However, the large gap remaining between the repo rate and market rates shows that monetary policy cannot resolve the financial crisis. But I would nevertheless like to emphasise that monetary policy fulfils an important complementary function in alleviating the effects of the financial crisis on the real economy. As I described earlier, the stimulating effect of the Riksbank cutting the repo rate has been weakened as the normal link between the short-term market rates and the repo rate has been broken. This situation should gradually change as conditions in the financial markets normalise. When the inflation rate falls again, there will be good opportunities for monetary policy to dampen the economic downturn without jeopardising the Riksbank’s inflation target. Thank you! 8  BIS Review 149/2008
It may also be difficult to predict financial market reactions to very low and negative real interest rates. As early as 1967, US economist William Brainard discussed how central banks should respond to economic shocks when there is uncertainty about the impact of the policy rate on the economy. He concluded that the policy rate should be used with greater caution when uncertainty about its effect increases (Brainard (1967)). This involves a trade-off that can be illustrated graphically. Chart: Monetary policy and uncertainty This chart describes a situation where the policy rate is used to counteract the effect of a negative shock to the real economy. Two different interest rate paths are shown. The uncertainty is illustrated using bands around the expected paths for the policy rate, inflation and the output gap. In the scenario denoted by the blue line, the central bank does not take the uncertainty associated with the interest rate into consideration. In contrast, the yellow line represents a scenario based on a more cautious monetary policy response to the perceived uncertainty involved. The expected real economic costs of a more cautious response – as measured by the output gap – are somewhat higher, and inflation moves further from the target. In that respect, this is a less appropriate path for the policy rate. But there is also a benefit: uncertainty about the future path is substantially reduced. As you can see in the chart, the uncertainty bands around inflation and output have narrowed.