As economic agents underestimate the total risks of their positions, the volume of investment in financial –and, in some cases, also real estatemarkets rises at a strong pace, and with it, asset prices and the overall level of credit, perhaps, with both being further fuelled through the feedback mechanism operating between collateral value and credit capacity. In that situation, there is a risk that a sharp asset price reversal might have a sizeable impact on the stability of the whole system. Therefore, an otherwise beneficial context of price stability and low financing costs might sometimes sow the seeds for the emergence of financial imbalances. This latter, somewhat ironic conclusion has spurred a recent debate on the role to be assigned to monetary policy as an instrument of use in correcting financial and real estate market excesses. Should central banks react to asset prices over and above their direct effects on purely monetary goals, such as inflation? The answers vary depending mainly on the confidence that one places in the ability of central banks to detect price misalignments early and to undo them without causing major damage to the economy. I tend to think that while in normal conditions monetary policy should react only to changes in economic variables insofar as they bear some influence on inflation dynamics, there are exceptional circumstances in which policymakers have enough signals to conclude that the economy, as a whole, is facing significant risks, thus warranting a more pre-emptive policy approach.
Undoubtedly, the emergence of new financial assets and financial intermediaries poses fresh questions here. Furthermore, the magnitude of the financial funds flowing across different countries at the present time and the uncertainty surrounding the sustainability and the possible effects of an eventual correction of the so-called global imbalances means that central banks worldwide must take a much broader and complex set of indicators into consideration when formulating their policies. Moreover, we are probably at a juncture that can be best described as one of “Knightian uncertainty”, in that some of the risks we are facing, and the hypothetical consequences following their realisation, are essentially immeasurable. Consequently, good monetary policymaking requires not only a continuous reassessment of market conditions and expectations, but also forecasts and projections flexible enough to encompass a wide set of scenarios. I share the view set out yesterday by Jean-Claude Trichet that a sound communication strategy takes on special importance in the current environment, as well. Anchoring expectations about future inflation is a valuable asset, and especially at times of financial and real turbulence. Fluent communication with market participants and the general public is also of great help in preserving credibility, especially when circumstances lead to relatively persistent temporary departures from what is sometimes called a “neutral” monetary policy stance, as some of our central banks have faced in recent times, or when specific factors push inflation rates above what the monetary authorities normally consider as satisfactory.