Monetary policy and financial instability

Loose monetary policy and financial market-sentiment

The central thesis of this paper by Kashyap and Stein is that monetary policy achieves much of its effectiveness through its impact on financial-market sentiment. The easing of monetary policy tends to reduce risk premiums on a range of financial assets, including stocks, Treasuries, corporate bonds, and foreign exchange. Banks also tends to make banks more willing to accept a lower return for taking the credit risk associated with the loans they make. There are two facts that indicate why such “elevated” financial-market sentiment can lead to a financial crisis:

• The rapid growth in credit which tends to portend adverse macroeconomic outcomes, be it a financial crisis or some kind of more modest slowdown in activity.
• Aggressive pricing of credit risk tends to carry negative information about future economic growth.

Taking account of these effects has the potential to overturn some basic presumptions about how monetary policy should be conducted. Perhaps most importantly, the risk of reversals means that optimal policy no longer always completely offsets even pure negative demand shocks. Instead, policy may in some cases need to trade off the benefits of supporting the economy now against the possibility that an unwinding of financial-market sentiment could lead to worse outcomes in the future.

Monetary Policy When the Central Bank Shapes Financial-Market Sentiment
Authors: Anil K Kashyap, Jeremy C. Stein
From: University of Chicago, Harvard University

Empirical evidence

In this paper Grimm et al. provide evidence that overheated credit markets can originate from accommodative monetary policy regimes. Their aim is to pin down the causal link between policy stance and financial fragility. Their findings support the conclusions of Kashyap and Stein, above, ie that credit creation and asset price overheating are important pathways that can lead to a financial crisis. For their empirical analysis they use the Jorda-Schularick-Taylor Macrohistory Database which combines macro-financial data with a banking crisis chronology for 18 advanced economies over the period from 1870 until 2020. They use a “stance” measure to capture movements in the component of interest rates affected by monetary policymakers ie they distinguish between secular trends in interest rates and shifts in the stance of monetary policy. They find that stance predicts financial instability.

Policymakers should take the dangers imposed by keeping policy rates low for long seriously, and thus weigh the potential short-run gains of loose monetary policy against potentially adverse medium-term consequences. Such policies increase the risk of financial crises and thus the risk of high social, political, and economic costs.

Loose Monetary Policy and Financial Instability
Authors: Maximilian Grimm, Òscar Jordà, Moritz Schularick, Alan M. Taylor
From: University of Bonn, Federal Reserve Bank of San Francisco, University of California-Davis