate the spillovers between the regular and the shadow banking systems ; • reduce the susceptibility of money market funds to runs ; • mitigate systemic risks posed by other shadow banking entities ; • align the incentives in the securitisation process to prevent excessive leverage in the financial system ; and • dampen risks and procyclical incentives associated with secured financing contracts such as repos and securities lending.