This crisis, however, shows that this view is painfully wrong. In fact, a financial bubble and even a credit boom, can have little or no effect on inflation, but that is not the point. 6  BIS Review 124/2008  Furthermore, an interest rate increase is probably unable to burst the bubble. But an excessive expansion of credit in the context of financial euphoria jeopardizes the other objective of central banks: financial stability. One important lesson from the present crisis is that we cannot wait for the bubble to burst to correct its effects. This may have worked with the technological bubble of the early 2000s, but the real-estate boom is proof that the problem can be worse. The way to deal with financial and price instability is different. For the first, the focus is on risk regulation and evaluation by the authorities. Detected vulnerabilities must be flagged and, if necessary, new regulations must be adopted. For price stability, there is monetary policy. It may well be the case that price stability and financial stability have different implications on interest rate management. The best example of this is the aggressive reduction of interest rates adopted by the Fed this year. Interest rate cuts were necessary to alleviate liquidity tensions in monetary markets and ensure the sound operation of the payments system. Failing to take these actions might have further exacerbated the financial crisis. However, conflicts of this kind are faced in extreme situations and this must be clear when making monetary policy decisions.
Overall, one cannot rule out that investors’ buy and sell strategies will have an effect on the high short-run volatility of prices, but it is difficult to blame on them the high and persistent levels we see today. The worst nightmare in terms of high inflation and low output has been the price of oil, which has broken all the records. After standing at $ per barrel in 1999 as a consequence of the Asian crisis, it started climbing throughout the 2000s in tandem with world growth. By mid-2006, when the oil price was approaching $ per barrel, the question was why the world economy was so insensitive to it. Researchers tried to explain why such a heavy price increase had been so mild on inflation and output (De Gregorio et al., 2007; Blanchard and Galí, 2007). Fingers pointed at the usual suspects: good monetary policies and less intensive use of oil around the world. In sum, the world economy was more insensitive to the oil price. However, if oil demand continued to rise without a corresponding increase in supply, a large enough price rise was necessary to begin having an effect on the demand. The levels of a couple of years ago were not enough to restrain the demand, and precisely because of that, researchers found little effects from the shock on output and inflation.