we work hard at fostering a close relationship, helped by the fact that i am a member of the fsa board and howard davies, who is giving the key - note address tomorrow, is a non - executive director of the bank. our respective roles and responsibilities, including in a crisis, are set out in a formal memorandum of understanding published in the autumn of 1997 between the treasury, bank of england, and fsa. the mou also established a tripartite standing committee that meets monthly to exchange information and discuss current threats to financial stability. i like to think that, with the departure of responsibility for day - to - day supervision of individual institutions, the bank has addressed the issue of systemic stability with a new - found clarity of purpose. that said, we know that there is a huge amount of work still to be done on understanding systemic risk. i see a clear contrast here with the monetary policy field. in monetary policy, we are closer to a general consensus about the policy framework and the objectives of monetary policy, even if at any moment of time uncertainty still surrounds our forecast for inflation and the appropriate policy response. certainly the uk target for monetary stability ( the 2. 5 % symmetrical inflation target ) is clear and transparent. in the field of systemic stability and financial crisis, however, our understanding is at a very preliminary stage. we face an array of fundamental questions : how to define systemic stability ; how to measure and predict it ; what policy weapons we should employ to achieve it ; what the costs are if we fail ; and how best to resolve instability if it occurs. we have only partial answers to these questions. defining the objective is possible only in the broadest sense, measuring how close we are to it is even more difficult ; there is certainly no agreed single indicator or set of indicators which tell us when we have achieved financial stability or when we risk failing to achieve it. importance of financial stability in part this is because we still lack evidence. this comment may strike some of you, perhaps those from scandinavia or japan, as ironic ; you may feel that the body of evidence we have is already disagreeably large. however, whilst banking crises are not exactly rare, they are episodic rather than regular and they tend to exhibit a number of idiosyncratic characteristics. this is in some sense reassuring – at least banks and the authorities do not keep making exactly the same mistakes – but at the same time it makes predicting crises very difficult. the causality is complex

output and employment. 10 specifically, to counter a contractionary demand shock, the monetary authorities need to reduce the short - run nominal interest rate ; however, the effectiveness of such a policy action may be hindered if long - run inflation expectations are not firmly anchored. for example, if the private sector becomes less certain about the longer - run inflation outlook, then an increase in the inflation risk premium could boost longer - term interest rates by more than the increase in expected inflation. the higher inflation risk premium would place upward pressure on the real costs of long - term financing for households and businesses ( whose debt contracts are almost always expressed in nominal terms ) and hence might partially offset the direct monetary stimulus. thus, a central bank commitment that firmly anchors long - run inflation expectations can make an important contribution to the effectiveness of the central bank ’ s actions aimed at stabilizing economic activity in the face of adverse demand shocks. third, a strong commitment to an explicit inflation objective provides the central bank with greater flexibility to respond decisively to adverse demand shocks. such a commitment helps ensure that an aggressive policy easing is not misinterpreted as signaling a shift in the central bank's inflation objective, and thereby minimizes the possibility that inflation expectations could move upward and lead to a rise in actual inflation. a strong nominal anchor can be especially valuable in periods of financial market stress ; at such times, prompt and decisive policy action may be required to prevent the financial market disruption from causing a severe contraction in economic activity that could further exacerbate uncertainty and financial market stress, leading to a further deterioration in macroeconomic activity, and so on. 11 thus, by providing the central bank with greater flexibility in mitigating the risk of such an adverse feedback loop, the strong commitment to an explicit inflation objective can play an important role in promoting financial stability as well as the stability of economic activity and inflation. fourth, a strong nominal anchor can help minimize the effects of an adverse cost shock, such as a persistent rise in the price of energy. generally speaking, such shocks tend to result in weaker economic activity as well as higher inflation. however, when longer - term inflation expectations are firmly anchored, an adverse cost shock is likely to have only transitory effects on actual inflation ; hence, there may be no need to raise interest rates aggressively to keep inflation from moving upward. thus, the commitment to a nominal anchor can help reduce output and employment fluctuations that impose unnecessary hardship on workers and, more broadly, the