It can be imagined that inflation (the red curve) must lie within the interval marked by the broken blue lines in Figure 3 if inflation expectations are not to drift away. This interval thus depends on the agents’ expectations and is not something that can be observed. If inflation lies below the interval, expectations will fall, sooner or later, and will pull actual inflation down too, as illustrated in Figure 4. If the central banks now have fewer possibilities to bring inflation back to the target as quickly as before, they must find ways to “extend” the interval, as in Figure 5. 12  See, for example, Blanchard et al. (2010), Ball (2014) and Krugman (2014). In the review of the monetary policy framework which the Bank of Canada publishes every five years, for example, an increase in the target is one of the areas to be examined – see Côté (2014) and Kryvtsov and Mendes (2015). 13  For arguments against raising the inflation target, see, for example, Yellen (2015), footnote 14. BIS central bankers’ speeches  9  This will probably be a fairly serious challenge. It will not just be a matter of trying to convince economic agents that monetary policy needs to be more “flexible”.
A concern from a financial stability standpoint is that heavy asset sales necessary in times of stress to meet investor redemptions could disrupt systemically important asset markets, particularly where a fund (or funds) has a concentrated market position. There have, so far, been few historical examples of financial instability caused by funds experiencing distress. But we should be careful about drawing too much comfort from this. The scale of funds and the market environment are different now. For example, funds’ investments in emerging market assets and high-yield bonds have quadrupled over the past five years. It is unclear what volume of redemptions could be met quickly without causing disorder in these markets. A year ago, the so called “taper tantrum” was a pointer to what could happen. And such risks may have become greater due to changes in the market. Concerns have been raised by some in the industry that reforms to bank capital and liquidity regulation could, taken together, have potentially serious consequences for market liquidity. The regulatory community takes such concerns seriously and is looking closely at them. But we should not set as an objective a return to pre-crisis liquidity conditions. Liquidity risk premia were likely too low before the crisis because liquidity risk was under-priced. And market-makers were permitted to fund their inventory with dangerously high levels of leverage, funded at very short maturities and, needless to say, the risk-weights attached to this sort of activity were very low.