This logically implies that an exclusive focus on the two-year ahead central inflation projection will cause policymakers to miss the risk of undershooting the inflation objective sometime in the future, possibly by a non-negligible amount. In turn, this implies that the central projection for inflation does not represent a sufficient statistic for monetary policy, and that a more sophisticated approach, factoring in the possibility of “tail risks” such as the bursting of a bubble, should be taken into account. A possible way of addressing the problem  9  See Dubecq et al. (2010). 10  See Reinhart and Rogoff (2009). 6  BIS central bankers’ speeches  within the traditional forecast-based framework which has been dominant among inflationtargeting central banks is to extend the forecast horizon beyond two years ahead. The risks to the central inflation projection deriving, say, from excessive credit growth and the resulting build-up of an asset price bubble would then be encoded in the probability distribution for inflation at longer horizons. This would allow the central bank to meaningfully discuss the dangers associated with such a build-up, and – assuming that within future policy frameworks monetary authorities will be endowed with macro-prudential instruments – it will allow them to explain to the public the adoption of measures designed to curb credit growth.
Over the past two centuries, upswings or downswings in the trend money growth have usually been followed, a few years later, by swings in the same direction in trend inflation.2 This relationship has remained significant over the past two centuries, across a variety of different monetary policy regimes and in spite of financial innovation. This naturally suggests that it is “hardwired” into the deep structure of the economy, i.e. that it is structural in nature. In turn, this suggests that by analyzing monetary developments – and in particular, by identifying swings in trend money growth, as well as its components and counterparts – a central bank can implement a more forward-looking monetary policy. The monetary nature of inflation, and given that money growth at the long-run horizon is ultimately under the control of the central bank, logically leads to a fifth key principle: the central bank has ultimate responsibility for inflation. Of course, in the short-run macroeconomic dynamics, and therefore also inflation, are determined to a significant extent by events outside the central bank’s control. The last four years provided a forceful reminder with the 2008 shocks in food and energy prices, which led to a temporary hump in Euro area inflation, followed by the large contractionary shock associated with the financial crisis and several months of deflation. These exceptional circumstances brought euro area HICP inflation to 4 per cent in the summer of 2008 and then to –0.6 per cent one year later.