Real short-term interest rates were reduced around the world, following a nearly decade long secular decline in inflation rates, a slowdown in growth at the turn of this decade and subsequent deflation. As central banks raised their policy rates when the outlook improved and deflation risks had dissipated, both real and nominal long-term interest rates remained anomalously low. Global savings appeared to rise faster than did perceived real investment opportunities, and this development helped to push down real long-term interest rates around the world. At the same time, many emerging market economies built up very large levels of official reserves to reduce external vulnerability and to hold the value of their currencies stable against the dollar. The exchange rate policies in these economies – economies that together accounted for a increasing share of global GDP – made overall global financial conditions more accommodative, even as the United States and other countries tightened their monetary policies. Expected and realized volatility in both debt and equity markets were remarkably low for most of the last half a decade. Term premiums declined and remained low over much of this period. Credit spreads across a wide range of asset classes fell to levels that assumed unusually low levels of future losses. In the United States, credit, and mortgage credit in particular, expanded relative to GDP.
If the risk of significant damage to growth from these financial market pressures is attenuated and if global growth remains strong and drives a continuing rise in energy and commodity prices, then inflation may not moderate as much as we anticipate. If the medium term outlook for inflation deteriorates significantly, the FOMC will move with appropriate speed and force to address this risk. This requires a fine balance. The principal challenge for policy is to provide an adequate degree of insurance against the downside risks that still confront the economy as a whole, without adding to concerns about inflation over the medium term. We cannot know with confidence today what level of the short-term real funds rate will be consistent with our objectives of sustainable growth and low inflation, but if turbulent financial conditions and the associated downside risks to growth persist, monetary policy may have to remain accommodative for some time. Liquidity provision Although concerns about credit quality are at the root of the current problems in financial markets, a substantial impairment in market liquidity conditions can exacerbate and prolong the adjustment in credit conditions. To mitigate this risk, we have taken a series of actions to help reduce the risk that market liquidity conditions exacerbate the adjustment process in credit markets.