Those dangers are often linked to excessive risk-taking in the credit or asset markets leading to episodes of financial instability. In that situation, it may be difficult for monetary policy to meet its objectives since the relationship between certain key variables and interest rates becomes unstable. Moreover, as market volatility increases, the ability of central banks to affect the relevant interest rates becomes more uncertain. The conduct of monetary policy then becomes much like steering a boat in the middle of a dark stormy night. Even if the likelihood of such episodes of macroeconomic distress is low, the considerable implications in the economy and in terms of welfare have led to increasing concern among central banks and much discussion and research on what the monetary policy response to this kind of underlying risk could and should be. There is now a broad consensus among central bankers that they should not directly target asset prices, and I must include myself among those who share this view. Detecting unsustainable patterns of asset prices or indebtedness ratios in real time is a complex task in practice. But even if central banks were able to do so, there would still be a lot of uncertainty as to how those financial imbalances would react to a specific change in monetary policy.
However, to have an impact on the real economy, there must be a way to transmit this signal all the way to the financial activities that determine economic transactions, such as business capital formation, household consumption and savings. The traditional channel is through commercial banks. And now we have another channel through the corporate bond market. This channel is poised to grow more rapidly in the future. The second aspect is that central bank also operates in the government bond market in its conduct of monetary policy. It can sell and buy bonds to pump money in or out of the system, through their open market operations. An efficient, deep and liquid bond market therefore will not only help make the intermediation process competitive and active - but also allow the central bank to transact in the market more effectively. The third aspect is the function of the bond market in managing the capital flows. Emerging market economies when they are successful tend to attract capital inflow very quickly, and in very large quantity. Unfortunately, if things turn bad, the outflow of capital can also be equally quick and in as large a quantity. How can one better manage this volatile capital flow? To some extent, I think the risks can be mitigated with a well functioning bond market.