Monetary Policy and Financial Stability: Cross‐Country Evidence

• Published date: 01 March 2019
• Author: CHRISTIAN FRIEDRICH,KRISTINA HESS,ROSE CUNNINGHAM
• Date: 01 March 2019
• DOI: http://doi.org/10.1111/jmcb.12526

DOI: 10.1111/jmcb.12526

CHRISTIAN FRIEDRICH

KRISTINA HESS

ROSE CUNNINGHAM

Monetary Policy and Financial Stability:

Cross-Country Evidence

Weexplain the heterogeneous response of central banks to financial stability

risks based on a financial stability orientation (FSO) index, which reflects

statutory, regulatory,and discretionary components of central banks’ mon-

etary policy frameworks. Our baseline results from a cross-country panel of

modified Taylor rules suggest that central banks with a high FSO increase

their policy rates in response to elevated financial stability risks by 0.27

percentage points more than central banks with a low orientation. Back-of-

the-envelope calculations suggest that this policy rate differentialtranslates

into a reduced crisis probability but also into considerably lower inflation

and output growth rates.

JEL codes: E4, E5, G01, G28

Keywords: monetary policy, financial stability risks, interest rates, leaning

against the wind.

THE EXPERIENCE OF THE GLOBAL financial crisis has highlighted

the adverse impact of financial instability on macroeconomic outcomes and thus

The views expressed in this paper are our own and do not necessarily represent those of the Bank of

Canada. Wewould like to thank Pok-sang Lam and two anonymous referees whose comments greatly im-

proved the paper.We would also like to thank YuriyGorodnichenko, Enrique Mendoza, Enisse Kharroubi,

Alessandro Barattieri, Gregor B¨

aurle, Chandler Lutz, Rafael Chaves Santos, Michael Ehrmann, C´

esaire

Meh, Bob Fay, Oleksiy Kryvtsov, Miguel Molico, Greg Bauer, and Michael Francis for valuable com-

ments on the paper as well as conference participants at the: 2015 Annual Conference of the CEA, Toronto;

2015 Joint Central Bank Conference,Bern;2015 ReCapNet Conference, Mannheim; XI Seminar on Risk,

Financial Stability and Banking of the Banco Centraldo Brasil,S

˜

ao Paulo; and seminar participants at the

Bank of Canada. We finally wouldlike to thank Bryce Shelton and Alexander Lam for excellent research

assistance as well as Geoffrey Halmo for valuable technical assistance with the text-search. An earlier

version of this paper has been circulated as Bank of Canada Staff WorkingPaper No. 2015-41.

CHRISTIAN FRIEDRICH is a Principal Researcher, International Economic Analysis Department, Bank

of Canada (E-mail: cfriedrich@bankofcanada.ca). KRISTINA HESS is a Senior Economist, International

Economic Analysis Department, Bank of Canada (E-mail: khess@bankofcanada.ca). ROSECUNNINGHAM is

a Director,International Economic Analysis Department, Bank of Canada (E-mail: rcunningham@bank-

banque-canada.ca).

Received March 3, 2016; and accepted in revised form May 21, 2018.

Journal of Money, Credit and Banking, Vol. 51, Nos. 2–3 (March–April 2019)

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2018 Her Majesty the Queen in Right of Canada. Journal of Money, Credit and Banking

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2018 The Ohio State University

Reproduced with the permission of the Minister of Bank of Canada.

404 :MONEY,CREDIT AND BANKING

on the real economy. Consequently, academics and policy makers are revisiting

the potential benefits and costs from actively using monetary policy to mitigate

unmaterialized financial stability risks, also referred to as “leaning against the wind.”

In this paper, we add to the debate by empirically documenting the extent of leaning

behavior in major central banks’ monetary policy decisions based on an assessment

of their monetary policy frameworks. In addition, we undertake first steps to quantify

the associated trade-off between financial stability and macroeconomic objectives

that central banks face in times of elevated financial stability concerns.

Smets (2014) provides an excellent summary of the academic literature on the

interaction of monetary policy and financial stability.1He argues that support for the

so-called “Jackson Hole Consensus” view (e.g., Bernanke and Gertler, 1999, 2001,

Gilchrist and Leahy, 2002), which stated monetary policy should not take financial

stability considerations into account and only “clean up after the crash,” has faded

over the years. Instead, this view has been replaced by a more heterogeneous set of

views, which, inter alia, include the idea that in the presence of financial imbalances,

monetary policy should actively lean against the wind.2

Central banks have approached this topic in an equally heterogeneous way, in

particular in the postcrisis period. For example, in its March 2012 Monetary Policy

Report, the Norges Bank writes that “[ . . .] the interest rate should be set so that

monetary policy mitigates the risk of a buildup of financial imbalances [. . . ].” In

a 2014 discussion paper, the Bank of Canada’s governor Stephen Poloz referenced

a risk management framework, in which financial stability issues represent a set of

risks that are taken into account in the monetary policy decision. In a speech in July

2014, Janet Yellen stated on the topic of financial stability that in the future, “[. . . ]

we consider the deployment of other tools, including adjustments to the stance of

monetary policy [ ...],” whilenoting thattheU.S.Federal Reserve (Fed) currently

remains with its traditional mandate.3

While the degree to which financial stability considerations are taken into ac-

count in the monetary policy decision differs substantially across central banks, it

appears, however, that not only the responses but also the underlying monetary pol-

icy frameworks and their interpretation with respect to financial stability differ. In

this paper, we therefore link the role of financial stability in monetary policy frame-

works, henceforth also referred to as the financial stability orientation (FSO), of

1. Gourio, Kashyap, and Sim (2017) extend Smets’ work by reviewing contributions to this literature

since 2014. Leeper and Nason (2014) provideanother excellent summary of the literature and offer practical

guidance on the integration of financial stability risk considerations into monetary policy frameworks to

central banks.

2. In addition to a “Modified Jackson Hole Consensus” view that largely remains with the traditional

perspective (e.g., Svensson, 2014), Smets characterizes the two newly emerging views as follows: a

“Leaning Against the Wind Vindicated” view that argues that monetary policy should prioritize price

stability, but consider more complex trade-offs between macrovariables and financial variables (e.g.,

C´

urdia and Woodford 2009, 2010, Woodford 2012, Angeloni, Faia, and Winkler 2014), and a more

extreme “Financial Stability is Price Stability” view that states that monetary policy should prioritize

financial stability (e.g., Brunnermeier and Sannikov 2014).

3. The corresponding references can be found under Norges Bank (2012), Poloz (2014), and Yellen

(2014).

CHRISTIAN FRIEDRICH, KRISTINA HESS, AND ROSECUNNINGHAM :405

major advanced economy central banks to their monetary policy decisions in re-

sponse to elevated financial stability risks arising from strong credit and house price

growth.4

Our contributions to the literature are threefold. First, we construct a time-varying

FSO index that classifies central banks based on the FSO of their monetary policy

frameworks between the two distinct viewpoints of the literature, “cleaning up after

the crash” (low index values) and “leaning against the wind” (high index values),

on a continuous scale. The FSO index encompasses three dimensions, based on the

central bank’s: (i) mandate and its interpretation with respect to financial stability,

(ii) regulatory tool kit, and (iii) references to financial stability in the context of

communicating monetary policy decisions. Second, we include our FSO index in

a modified Taylor rule, which we estimate using a cross-country panel of up to 10

advanced economy central banks for the period 2000Q1–2014Q4. This approach

allows us to empirically document the extent of central banks’ leaning behavior

and thus to explain their heterogeneous response to financial stability risks in a

systematic way. Third, using back-of-the-envelope calculations, we give a sense of

what magnitudes our results would imply for the trade-off between central banks’

macroeconomic objectives and financial stability objectives.

Our baseline results suggest that central banks with FSO index values at the 75th

percentile of the FSO index distribution appear to tighten their policy rates by 0.27

percentage points more than central banks with index values at the 25th percentile

in response to a 10-percentage point increase in a measure of financial stability risk

based on credit and house price growth. The findings of our baseline specification

are robust to a wide range of misspecification tests, carry over to periods of uncon-

ventional monetary policies, and indicate that under more restrictive assumptions

the differential policy rate increase can be as high as 0.60 percentage points. We

further show that our results can be generalized to alternative measures of financial

stability risk and that the differential responses are mainly driven by the rule-based

components of central banks’ monetary policy frameworks, such as the FSO of a

central bank’s mandate or the regulatory tool kit available to a central bank. Finally,

our back-of-the-envelope calculations suggest that the policy rate differential of 0.27

percentage points translates into a reduction in the crisis probability of about a third

of a percentage point for the economy of the tightening central bank. However, the

tighter policy rate generates macroeconomic costs of a quarter percentage point lower

output growth and a third of a percentage point lower inflation rate.

Our findings tie in with previous work on financial stability and monetary policy

as follows. Our results complement those of Jord`

a, Schularick, and Taylor (2015)

who examine the joint occurrence of credit booms and asset price booms for up to

17 advanced countries over the last one and a half centuries. These authors find that

credit-fueled asset price booms and, in particular, credit-fueled house price booms,

4. The term “financial stability risk” in this paper describes a situation where potential financial

vulnerabilities are building up (i.e., the presence of a “financial boom”). It is distinct from a situation

where risks have already started materializing (i.e., “financial downturns”or “financial stress”). For details

on our empirical measures see Section 2.2.