toshihiko fukui : inflation dynamics and monetary policy summary of a speech by mr toshihiko fukui, governor of the bank of japan, at the international conference on inflation dynamics, hosted by hitotsubashi university, tokyo, 28 june 2007. * * * it is my great pleasure to be invited to speak before such distinguished economists from both japan and overseas. the theme of this conference, " inflation dynamics, " is, without any question, one that cannot be ignored by any central banker pursuing the most desirable monetary policy. presumably it is the interest in a central banker's perspective on this key topic that explains why i have been given the privilege of speaking to you today. accordingly, i would like to take this opportunity to give my thoughts on the subject. the issue of inflation dynamics has been studied for a long time, yet remains as relevant today as ever. the year i joined the bank of japan, 1958, was the year when the seminal paper by professor alban w. phillips was published. half a century on, the basic idea behind the phillips curve has been considerably extended, and many related theories have evolved in connection with the role of expectations, the mechanisms that bring about price rigidity, and so forth. for monetary policy to achieve its objective of price stability, it is extremely important to accurately understand the dynamics of inflation. these dynamics, however, may change along with changes in the economic structure, and it is often difficult to detect such changes in a timely manner. this often becomes a source of anxiety to central bankers conducting monetary policy in the real world. in recent years, especially, the biggest challenge facing central bankers may be the conduct of monetary policy in the face of the flattening of the phillips curve and increase in uncertainty with regard to inflation dynamics. with a flatter phillips curve and given a situation where the inflation rate is within the desirable range, small economic fluctuations will not cause the inflation rate to shift outside the range. on the other hand, a flatter phillips curve means that, once inflation shifts outside the range, bringing it back is that much harder, since the output gap or the change in the output gap necessary to raise or lower the inflation rate becomes correspondingly larger. for example, in the united states, governor mishkin of the federal reserve board, in his speech delivered in april, stated that " returning inflation too quickly to levels consistent with price stability might unnecessarily exacerbate the economic weakness

$ 100 000 each would be created and sold to a cash - flush investor such as a pension fund for us $ 500 million. this is nothing new – mortgage advances have been securitised on a substantial scale for many decades. incidentally, the borrower would usually not even know that his or her mortgage loan had been securitised – the borrowers continue to send their instalments to the institution or “ mortgage originator ” which initially extended the loan. but the mortgage originator now simply passes on the instalments received to a company created to handle the pool of securitised mortgages, a “ special purpose vehicle ”, from where it is redistributed to the ultimate owner of the securitised mortgages – the pension fund in this example. numerous “ structured financial products ” were developed around the securitised mortgages. for instance, a batch of risky or sub - prime mortgage advances could be lumped together and sold off as a separate “ tranche ” which would pay a higher rate of interest than a batch of standard mortgages. furthermore, some institutions provided guarantees or partial guarantees to enhance the risk - return characteristics of some of these products. and all remained well as long as the property boom continued. loans could be extended quickly and repackaged and securitised speedily. the us housing market eventually ran out of steam around 2006 as supply started to outstrip demand, reinforced by tighter interest rates. this set in motion a chain of events in which subprime borrowers increasingly fell behind on their commitments and certain types of securitised assets and structured products started to show their true colour. as these assets stopped performing ( or, at best, paid significantly less than previously projected ) investor appetite for structured products and securitised assets diminished rapidly. this interrupted the process in which original lenders ( mortgage originators ) could so comfortably extend a loan and sell it off to somebody else to carry the credit risk. liquidity in that market evaporated rather quickly, its previously smooth - running machinery grinding to a halt. more fundamentally, investors and borrowers as well as all those institutions in between discovered that the risk premia which they had priced into a range of financial assets were grossly inadequate. this inadequacy extended beyond sub - prime mortgages, and beyond the usa only : numerous types of securities and derivatives were involved. during the credit boom, investors had struggled to understand