Not only has an unusually wide divergence in cyclical positions opened up that creates immediate strains, but there are also important structural imbalances that have developed that must be addressed. I will close by turning my attention to what can be done to address these cyclical and secular challenges. Although I will discuss the role of U.S. monetary policy in this context, I will also discuss what other steps can be taken to strengthen the relationship and make it more sustainable. As always, what I have to say reflects my own views and not necessarily those of the Federal Open Market Committee or the Federal Reserve System. Over the past few decades, the most salient feature of the global economy has been the growing importance of the emerging market economies and the ever-deepening integration of these economies into the global economic system. A shift toward more market-based and outwardly oriented development on the part of the EMEs has enabled hundreds of millions of people across the emerging world to become integrated into the global economy for the first time. The outcome has been a rapid rise in living standards and a reduction in poverty on a scale that is without precedent in human history. These changes have been most evident in China, with a historic transformation that began with the economic reforms of Deng Xiaoping and continues to this day. But the EME story is much broader than China.
The chart illustrates the best possible combinations of variation in inflation and output that can be 1 achieved in the economy. The three points on the chart refer to different forms of inflation targeting. It would probably be possible, with an aggressive use of instruments, to force inflation back to the target within a time-frame of only a few quarters. This is often called strict inflation targeting. Monetary policy has the most rapid effect through the exchange rate channel. Strict inflation targeting will therefore often involve a relatively substantial appreciation of the exchange rate so that inflation can be brought down through a fall in imported inflation. Monetary policy should not cause unreasonably wide fluctuations in the real economy. We therefore apply a two-year horizon to achieve the inflation target. In practice, we allow inflation to vary in the very short term. 1  I refer to a more detailed discussion in a lecture entitled “Monetary policy, cyclical fluctuations and competitiveness”, given by Deputy Governor Jarle Bergo at a conference hosted by the Norwegian Association of Economists in Oslo, 5 September 2002. BIS Review 2/2003  3  Another possibility would be to place weight solely on minimising variation in output or unemployment. This kind of policy does not improve the growth potential in the economy, but smooths fluctuations. Furthermore, this would generate very large variations in inflation as the economy would then be without a nominal anchor.