But the underlying message of these models remains: a policy aimed at stabilising inflation and the output gap at a horizon around two years ahead is both desirable on welfare grounds and consistent with price stability over the medium term. Given our experience over the past few years, these strong conclusions are now rightly treated with scepticism. With the benefit of hindsight, it is apparent they served to breed complacency among both policy-makers and market participants, resulting in overconfidence in the ability of macro policies to stabilise the economy. Such complacency contributed to both poor policy choices and destabilising private sector behaviour. Such decisions may help to explain the emergence of financial crises in recent years. Critiques of the benchmark New Keynesian model are legion. 13 I will not repeat them here. Suffice to note that an important weakness of these models was the absence of a financial sector. As a consequence, the financial intermediaries, financial frictions and asset price bubbles and corrections that have played a key role in the events of the past three years were neglected. To illustrate, imagine a scenario where inflation falls because of a positive supply shock, such as a reduction in manufacturing import prices from Emerging market economies. An inflation-targeting central bank would decrease its policy rates to boost inflation back towards its target level, simultaneously raising output closer to its new (temporarily higher) potential level.
BIS Review 45/2010  11  Second, monetary policy should have been less geared to fine-tuning the economy, in particular to trying to reduce the output gaps which ex post turn out to be very different from their real-time measurement. The long and variable lags in monetary policy transmission mean that a medium-term orientation for monetary policy must be maintained. Temporary deviations from a precise inflation objective are inevitable – monetary policy-makers must focus on containing persistent trends in inflation. Distinguishing between temporary and more persistent shocks to inflation is therefore crucial. Experience has shown that paying attention to specific measures of “core inflation” may mislead monetary policy. An overly mechanical view of such indicators can lead to an underestimation of the strength of inflationary pressures at the global level. Third, policy decisions should have been based on better models of monetary policy transmission. Monetary and financial factors have been too easily dismissed, especially by inflation targeting regimes. Placing greater weight on monetary and credit indicators should allow interest rate decisions to be better calibrated to achieve the appropriate medium-term objectives of monetary policy. Can central banks learn from experience? They can if they are able to recognise what went wrong, rather than sweeping the hard questions under the carpet, and if they are able to adapt their analytical and decision-making framework. Suggesting that monetary policy had nothing to do with the crisis will not help, and might encourage us to make the same mistakes in the future.