To prevent the risk that central banks react too late to such imbalances, the monetary policy strategy has to enlarge its informational basis: monetary indicators, including money but also credit developments, may then be a good candidate to detect inflationary pressures early on. 2  BIS Review 15/2008  However, the theoretically founded long-term relationship between money and inflation may be blurred in econometric estimates of long run money demand equations, and part of this could be due to financial innovation. Indeed, as far as the euro area is concerned, recent Banque de France research has pointed to a structural break around 2001 in the income velocity of money. In the euro area, the velocity of money seems to have now established along a new, faster declining trend. This is consistent with the hypothesis of a financial deepening in the economy, in particular an increase in financial wealth held by households. Although the precise role of financial innovation in this process is still not fully understood, we should think of it in terms of both new players and new products: -  In terms of new players, a plausible explanation is the rapid pace of expansion in the business of the so-called other financial institutions (OFIs). These institutions include mutual funds as well as financial vehicles that buy and repackage loans that are securitised by banks. This activity reduces mechanically the growth of MFI loans to the private sector, while it is mirrored in the strong increase in OFIs’ deposits holdings, hence contributing to M3 growth.
To sum up, financial innovation is on the whole expected to have facilitated the job of monetary policymakers by accelerating the transmission of monetary impulses to the economy. However, in times of stress, when financial sophistication may have gone further and quicker than risk-management practice, the confidence crunch that may ensue paves the way to non-linear responses of the economy that seriously challenge our common understanding of how monetary policy impulses are transmitted to the economy. Challenges for our reliance on monetary indicators As you know, the Eurosystem’s monetary policy strategy assigns an important role to money, which is based on the premise that monetary developments provide valuable information on future inflation in the longer run. I would like to ground this with two reasons, a well-known stylised fact and a conjecture. The stylised fact first: there is ample statistical evidence, in the euro area and elsewhere, that low frequency movements in money growth are closely correlated with trend inflation, e.g. for frequencies corresponding to cycles of eight to ten years. The conjecture, then, brings us to an issue that will be tackled this afternoon, namely the flattening of the Phillips curve: changing inflation dynamics, which can partly be viewed as a consequence of a successful anchoring by credible monetary policies, tend to reduce the sensitivity of inflation to incipient imbalances in the economy.