5 My interpretation of these findings is that, although global forces have played an important role in determining domestic long-term  1  See Woodford (2007). 2  See Wu (2006). 3  See Reichlin (2006). 4  See Giannone, Lenza, Reichlin (2007). Barro and Sala-I-Martin (1990) found that real interest rates for seven of the nine OECD countries they investigated mainly depended on world factors for the period 1958-1989. 5  See Ferguson et al. (2007). 2  BIS Review 9/2008  interest rates, they do not provide sufficient evidence to conclude that the effectiveness of monetary policy in controlling inflation has been reduced. The increased significance of global factors identified by empirical analysis is likely to reflect common trends as well as the similar orientation of monetary policies and their success in containing inflationary pressures. If national monetary policies diverge from such a common orientation, which itself has been fostered by increasing competition between currencies, 6 the observed regularities are likely to be affected. A central bank is still able to influence aggregate demand and preserve price stability under floating exchange rates. Effects of globalisation on aggregate supply Let me now turn to the effects of globalisation on the aggregate supply and on the dynamics of inflation. Several effects have been identified or suggested, some of which are relatively direct and others indirect.
In this context, perhaps the biggest advances of monetary policy of the last 20 years leading to the GFC had to do with the transparency and the overall macroeconomic coherency of interest rate decisions, which led, among other transformations, to the adoption of explicit inflationary objectives in a number of advanced and emerging market economies. In the aftermath of the global crisis, it soon became clear that traditional MP was simply not going to cut it, especially given the limitations of other policy options, such as fiscal expansion, to reactivate the global economy after the major blow it suffered. Central bankers were forced to be creative and think outside the box of traditional monetary tools in order to make a difference. A useful framework to understand how policy tools have evolved is to think about interest rates in the following way. The price of a given form of debt, issued at a particular maturity and by a specific counterparty, is the sum of three main components. The first is the expectations of short-term, risk-free debt over the maturity of the instrument. Let’s call this component the path of risk-neutral rates. The second is the compensation for risk that must be offered to an investor to account for the fact that longer maturity instruments are more volatile (have higher duration) than short-term rates, let’s call it the term premium channel. The third is simply default risk.