Capital markets could go through a process of progressive and partial fragmentation: no significant capital account opening would occur in many parts of the world. Conversely, new barriers could be erected either in the form of “soft” capital controls or through national regulations forcing financial institutions to ring‐fence local pools of capital and liquidity. There would be little convergence in domestic financial systems and regulations. Foreign exchange reserves would keep growing, both in absolute terms and as a percentage of world GDP. This scenario may be seen as the only realistic response to increased diversity in a multipolar world. The systemic consequences, however, are not clear. In such a world,  BIS Review 127/2010  3  current account imbalances would be heavily influenced by public actions and policies. Regulatory competition would determine the location of financial activities and the allocation of savings. In the absence of some “rules of the game”, tensions would naturally arise between countries regarding many aspects of their domestic and international macroeconomic policies. The opposite scenario would involve the progressive opening of all capital accounts, together with some (more or less intensive) convergence in financial systems and regulations. This would allow for the emergence of a unified world capital market, an efficient allocation of savings across countries and a smooth financing of current account imbalances. Experience shows, however, that an open international financial system is not inherently stable and, therefore, very dependent on strong infrastructure. Two elements of such an infrastructure seem especially important.
Conclusion: policy should be flexible but don’t over-react to low inflation We’ve heard a lot about the risk that deflationary expectations persuade people to defer spending. We’ll no doubt hear it again if inflation were to dip below zero over the next couple of months. But it’s at best a partial point. All else equal, the incentive to save depends not on inflation expectations per se but on how far away they are from the nominal interest rate, i.e. the real interest rate. By any measure – even if you use the near-term household surveys as measure of inflation expectations – the real rate is extremely low, and still negative (Chart 15). The extensive empirical evidence for this “inter-temporal substitution” channel is in any case relatively weak – as the Governor pointed out recently, the more important threat, particularly in developed economies with large balance sheets, is debt deflation. And in that regard, it’s the gap between interest rates and nominal income growth that matters. Notably, nominal income growth has not declined of late. Real interest rates still need to be low. Our inflation target is 2% not zero: what makes the current position “good” is not low inflation per se but the fact that, in this particular instance, it’s been caused by something (a drop in oil prices) that improves real incomes.