The credit crisis turned the spotlight on financial system excesses that allowed record levels of leverage to accumulate -- including bank lending against risky, cyclically priced assets. Policy responses have focused on regulatory reform. However, a greater policy impact may be a changed monetary policy framework.

Inflation targeting. A generation of central bankers has applied a doctrine of 'inflation targeting', which uses a model-based approach:

· The 'Taylor rule' sets a desirable inflation rate to maximise employment.

· The central bank uses interest rates to adjust growth toward the inflation goal, assuming there is a known equilibrium interest rate for stable full employment.

Asset prices. This model traditionally excludes asset prices, assuming that:

· these adjust around the equilibrium interest rate (ie are self-correcting);

· financial regulators should monitor leverage, not the central bank; and

· markets are better than central banks at identifying asset bubbles.

Recipe for failure. This approach became a victim of its own success:

· Financial markets became confident in central bank willingness to control inflation.

· This created profitable leverage structures within central bank model parameters.

· Leverage drove up asset prices -- which, as they rose, provided collateral for further leverage.

Fed easing. As the US Federal Reserve does not have an inflation target, and couches its price stability mandate over a long horizon, it can allow inflation to rise without formal constraint. Yet its loss of credibility fighting inflation allows wage demands to rise:

· 1970s surge. Commodity -- especially oil -- prices drove inflation in the 1970s. However, when the Fed eased monetary policy to accommodate this, the general price level took off, and workers demanded compensation.

· Tech bubble. When the Fed raised rates after its 2001-02 post-'tech bubble' easing, markets reacted by using increasing leverage to achieve desired returns, since they were confident the Fed could control inflation and keep interest rates low.

'Great reflation'? Historical trends might be categorised as:

· 'great inflation' in the 1970s;

· 'great moderation' in the 1980s-present; and

· a period of surprise inflation today, which might be christened 'great reflation'.

Globalisation. Gobalisation may be helping lay foundations for reflation. A recent Bank for International Settlements paper sketches this relationship, considering interacting demand- and supply-side forces:

· High 1970s inflation was demand-driven (eg government deficits financed social programmes) eventually leading to oil price rises and a wage-price spiral.

· The 'great moderation' has been supply-driven, especially given Asia's rise as a low-cost producer. Globalisation has expanded labour supply, introducing low-cost imports and restraining OECD wage growth. This suggests that central bank inflation targeting in advanced economies has been relatively unimportant.