to assume that inflation will during certain periods deviate from the target and sometimes deviate substantially. the important thing in the long term is not the temporary fluctuations in inflation, but that expectations are anchored around the inflation target. the inflation target can then fulfil its important function as nominal target when prices and wages are set and investment decisions are made. and in this respect we appear to have succeeded well ( figure 7 ). let me in this context also briefly mention how we make our forecasts. previously we made forecasts on the basis that the repo rate - our policy rate - would remain constant during the forecast period. if inflation was expected to be lower than two per cent, this was a signal that the interest rate needed to be cut, and if it was expected to be higher, the rate needed to be raised. however, the assumption that the repo rate would remain entirely unchanged over a long period of time is fairly unrealistic. many times – for instance when everyone is expecting a long period of interest rate increases or interest rate cuts – this assumption of a constant repo rate makes it difficult for us to make reasonable forecasts. now our forecasts are instead based on an assumption that the repo rate will develop in line with market expectations. our current forecast assumes, for instance, that there will be gradual increases in the repo rate over the coming period. this new assumption does not in itself have any significance for the policy conducted. however, it makes it easier to evaluate our forecasts as they become more realistic and it is easier to compare them with others ’ forecasts. it is also important to know this assessment to understand our communication. if the forecast shows inflation as being lower than two per cent a couple of years ahead, this is no longer a reason to cut the repo rate. it may instead mean that there is reason to raise the interest rate at a slightly slower pace than the market is expecting. a further step in our method of making forecasts could be to make our own forecasts for interest rates, instead of using market expectations as a basis. this would require a number of changes in working methods, both for those making forecasts and for us executive board members. personally, i think this would be a natural progression and it is a possibility we are considering. it is not only the inflation forecasts we examine when formulating monetary policy and considering how to set the interest rate in future. our policy is flexible in the sense that we

and o. tristani ( 2010 ), “ lessons for monetary policy strategy from the recent past, ” paper presented at the 6th ecb central banking conference, frankfurt am main, 18 – 19 november 2010. bis central bankers ’ speeches shifted attention to credit and leverage as critical parameters that a central bank should consult regularly to measure the pulse of the economy. 11 the ecb consistently used these parameters even when they were derided as relics of a defunct monetary doctrine. they proved useful. they gave information about financing conditions and the financial structure, as well as about the condition and behaviour of banks, when these sources of information were critical to the assessment of the health of the transmission mechanism and, more broadly, the state of the business cycle. and this dimension of monetary analysis has proved particularly valuable in shaping the ecb ’ s response to the financial crisis. there is indeed evidence for the euro area that without duly taking the monetary analysis into account, inflation in the euro area would have been distinctly higher at times of financial exuberance and would have fallen deep into negative territory in the wake of the financial market collapse, starting in the autumn of 2008. the economy as a whole would have been more volatile. 12 on a more general note, by including monetary analysis in their monetary strategy, central banks can ensure that important information stemming from money and credit, typically neglected in conventional cyclical forecasting models of the economy, is considered in the formulation of monetary policy decisions. there is compelling empirical evidence showing that at low frequencies, that is over medium to longer - term horizons, inflation shows a robust positive association with monetary growth. 13 5. complementarity between price stability and financial stability the fifth lesson from the financial crisis is that ensuring price stability is not sufficient for financial stability. to be sure, the conventional wisdom prevailing before the crisis was twofold. first, stabilising inflation would do the job. as inflation is – according to the pre - crisis consensus – a summary statistic for the state of the economy, for demand pressures, then any exuberance in financial markets would not be policy - relevant unless it exerts upward pressures on inflation. second, and partly as a consequence, central banks should only pick up the pieces after the bubble has burst, and the costs of doing this relative to a policy of resisting the bubble while it is forming would not be large. both these prescriptions have turned out to be major mistakes. for one thing, inflation and financial exuberance are