to be very robust. most major central banks were normalising interest rates. strong demand for commodities put upward pressure on prices so that interest rates were rising in the first half of the year. 3. mortgage rate re - settings at higher interest rate levels caused delinquency rates to rise, most pronounced in the sub - prime mortgage market. this led to losses in the hedge fund sector and increasing difficulties in finding a fair value price for structured deals. moreover, investment funds experienced difficulties in nav pricing, resulting in the temporary closures of some funds. asset - backed securities with high credit ratings have proved not to be as sound, nor as liquid as they appeared. some of those structured investment vehicles or conduits were extensively leveraged and strongly dependent on short - term funding. in the absence of liquidity, sponsoring banks had to fund off - balance - sheet vehicles from their own balance sheet. this led to de - leveraging and forced asset sales. 4. higher default rates caused the first bankruptcies in the us and credit spreads started to rise. risk aversion spread to all asset classes. forced sales to cover margin requirements saw volatility rise sharply ( vix doubled from 15 to 30 % ). the unwinding of riskier positions caused stock markets to fall ( stoxx50 - 11 % ) and carry trades were liquidated ( eurjpy fell from 169 to 152, a 10 % appreciation ). as markets fell, margin requirements rose further. the uncertainty about the pricing of some instruments added additional pressure. 5. as the credit crisis spread further short - term liquidity evaporated. short - term funding in the interbank market became unavailable, causing casualties amongst banks and funds. in europe, ikb and landesbank sachsen were rescued from insolvency. northern rock followed later. funding in the primary market was impossible for banks. trading in the secondary market stopped, with the exception of government issues. 6. the effective shut - down of the refinancing pipeline left banks to rely on shortterm funding from central banks. neither primary issues nor short - term papers, such as abs or abcp, could be placed in the market. banks hoarded liquidity in order to be safe from unexpected outflows or the unknown extent of write - downs. because the usual market refinancing possibilities were blocked banks relied on highly rated collateral for their funding and the liquidity provided by the central bank

within the banking sector can occur over time, creating increasing vulnerability. 17 low interest rates also encourage a higher level of leverage. because financial intermediaries – whether banks, broker - dealers, shadow banks, or hedge funds – finance themselves with short - term liabilities, central bank decisions on the level of short - term rate affect their marginal price of leverage. as a result, the behaviour of financial intermediaries – which, by their nature, have high levels of leverage – can be strongly influenced by even small changes in short - term rates. 18 low levels of interest rates encourage higher levels of leverage and, as a result, an accumulation of additional risk on bank balance sheets. through all these channels, a prolonged period of low short - term interest rates can support the accumulation of risks and financial imbalances on the balance sheets of both financial intermediaries and the private sector. these imbalances render the economy vulnerable to financial crises : if confidence evaporates, lenders call in loans, balance sheets contract and a painful readjustment is required, with adverse implications for financial stability and the real economy. in particular, the build - up of leverage within the financial sector may unwind abruptly, leading to a tightening of overall financing conditions. 19 such thinking sheds light on recent developments in the run - up to the financial crisis. viewing the impact of globalisation on goods prices as the manifestation of a positive supply shock, we can map this abstract scenario into our experience of the past decade. at the global level, the incorporation of emerging markets into the world economy weighed down on price developments ( especially of manufactured goods ). in response to the resulting benign inflation developments, the prevailing inflation targeting orthodoxy led to the adoption of an accommodative monetary policy stance. in retrospect, such accommodation was probably inappropriate, at least to the extent that it supported the financial imbalances and asset price bubbles that underlay the recent financial crisis. failure to take into account financial factors and channels of transmission led to a mis - calibration of the monetary policy response to the impact of globalisation. a simplistic account of the financial sector may have had other, adverse implications for the conduct of monetary policy in recent years. within the canonical new keynesian model, financial markets are “ perfect ”. on the basis of arbitrage considerations, long - term interest rates and other yields and asset returns all derive from the expected path of short - term interest rates determined by the