The spot nominal interest rate on a ten-year zero-coupon government bond can be thought of as the average of the short-term interest rates expected to prevail over the ten year period, plus a term premium (which is often thought of as compensating investors for uncertainty around those short-term interest rates). Comparisons between yields on government bonds of different maturities can be used to identify a sequence of forward rates (ie the expected short rates at each point in time plus a forward term premium associated with that maturity). Using the information from the yields on inflation-linked government bonds, expectations of nominal short-term interest rates and forward premia can be broken down further into the expected future inflation rate (and an associated forward inflation term premium) and the expected future real interest rate (together with the associated forward real term premia), equation (1). ftnominal(n) = (Et[rt+n] + RPtReal) + (Et[πt+n] + RPtπ) ; where ftnominal(n) denotes the n-period ahead forward interest rate prevailing at time t; Et[rt+n] and Et[πt+n] the expectations for the real interest rate and the rate of inflation at that point and RPtReal and RPtπ the corresponding forward real and inflation term premia. In principle, then, there are two broad channels through which a decision by monetary policy makers to change their policy rate could affect longer-term interest rates, such as the 10-year government bond yield. First, the decision could change market participants’ expectation of either real interest rates or inflation. It is worth noting two standard bedrocks of monetary economics here.
–  The public finances should be managed with an eye to the nature and extent of risk exposures elsewhere in the economy. –  It is the precise pattern of capital flows, and the resulting composition of the resulting balance sheets, that matter to the stability of the financial system. All macro policymakers – monetary, macroprudential and fiscal – should, therefore, pay attention to the national balance sheet; and to the pattern of gross as well as net capital flows. –  But, in doing so, we and our peers must avoid financial protectionism just as a previous generation learned to oppose trade protectionism. And we must not leave anyone thinking that we can eradicate economic problems. 26  The IMF’s most recent spillover report on the UK can be found at http://www.imf.org/ external/pubs/ft/scr/2011/cr11225.pdf. That report concluded: “the size and interconnectedness of the UK financial sector make it a powerful originator, transmitter, and potential dampener of global shocks. The stability and efficiency of the UK financial sector is, therefore, a global public good requiring the highest quality supervision and regulation”. 10  BIS central bankers’ speeches  Conclusion Around the Western world, excess indebtedness became legion during the opening years of the last decade. US subprime mortgages, perhaps the most egregious although by no means the largest example, became the straw that shattered the camel’s back. In this metaphor, both the “straw” and the “camel” are balance sheets.