This motivates more research on how to incorporate financial factors into the standard models of the transmission mechanism used by central banks. A rapidly-increasing volume of such research is now being produced by academic and central-bank researchers and presented at an increasing number of conferences on financial factors and monetary policy. Important and challenging questions include how potential output and neutral real interest rates are affected by financial factors and financial distortions (Curdia and Woodford 2009, Walsh 2009), and  15  However, conceptually distinguishing the two policy areas does not rule out that there might be advantages of to keeping a large part of the responsibility for financial-stability policy within the central bank, as argued by, for instance, Blinder (2010) and Nyberg (2010). BIS Review 16/2010  5  what impact financial factors have on the general equilibrium effects of alternative policy-rate paths on inflation and resource utilization forecasts. 16 Even with much better analytical foundations concerning the role of financial factors in the transmission mechanism, there will of course, as always, be considerable scope for the application of good judgment in monetary policy. Another conclusion, which is not new, is that consideration of the impact of financial factors on the forecast of inflation and resource utilization may require longer forecast horizons. Several inflation-targeting central banks (including the Bank of England, Norges Bank and the Riksbank) have for other reasons already extended their forecast horizon from the previously common two years to three years.

Real interest rates were low to a large extent because of global imbalances, the global saving glut and investment shortage. I believe that somewhat higher interest rates would have made little or no difference. Empirical evidence indicates that only a small portion of house-price increases can be attributed to monetary policy. 10 Bernanke (2010) shows that the recent phenomenon of a higher share of adjustable-rate mortgages was unlikely to have significantly increased the sensitivity of house prices to monetary policy. The availability of new, more exotic mortgage types mattered much more for initial mortgage payments than the level of shortterm interest rates. In my view, interest rates would probably have had to be raised very high so as to cause considerable damage to the real economy in order to stop the credit growth and housing boom. 11 That could have thrown the U.S. right into Japanese-style deflation and eventually a liquidity trap. Certainly, higher interest rates would have had no impact on the regulatory problems, distorted incentives and information problems mentioned above  7  I remember this period very vividly, because I was fortunate to have the opportunity to discuss and debate the problems of current monetary policy, deflation and liquidity traps in a group of great economists at Princeton University that included Ben Bernanke (before he left to be a Governor on the Federal Reserve Board), Alan Blinder, Paul Krugman, Chris Sims and Michael Woodford. 8  See Svensson (2003) for a discussion of policy options before and in a liquidity trap.