2  BIS Review 113/2009  However, some will argue that monetary policy should react directly to asset prices, for example, by including them in the Taylor rule. Cecchetti et al. (2000) are perhaps the best representatives of this position, claiming that any inflation-targeting central bank should react to asset price misalignments beyond their implications on expected inflation over the policy horizon. In my view, there are three reasons why monetary policy, in general, should not react to asset prices beyond their impact on projected inflation: •  First, it is not clear that an increase in interest rates will be capable of stopping an increase in asset prices. The required adjustments might be so large that they could end up unnecessarily generating high unemployment and an undesired drop in inflation. •  Second, what matters here is to safeguard the stability of the financial system. An excessive interest rate aiming at controlling asset prices could even trigger financial instability, which is precisely what it is meant to avoid, especially if the increase in asset prices is accompanied by higher financial fragility. •  Finally, under inflation targeting, any interest rate movements that are inconsistent with inflation converging to the target may undermine the credibility of monetary policy, destabilizing inflationary expectations, and weakening the effectiveness of monetary policy. This is particularly important in the case of emerging economies with a shorter record of monetary stability.
As for emerging markets, strong reserves positions help emerging markets to be in a better position to weather the impact of market volatility that may occur during the adjustment process. A case in point is the recent experience with the US sub-prime problem. Compared with other markets, the impact of the US sub-prime has been more limited for Asia. This is because direct exposure to subprime CDOs is relatively small compared to the overall assets of the Asian banking system. Moreover, a number of positive developments have taken place since the Asian financial crisis that has made the region more resilient to such a downturn. First, the financial positions of banks and corporate are much stronger with reduced indebtedness and less mismatch, as well as improved balance sheets. Second, Asian economies are much stronger in terms of external position, especially the levels of reserves that can comfortably cushion the outflows. And third, the economies overall have become more flexible both in terms of policy regime and the key prices. All these have put Asian economies in a much firmer footing to cope with the second-round effects of the sub-prime crisis. Let me now turn to policies that are needed for an orderly process of adjustment. In the short-term, an orderly movement in the US dollar is key for ensuring an orderly process of adjustment. The risk at this time is that market forces and expectation can lead to a disorderly movement. Hence, foreign exchange intervention remains a viable option to guide an orderly adjustment.