This general constellation of market conditions and asset prices is unusual, at least in comparison to what we have seen over the past several decades. This has been a distinguishing feature of the present expansion, but it is not something we fully understand, and we cannot be confident in judgments about how durable it will prove to be. To a significant extent, these financial developments reflect a high degree of confidence in future macroeconomic and financial stability, reinforced by the improvements in inflation performance, growth outcomes and financial resilience of the past several years. Better monetary policy has lowered expectations of future inflation and inflation volatility and has contributed to lower risk premiums in general. Changes in the cyclical behavior of financial  BIS Review 2/2007  1  intermediation and credit provision, coupled with the increased stability of the real economy, seem likely to have reinforced the improvements on the monetary policy front. And rapid growth in the major emerging market economies, together with the substantial earnings of energy-producing and commodity-exporting countries, have produced a substantial increase in wealth and savings relative to perceived investment opportunities. In a world where capital can now flow much more freely across national borders, a significant portion of these savings has moved across national borders. These are powerful and fundamental forces, and they certainly help explain the broad reduction in risk premiums and the substantial demand for credit risk and financial assets. There are other factors at work as well, however, that have less favorable implications.

Improvements to risk management and to capital cushions are likely to have made the financial system more stable and more resilient. And macroeconomic policy has improved around the world. The increase in monetary policy credibility in a broad range of countries has produced lower rates of inflation and more stability in inflation expectations. Greater public confidence in monetary policy was critical to laying the foundation for the improvements in real economic performance, by providing a stable foundation for long-term investment decisions. In emerging markets, better monetary policy has been accompanied by more disciplined and conservative fiscal policy and a range of other policies that have reduced, though not eliminated, vulnerability to changes in confidence, capital flows and exchange rate movements. These factors are each fundamentally important, and they are, of course, interrelated. The policies that delivered better inflation outcomes, more openness and competition and stronger financial systems were critical to fostering an environment in which improvements in productivity and growth could occur. This expansion has also been notable for the financial conditions that have prevailed over the past several years. Long-term interest rates have remained relatively low in nominal and real terms. Equity and other asset prices have moved higher. Credit spreads have declined to quite low levels. Market participants report exceptionally high levels of liquidity. And volatility, both realized and expected, has remained low across many different types of financial assets, market and economies.