We examine whether and how selected central banks responded to episodes of financial stress over the last three decades. We employ a new monetary-policy rule estimation methodology which allows for time-varying response coefficients and corrects for endogeneity. This flexible framework applied to the USA, the UK, Australia, Canada, and Sweden, together with a new financial stress dataset developed by the International Monetary Fund, not only allows testing of whether central banks responded to financial stress, but also detects the periods and types of stress that were the most worrying for monetary authorities and quantifies the intensity of the policy response. Our findings suggest that central banks often change policy rates, mainly decreasing them in the face of high financial stress. However, the size of the policy response varies substantially over time as well as across countries, with the 2008-2009 financial crisis being the period of the most severe and generalized response. With regard to the specific components of financial stress, most central banks seemed to respond to stock-market stress and bank stress, while exchange-rate stress is found to drive the reaction of central banks only in more open economies.
JEL Codes:E43, E52, E58.
Nontechnical SummaryThe recent financial crisis has intensified the interest in exploring in greater detail the nexus between monetary policy and financial stability. Although keeping the financial system stable is a major task, often delegated to central banks, how to consider financial stability concerns for monetary policy decision-making remains a puzzling question. Monetary policy is likely to react to financial instability in a non-linear way. When a financial system is stable, the interest-ratesetting process largely reflects macroeconomic conditions, and financial stability considerations enter monetary policy discussions only to a limited degree. On the other hand, central banks may alter their monetary policies to reduce financial imbalances if these become severe.This paper examines the reactions of the main central banks (the US Fed, the Bank of England, the Reserve Bank of Australia, the Bank of Canada, and Sveriges Riksbank) during periods of financial stress over the last three decades. In particular, we estimate the time-varying policy rule of each bank to assess whether and how its policy rate was adjusted in the face of financial instability. We track financial stress by means of a continuous financial stress indicator developed recently by the International Monetary Fund as well as its main subcomponents (banking stress, stock-market stress, and exchange-rate stress). Therefore, our empirical framework is suitable for detecting the periods and types of stress that were perceived as the most worrying and for quantifying the intensity of the policy response.Although theoretical studies disagree about the viability of considering financial instability for interest-rate setting, our empirical results suggest that central banks often alter the course of monet...
