overall index. we look at these over different time horizons. we look at a variety of other measures that use different statistical techniques to strip out the more volatile parts of the index. these all have limitations, and their relative merits may change over time. central banks approach this challenge of capturing underlying inflation differently, but ultimately we are all judged by what happens to overall inflation over time. these issues are common to central banks everywhere. but economic and financial integration has brought particular challenges for monetary policy makers in emerging market economies. the broad pattern of exchange rate and monetary policy regimes in emerging market economies has shifted dramatically over the past decade. most now operate a more flexible exchange rate regime, though a significant number have moved to the opposite extreme, relinquishing monetary sovereignty in favor of full monetary integration. it is true that fewer countries now operate with the fixed but adjustable exchange rate pegs - the middle ground that characterized much of the emerging world up to the crises of the late 1990s. but many still make monetary policy subject to the overriding objective of limiting the variability in the exchange rate against their major trading partners. viewed through this lens, it becomes apparent that the dramatic rise in the level of official reserves in much of the emerging world is not simply the consequence of a desire for a greater financial cushion against external vulnerability. it also results from the lingering aversion to letting exchange rates adjust upwards in response to market forces. as capital markets become more open, this middle ground is harder to sustain. the broadening recognition of this is leading to a gradual increase in exchange rate flexibility, and this process is likely to continue. the pace of progress, progress in the direction of more openness to capital flows and greater exchange rate flexibility, will depend in part on the pace at which these governments are able to strengthen the resilience of the domestic financial system and set in place the broader institutional framework and supervisory regime that are vital for an open economy. for those countries that are less far along in this transition, policy still reveals a substantial degree of ambivalence about the benefits of integration ; and doubts about their ability to limit the risks in greater exposure to volatility. for most, though, this is not a question of whether to integrate, but of how to do so. and the success of this process will depend in part on the ability of central banks to conduct monetary policy in a manner consistent with achieving low inflation. this constellation of exchange rate and monetary policy regimes among emerging market economies,

including the major oil exporters, has broader consequences for the world economy as a whole. insufficiently flexible exchange rate regimes have the potential to alter the pattern of capital flows and the price of financial assets. so do the increase in the mobility of saving and investment ; the increase in the desired exposure to foreign assets ( the reduction in home bias ) ; the financial market innovation that allows for better diversification and risk sharing ; and the differentials in the pace of technology adoption or workplace practices that give rise to varying productivity trends across countries. these all contribute to the patterns of capital flows and imbalances that we observe in the world today, and it is very hard to disentangle their effects from those of exchange rate and monetary policy arrangements. that some of the forces governing capital flows and asset values are driven not by market - determined expected return but by policy measures directed at, for example, an exchange rate objective means that at least some of what we observe in global capital markets may be attributed to these distortions. the fact that official purchases of financial assets are determined by different factors than those influencing private investors suggests that we would probably see a somewhat different combination of capital flows, exchange rates and interest rates in the absence of official intervention. to the extent that the factors affecting capital flows act to raise asset prices, lower interest rates and reduce risk premiums, it is harder for the markets to assess how much of the currently very favorable conditions are likely to reflect fundamentals and prove more durable. if the prevailing patterns of capital flows were to exert downward pressure on interest rates and upward pressure on other asset prices, they would contribute to more expansionary financial conditions than would otherwise be the case. among other things, this outcome complicates our ability to assess the present stance of monetary policy. it can change how monetary policy affects overall financial conditions and the economy as a whole. such complications can mask the effect of other forces that might otherwise find expression in risk premiums or interest rates : forces, for example, associated with the concern about fiscal sustainability in the united states or the sustainability of our external imbalances. moreover, the policies that have played an important role in this pattern of global capital flows are already in the process of evolution, thus adding still further to the considerable degree of uncertainty we face about the longer - term outlook for the economy. in today ’ s rapidly evolving global economy, monetary policy makers cannot ignore the international dimension. as economies become more open, external developments inevitably affect