Introduction: the unsustainable has run its course

After a number of years of strong global growth, low inflation and stable financial markets, the situation deteriorated rapidly in the period under review. Most notable was the onset of turmoil in the US market for subprime mortgages, which rapidly affected many other financial markets and eventually called into question the adequacy of capital at a number of large US and European banks. At the same time, US growth slowed markedly, reflecting setbacks in the housing market, while global inflation rose significantly under the particular influence of higher commodity prices.

This sudden change in financial conditions was blamed by some on shortcomings in the extension of the long-standing originate-to-distribute model to new mortgage products in recent years. Others, however, noted that the sudden deterioration in both financial and macroeconomic conditions looked more like a typical "bust" after a credit "boom". Indeed, several factors seem to support this second hypothesis: the previous rapid growth of global monetary and credit aggregates; an extended period of low real interest rates; the unusually high price of many assets (both financial and real); and the way in which spending patterns in different countries (the United States and China in particular) reflected their different stages of financial development (encouraging consumption and investment respectively).

While central banks in all the major financial centres took action to reliquefy financial markets, the setting of policy rates diverged markedly in light of domestic macroeconomic circumstances. Some central banks were more concerned about actual inflation and raised policy rates, whereas others focused on the disinflationary pressures likely to emerge as growth slowed, and lowered policy rates instead.