But interest rate normalisation in the US is not without its challenges. First, it amounts to a de facto tightening of global financial conditions. Second, it accentuates a divergence in monetary policies among the advanced economies. The tightening of financial conditions will have a dampening effect on spending in both advanced and emerging economies. Such is the strength of US monetary policy dominance that the recent back-up in long-term interest rates in the US has lifted bond yields everywhere – including in the EU, despite the ECB’s ongoing asset purchase programme. Higher growth in the US will provide some support to emerging Asia through the trade channel. Asian exports should benefit, especially if corporate investment picks up in the US. But the increase in US interest rates will weigh down on emerging Asia’s prospects through the financial channel. Higher interest rates will squeeze the debt servicing capacities of corporates and households in Asia, which have taken on more leverage in recent years amid the low interest rate environment. The trajectories of economic growth, inflation and monetary policy between the US and the rest of the world are expected to diverge further. Headline and core inflation rates in the US are well above those in the Eurozone and Japan. While demand is expected to pick up slightly in the Eurozone and Japan this year, inflation will remain well below target. Monetary policies are therefore expected to remain ultra-easy. The divergence in monetary policies could mean considerable movements in exchange rates and capital flows.

I shall address policy responses in two steps; first, responses by the ECB and, second, responses by fiscal authorities. Sovereign contagion, the monetary transmission mechanism and the ECB’s Securities Markets Program The intensification over time of the sovereign debt crisis – as also illustrated by the contagion evidence I have just referred to – has presented the ECB with the challenge of preserving the proper functioning of the monetary policy transmission mechanism. In normal times the key interest rates decided by the central bank have an initial impact on short-term interest rates in the money market, and arbitrage relationships further propagate the policy impulse along the maturity spectrum and across different asset classes. Coupled with adjustments of money, credit and financing conditions, monetary policy can ultimately affect prices. The smooth working of this transmission mechanism allows the central bank to fulfil its mandate of maintaining price stability. Security markets, especially sovereign bond markets, have traditionally come to play a distinct role in the transmission of monetary policy in all advanced economies. This occurs  7  P. Donati, (2011), “Modelling spillovers and measuring their impact and persistence: Application to CDS spreads during the euro area sovereign crisis”, unpublished ECB internal manuscript, August. 8  X. Zhang, B. Schwaab and A. Lucas (2011), “Disaster calculus: Joint and conditional measures of euro area sovereign default risk”, unpublished ECB internal manuscript, November. 4  BIS central bankers’ speeches  via three channels. First, government bonds are often used as a reference rate for pricing loans or other asset classes.