markets. ” review of finance 13, 181 – 223. the giovannini group, second report on eu clearing and settlement arrangements, april 2003. bis central bankers ’ speeches convergence process is not again disrupted by the financial cycle? one would hope that a better supervised and more diversified financial system will have a smoothing effect on the financial cycle. yet, some academics argue that such is the force of the financial cycle that it is unavoidable that monetary policy will also have to play a central role in “ leaning against the wind ”. in the euro area, however, the situation is not quite so clear cut. the ecb ’ s two - pillar strategy does make financial imbalances an important element of our policy assessment, even when inflation is low. specifically, the monetary pillar captures the connection between excess credit and liquidity creation and potential risks to future price developments, including disruptive asset price booms. and our medium - term orientation grants us a sufficiently long policy horizon to account for the financial imbalances in our strategy. in this way, it implicitly incorporates elements of a “ leaning against the wind ” approach. to quote the ecb monthly bulletin from april 2005 : “ [ our ] approach amounts to a cautious policy of ‘ leaning against the wind ’ of an incipient bubble. the central bank would adopt a somewhat tighter policy stance in the face of an inflating asset market than it would otherwise allow if confronted with a similar macroeconomic outlook under more normal market conditions. it would thus possibly tolerate a certain deviation from its price stability objective in the shorter term in exchange for enhanced prospects of preserving price and economic stability in the future. ” 23, 24 yet, were evidence of financial imbalances to reappear, we would have to reflect carefully on whether standard monetary policy would be the right tool to use in response. this is for two reasons. first, there is some uncertainty as to what interest rate path would be required to prick an emerging credit bubble. some studies find that in a leverage - driven boom profits are very sensitive to even small interest rate changes, implying monetary policy could provide a powerful offset. 25 however, other evidence suggests that quite large interest rates movements would be needed to offset the financial cycle, which would in turn create collateral damage for the economy and price stability. 26 second, there is still heterogeneity between the financial cycles of individual countries within the euro area. while it is true that aggregate euro area money and credit growth

could have led firms ’ and households to bring forward future consumption and investment into the present, based on an overestimation of their lifetime income. one way such misperceptions can arise is if a prolonged credit - driven economic expansion weakens supply constraints and raises estimates of potential output, making growth appear more structural in nature. in spain, for example, the boom in the construction sector raised both domestic participation rates and immigration levels. the european commission ’ s latest estimates of potential growth rates are in the range of 3. 2 % and 4 % for the period 2000 – 2007, driven mainly by the increasing labour contribution ( adding around 2 percentage points on average per year ). since 2008, however, the labour contribution has been the largest drag on potential growth, for example, subtracting more than 2 percentage points from the 2013 estimate. a final explanation is that observers mistook the significance of inflation differentials within the euro area. excess domestic demand combined with low productivity growth should be reflected in rising prices, and domestic measures of price and wage inflation in the catchingup economies were indeed running considerably higher than the euro area average on a cumulative basis. average annual inflation differentials in the 2002 to 2008 period were in the range of 0. 5 to 1. 5 percentage points. however, these developments were not considered especially alarming by some observers as they were interpreted as reinforcing the theory of balassa - samuelson equalisation. some also saw inflation differentials as being more reflective of low inflation in germany as it went through a phase of wage adjustment. overall, this may have led to less concern about the lack of real convergence in productivity levels than was warranted. european commission, “ emu @ 10 : successes and challenges after ten years of economic and monetary union ”, european economy 2, 2008. see for example minsky, h ( 1982 ), “ can ‘ it ’ happen again? ”, essays on instability and finance. drehmann et al ( 2012 ), “ characterising the financial cycle : don ’ t lose sight of the medium term! ”, bis working papers no 380, june 2012. for a detailed explanation see borio et al ( 2013 ), “ rethinking potential output : embedding information about the financial cycle ”, bis working papers no 404, february 2013. bis central bankers ’ speeches achieving sustainable convergence it was only when the financial cycle turned that the unsustainability of economic convergence became apparent. the majority