Monetary tightening, inflation drivers and financial stress

(December 2023, revised July 2024)

Summary

Focus

Since mid-2021, central banks have swiftly raised policy rates against the backdrop of a flare-up in inflation. Experience shows that rapid monetary tightening can usher in financial stress.

We study empirically whether the tightening of monetary policy affects financial stress differently depending on the underlying supply versus demand nature of inflation. We regress a wide range of measures of financial stress on unanticipated changes in policy rates. Further, we differentiate the effects based on whether inflation is driven by adverse supply factors (eg oil and energy shocks, supply chain disruptions or adverse technological shocks) or expansionary demand factors.

Contribution

Financial stability risks have become a central consideration in central banks' decision-making processes. One reason for this is that financial instability may prevent central banks from achieving their primary objectives. Another is that monetary policy may, on its own, inadvertently create stress in the financial system.

For instance, raising the policy rate to address inflationary pressures may cause existing financial vulnerabilities to surface and lead to financial instability. In theory, the type of inflationary pressure that prompted tightening monetary policy in the first place is a key factor determining how far a central bank can raise its policy rate without posing a threat to financial stability.

The main contribution of this paper is to assess empirically whether the relationship between monetary tightening and financial instability varies with the nature of inflationary pressures.

Findings

We find that financial stress tends to increase shortly after a policy rate hike when inflation is supply-driven but not when inflation is demand-driven. In the latter case, financial stress tends to remain roughly unchanged or even recedes.

Our findings point to a particular tension between price stability and financial stability when inflation is high and largely driven by adverse supply factors.

Abstract

The paper explores the state–dependent effects of a monetary policy tightening on financial stress, focusing on a novel dimension: whether inflation is driven by supply factors versus demand factors at the time of the policy intervention. We use local projections to estimate the effect of high frequency identified monetary policy surprises on a variety of financial stress measures, differentiating the effects based on whether inflation is supply–driven or demand–driven. We find that financial stress flares up after a monetary tightening when inflation is supply–driven whereas it remains roughly unchanged or even declines when inflation is demand–driven. Our findings point to a potential trade–off between price and financial stability when inflation is high and driven by supply factors.

JEL classification: E1, E3, E6, G01

Keywords: supply– versus demand–driven inflation, monetary tightening, financial stress