short - term adjustments to strong recessionary forces and long - term macroeconomic stability. a key challenge is how to calibrate the policy response in the face of these forces : too timid a reaction may be costly in the near term, but an overreaction may sow the seeds of the next crisis. i will argue that a policy action that aims to ensure macroeconomic stability in the medium term requires a i would like to thank lorenzo cappiello, gianluigi ferrucci, dieter gerdesmeier, matthieu darracq paeries, juan angel garcia, jacob ejsing for their contributions. the opinions reflect only those of the author. in the united states, the debate is well captured by the two editorials that appeared in the new york times on 4 may 2009 : one by paul krugman arguing that japan - style deflation loomed ; and the other by allan meltzer fearing a return of 1970s inflation : http : / / www. nytimes. com / 2009 / 05 / 04 / opinion /. see also the economist of 9 may 2009, page 15. the risk of global deflation has been pointed out in several articles by nouriel roubini ( www. rgemonitor. com ). inflation risks in europe and globally were flagged by german chancellor angela merkel in a speech in berlin on 2 june 2009 ( http : / / www. bundesregierung. de / nn _ 1498 / content / de / rede / 2009 / 06 / 2009 - 06 - 02 - merkel - insm. html ). thorough examination of the risks, in much the same way as a disease calls for a sound diagnosis if it is to be properly treated. i will start the discussion by explaining how deflationary risks should be monitored and assessed by central banks, in particular with respect to the current situation. i will then turn to inflation expectations, over the short and medium term, to assess in particular how well they are anchored to the objective of price stability. then i will consider how monetary and credit aggregates can be of use in the current conditions to assess the balance of risks. i will conclude with the monetary policy actions required to ensure price stability in an environment subject to downward and upward pressures to price stability. 1. short - term deflation risks to discuss deflation risks in the euro area, it is useful to begin with a definition. deflation is a

lorenzo bini smaghi : inflation and deflation risks – how to recognise them? how to avoid them? speech by mr lorenzo bini smaghi, member of the executive board of the european central bank, at xxi villa mondragone international economic seminar “ global crisis and long term growth : a new capitalism ahead? ”, tor vergata economic foundation and ceis – centre for economic and international studies, university of rome, rome, 24 june 2009. * * * introduction 1 let me begin by thanking the organisers for inviting me to this conference in villa mondragone. it ’ s a honour to give the “ riccardo faini lecture ”. riccardo was not only a great colleague, at the imf and at the italian treasury, but also a friend. the international economy is going through one of the worst recessions in generations. demand and output have fallen sharply and synchronously in many developed and developing economies. unemployment has drifted up. global trade has shrunk for the first time in almost three decades, leading some to talk about incipient ‘ de - globalisation ’. spare capacity has grown, dampening inflationary pressures – in central bank speak, downside risks to price developments have emerged – and fears of a sustained period of deflation are spreading. on the other hand, unprecedented recessionary forces have elicited an unprecedented policy response. monetary policy has been swiftly loosened, both with conventional and unconventional tools. governments have embraced aggressive fiscal expansions. the speedy reactions have surprised many observers, leading some to argue that inflation, not deflation, is the spectre that we have to fear over the next few years. the worry is that abundant liquidity combined with high fiscal deficits may trigger inflation once a recovery is underway, if policy - makers are unable or unwilling to reverse the policy stimulus on time. the debate between those who consider that inflation represents the main risk for advanced economies over the next few years and those who instead believe that deflation is the most immediate threat, has polarised, especially in the united states. it has also had an interesting echo here in europe. 2 both concerns are legitimate. to some extent, the fact that informed observers can maintain both views simultaneously can be seen as a sign that monetary policy is managing to walk the fine line between the two risks. the debate neatly encapsulates the trade - off currently facing policy - makers. they have to choose between