Financial stability and monetary policy — is there a connection?

Abstract

Price stability has been central banks’ primary objective for decades. Before the global financial crisis, price stability was thought to be enough to safeguard both economic growth and financial stability. However, the global financial crisis showed that disruptions in the financial system could cause significant issues to the real economy and that price stability might not be enough.

This thesis studies whether central banks react to financial stability measures like asset prices or credit when setting monetary policy. An econometric study is performed on the Bank of England, Norges Bank, and Sveriges Riksbank to determine whether their monetary policy includes financial stability considerations. Additionally, a literature review is provided on the relationship between monetary policy and financial stability to lay the foundations for the estimations.

Financial stability, defined as the smooth functioning of the financial system, is an alternative goal for central banks, usually maintained with macroprudential policies. Central banks’ primary goal is price stability, maintained with monetary policy. The monetary policy toolkit consists of conventional policies, such as the policy rate and open market operations, and unconventional policies, such as quantitative easing and forward guidance. The prevalent view is that monetary policy should focus on price stability and macroprudential policies on financial stability, but competing views, such as the leaning-against-the-wind policy, have been introduced.

In theoretical literature, expansionary monetary policy causes asset prices to increase, sometimes over fundamentals. Additionally, the expansionary monetary policy increases lending and leverage, enabling the buildup of financial imbalances. Relaxed monetary policy can also increase the risk-taking of both investors and banks.

The empirical literature has no consensus on the relationship between monetary policy and financial stability. Expansionary monetary policy surprises are found to increase asset prices, but the effect is minor and depends on the initial price level for property prices. Additionally, expansionary monetary policy is found to increase risk-taking.

We use the autoregressive distributed lag model (ARDL) to study an augmented Taylor rule. The monetary policy indicator is a dependent variable, with inflation, output gap, stock prices, real residential housing prices, and total credit to the non-financial private sector being explanatory variables. We find that central banks do not significantly react to financial stability measures.