Introduction

Over the last couple of years the global financial system has undergone a period of unprecedented turmoil initiated by problems in the US mortgage market, which then spread to securitised products and a wide range of credit markets. Interbank markets have struggled to provide liquidity across the banking sector, thereby failing to act as a conduit for monetary policy, and systemically important financial institutions have collapsed, calling for public intervention on a scale not seen for decades. We believe that this crisis is a reflection of an overly expansionary monetary policy, carried out through an inflation-targeting regime, which induced excessive growth in credit and asset prices, as well as the inability of regulators to predict and deal with the distortions generated by financial innovations.

Inflation targeting has been successful in keeping inflation low and stable, but its proliferation is threatened by the fact that it accords overriding importance to price stability while central banks remain responsible for promoting financial stability. Since these two objectives reinforce each other in the long run, the conventional central banker's wisdom has been sceptical about the existence of a trade-off between price and financial stability. However, the current crisis has demonstrated that there are situations of short-term conflict; in the recent past, low interest rates and the success of central banks in achieving low inflation gave market participants a false sense of security, which contributed to the mispricing of risks and made the financial system more vulnerable.