In the period leading up to the crisis, what was missing clearly was the recognition of the implications that a stable growth and inflation environment could have on developments in the financial sector in terms of its impact on risk perception and on the risk-taking behavior. As it turned out, the reduced volatility of growth and inflation did not tell a complete story. In addition, the intellectual underpinning of central bank’s approach to policy, based on efficient market hypothesis, did not encourage policy makers to look beyond the focus on inflation risk. As a result, the interaction and feedback between the real economy and the financial sector were not given the needed attention in the deliberation of monetary policy. A case in point is the typical absence of the financial sector, especially banks, in the macroeconomic models used in the analysis of monetary policy. This absence leaves a big gap in our understanding of the interactions between the financial side and the real side of the economy which, as a result,  BIS Review 8/2010  1  can lead to an underestimation of risk in the good time, and an overestimation of risk in the bad time. The third lesson is that monetary policy is a powerful tool for managing growth and stability, but it can also be a double-edged sword.
Combining macroprudential measures with inflation-targeting is one area that flexibility can be added. The Bank of Thailand is one central bank that has pursued this line of flexibility since 2004. Another approach is to have greater flexibility in the setting of the inflation targets, in terms of the choice between core and headline inflation, as well as the level of the inflation targets itself, so that monetary policy will have greater room to maneuver in responding to shocks. If done carefully, the room for flexibility can be added without undermining the credibility of the inflation-targeting framework. But whatever flexibility we add, it is most important that the long-term objective of monetary policy in sustaining a low and stable inflation environment and in anchoring inflation expectations over the cycle is maintained and not compromised. BIS Review 8/2010  3