Policy rate hikes and financial stability: the role of inflation sources
In this paper, Boissay et al. explore the state-dependent effects of monetary tightening on financial stress, with a focus on the nature of supply versus demand inflation at the time of policy rate hikes. The authors estimate a sequence of linear regressions to assess how a rise in the policy rate affects financial stress over a 36–month horizon. They address the reverse causality problem by using high-frequency identified monetary policy surprises as a measure of exogenous variations in interest rates, rather than the policy rate itself. The data used in the paper includes:
Financial stress indices (FSIs) to proxy financial instability, with the baseline FSI for the US being an updated version of the index used by Hubrich and Tetlow (2015), which assesses the degree of financial market dysfunction during the Great Financial Crisis (GFC).
High-frequency identified monetary policy surprises from Bauer and Swanson (2023) for the US, transformed to monthly frequency by summing up daily observations within each month.
Demand and supply components of inflation, borrowed from Shapiro (2022), which allow for the computation of these components at a monthly frequency. Control variables such as industrial production, unemployment rate, and corporate credit spreads.
Boissay et al. find that:
- Policy rate hikes in response to supply-driven inflation, due to supply chain disruptions or high energy prices, increase financial stress. Adverse supply shocks not only spur inflation but also weigh on borrowers’ cash flows. By contracting aggregate demand, a policy rate hike further reduces borrowers’ cash flows and leads to a rise in credit default risk. Financial frictions make borrowers excessively sensitive to rate hikes, and when credit markets are subject to frictions, higher default risk induces lenders to require additional guarantees in the form of higher credit spreads and external finance premia, thereby further increasing borrowers’ default risk.
- Policy rate hikes may leave unaffected or reduce financial stress in the presence of demand-driven inflation, especially if the latter is strong. When aggregate demand is growing, borrowers’ cash flows tend to increase as well, acting as natural buffers against the tightening of monetary policy, allowing borrowers to deleverage through the tightening cycle without experiencing severe strains.
Monetary Tightening, Inflation Drivers and Financial Stress
Authors: Frederic Boissay, Fabrice Collard, Cristina Manea, Adam Shapiro
From: Bank for International Settlements, Toulouse School of Economics, Federal Reserve Bank of San Francisco
Financial stability as the third leg of the Fed’s mandate
In this paper, Gomes and Sarkisyan, study how monetary policy should respond to financial market conditions. The authors develop a computable dynamic general equilibrium model that integrates banks, or financial intermediaries, with nominal rigidities in wages, prices, and nominal debt contracts. In their model, credit spreads are driven both by separate shocks to the expected profitability of the corporate sector and that of the banking sector’s. They perform a quantitative analysis to examine how the U.S. economy responds to a set of specific shocks under both a classic Taylor rule, that seeks to stabilize output and inflation, and a a modified Taylor rule that also seeks to stabilize corporate spreads. The authors estimate most of the key parameters using state-of-the-art Bayesian methods. The estimated parameters include the average debt maturity, the cost of default, a measure of the sensitivity of credit prices to leverage, as well as the persistence and volatility of shocks to productivity and corporate default rates.
Our results also show that targeting credit spreads can often be welfare-improving. Perhaps more remarkably, a policy rule that seeks to aggressively stabilize credit spreads can even reduce the need for explicit inflation targeting. Using a detailed second-order welfare analysis across a wide range of values for the monetary policy weights on the inflation rate, the output gap, and corporate spreads we show that when the central bank commits to react to corporate spreads strongly enough, aggressive inflation targeting is no longer necessary or even desirable.
Monetary Policy and Financial Stability
Authors: Joao F. Gomes, Sergey Sarkisyan
From: The Wharton School, University of Pennsylvania
