Should financial stability be the third leg of a central bank’s mandate?
In this paper, Gomes and Sarkisyan develop a dynamic general equilibrium model which combines financial frictions with wage and price rigidities to study how monetary policy should respond to financial market conditions which they define as defaultable long-term nominal corporate debt.
Our key results imply that a monetary policy rule that credibly responds to, and seeks to stabilize fluctuations in credit spreads is generally welfare-improving. Specifically, including credit spreads is welfare-improving and even obviates the need for explicit inflation targeting when addressing TFP, corporate default, or intermediation shocks. Targeting corporate spreads dominates more aggressive output gap targeting when mitigating consequences of corporate default and banking shocks.
Monetary Policy and Financial Stability
Authors: Joao F. Gomes, Sergey Sarkisyan
From: The Wharton School, University of Pennsylvania
Can monetary policy stance considerations be separated from financial stability concerns?
In a recent speech, Isabel Schnabel discussed financial instability’s role in central bank policy choices, especially when inflation is high. She argued that central banks need to consider potential side effects regarding the build-up of financial stability risks, even if those risks may materialize only in the future. In conclusion:
[R]ecent history has shown that, even in high-inflation periods, separation between monetary and financial stability considerations can be ensured if financial disturbances are caused by market dysfunction and liquidity issues rather than solvency concerns. A fundamentally sound, well-regulated financial sector protects central banks from any form of financial dominance, allowing them to focus on their primary mandate of price stability.
Schnabel mentioned the Bank of England’s response in the fall of 2022 to the “mini budget crisis,” as a successful application of the separation principle which distinguishes between the use of “standard” (i.e. interest rates) and “non-standard” measures. This principle also emphasizes that longer-term liquidity operations and asset purchases should not be considered tools to steer the monetary policy stance.
Monetary and financial stability – can they be separated?
By: Isabel Schnabel – ECB
