While not questioning the basic framework, they suggest 3 that inflation targeting central banks should aim to hit a rather higher inflation rate of around 4%, so as to give more room to cut official interest rates in the face of a collapse in demand before they hit their natural floor of zero. Thus, during the years leading up to the crisis, Bank Rate averaged around 4½%–5% and inflation averaged around 2%, so the real interest rate averaged 2½%–3%. If instead, inflation had been averaging 4% and Bank Rate 6½%–7%, i.e. the same real interest rate as before, then we would have been able to lower Bank Rate by another two percentage points before it approached its lower limit. The thinking behind this seems entirely reasonable. But, aside from ignoring the fact that monetary policy, in the shape of asset purchases 4 , can still be effective even when the policy rate reaches zero, it underplays the costs of higher inflation. Inflation at 2% or less is  3  Olivier Blanchard, Giovanni Dell’Ariccia and Paolo Mauro, “Rethinking Macroeconomic Policy”, International Monetary Fund, January 2010. 4  As well as more exotic options; see Willem Buiter, “Don’t Raise the Inflation Target, Remove the Zero Bound on Nominal Interest Rates Instead”, Citibank , 5 March 2010. BIS Review 31/2010  5  generally felt to be low enough that businesses and households do not have to consciously plan for rising prices – it is “close enough” to price stability, in other words.
Although regulators and supervisors conspicuously failed to address these issues during the run-up to the crisis, prudential regulation and supervision should surely be the first line of defence, as they can be focussed directly on the source of the problem. Regulatory policies have a comparative advantage in combating excesses in financial markets. By contrast, inflation is, in the long run, a monetary phenomenon, so it is more naturally suited to the pursuit of price stability. Beefing up the regulatory regime so it is better suited to preventing the re-emergence of financial excesses is very much work in progress. There are sound arguments for forcing banks to build up more capital and reserves during the good times, which they can then draw down if things turn bad, so improving the general robustness of the system – so-called “macro-prudential regulation”. Under instruction from the G20, the Financial Stability Board, together with the Basel Committee on Banking Supervision, is therefore developing an appropriate set of cyclically-varying regulatory requirements on financial institutions 5 , together with a range of other changes to improve the stability of the global financial system. Of course, no regulatory regime will be perfect, and financial institutions have an incentive to try to circumvent requirements that they perceive as onerous. So there may be times when monetary policy will need to work alongside regulatory policy in order to restrain excessive credit and asset price growth, even though the achievement of the inflation target may not immediately appear threatened.