This paper argues that financial imbalances can build up in a low inflation
environment and that in some circumstances it is appropriate for policy to
respond to contain these imbalances. While identifying financial imbalances ex
ante can be difficult, this paper presents empirical evidence that it is not
impossible. In particular, sustained rapid credit growth combined with large
increases in asset prices appears to increase the probability of an episode of
financial instability. The paper also argues that while low and stable inflation
promotes financial stability, it also increases the likelihood that excess
demand pressures show up first in credit aggregates and asset prices, rather
than in goods and services prices. Accordingly, in some situations, a monetary
response to credit and asset markets may be appropriate to preserve both
financial and monetary stability.
This paper was presented at the conference on "Changes in risk through time: measurement and
policy responses" organised by the BIS on 6 March 2002 and, as such, is
appearing in the BIS Working Papers series.
