BIS Review 94/2008  5  Chart 1: Financial Market Liquidity  Chart 2: EME holdings of FX reserves  Liquidity index 1.0  Per cent  0.8  40  0.6  35  0.4  30  0.2 + 0.0 0.2  0  08  1  Chart 3: Brent Oil Prices Nominal  2008  2007  2006  2005  2004  2003  2002  0 2001  -5 2000  06  1.2  1999  04  5  1998  02  1.0  1997  00  2  10  1996  98  3  1995  96  4  15  0.8  94  5  20  0.6  92  6  $ (RHS) Annual percentage change (LHS)  25  0.4  90  $  Chart 4: Survey-based measures of activity Construction  US dollars (2008) per barrel  Real  Index: 50 = no change  Services  140  70  Manufacturing  65  120  60  100  55  80  50  60  45  40  40  20  1960  1968  1976  1984  1992  2000  0 2008  35 2000  2001  2002  2003  2004  2005  2006  2007  2008  Source: CIPS  Chart 5: Global inflation Per cent 9  EMEs UK US Euro Area  8 7 6 5 4 3 2 1 0  2003  6  2004  2005  2006  2007  2008  BIS Review 94/2008
A rise in long-term inflation expectations above levels consistent with price stability would be a very unwelcome development because inflation expectations are an important determinant of actual inflation. In principle, if inflation expectations rose, this could push up actual inflation despite the high unemployment rate. Obviously, this would make it more difficult for the Federal Reserve to use monetary policy to achieve its dual objective of full employment and price stability. On the issue of the size of the Fed’s balance sheet, the worry among some is that the rapid growth of the Fed’s balance sheet will ultimately lead to an inflation problem. This anxiety stems from the fact that periods of rapid growth of the monetary base (that is, currency plus bank reserves) in the past have typically been followed by rapid credit growth and inflation. While I understand the concerns, I do not believe they are well-founded. We have a new tool: the ability to pay interest on excess reserves and that should enable us to cut the link between the size of our balance sheet and credit creation and inflation. If we raise the interest rate on excess reserves, we can incentivize banks to hold the excess reserves with us rather than lend them out. And that should work, because the price of credit is an important determinant of credit demand. If the FOMC were to raise the interest rate paid on excess reserves, this would raise the price of credit. That, in turn, would limit the demand for credit.