Any shock could lead banks to fail through a domino effect. The superstructure of complex transactions within the financial sector (in derivatives for example) greatly increased this interconnectedness. The time-series aspect is the pro-cyclical behaviour of risk-taking in the financial system that I described earlier. Optimism feeds on itself until the occasional setback changes the mood to one of pessimism. And individuals are reluctant to accept that success may not be the  BIS Review 32/2009  3  result of superior wisdom, which should naturally be reflected in compensation, but the shortrun outcome of a risky strategy. To deal with the “cross-section” problems we need to reduce the exposure of the system to domino effects. For some, especially over-the-counter, markets this could be achieved by increasing the role of central counterparty clearing houses. Much good work on this is going on, led by the Federal Reserve Bank of New York. But a clearing house should not be an excuse for allowing flawed financial instruments, such as many of the mortgage-backed securities, to be treated as high quality assets. We also need to improve the regulation of the liquidity of banks. After the crisis began, the most striking feature of the regulatory system, as embodied in the Basel arrangements and implemented in the UK, was the absence of any effective regulation of liquidity. The FSA is acting to remedy the situation, and the Bank is in active discussion with FSA about how such regulation should best be implemented.
The period during which inflation undershot the target thereby became gradually more prolonged. In mid-2014, inflation had been continuously below target since 2010, and periodically quite far below (see Figure 1). Once inflation had undershot the target for a while, inflation expectations also began to fall, including long-term expectations. Thus, economic agents did not expect inflation to meet the target even five years ahead (see Figure 2). In wage formation as well, there were signs that the inflation target was beginning to be of less significance. In other words, a risk began to build up that the role of the inflation target as benchmark for price-setting and wage formation would begin to weaken – that the nominal anchor that has been an important part of the favourable developments in Sweden since the early-1990s crisis would begin to slip. As the basic premise of inflation targeting policy is to anchor long-term inflation expectations at the target, this development made it urgent to bring inflation back up towards 2 per cent fairly rapidly. It was therefore clear that the Riksbank needed to focus entirely on the task of maintaining confidence in the inflation target. Consequently, there was no longer any scope for conducting a policy that “leans against the wind”. As a result, the Riksbank cut the policy rate quite rapidly down to –0.50 per cent and also began to purchase substantial volumes of government bonds, particularly in relation to the size of the sovereign debt.