The reaction function channel of monetary policy and the financial cycle

Focus

Financial stability is key in monetary policy deliberation. There is ample evidence that low interest rate levels create financial imbalances. But how policy reacts to macro-financial developments could also matter. This is the subject of this paper.

Contribution

We measure how responsive US monetary policy appears to be to imbalances in equity, housing and credit markets. We examine if this policy sensitivity predicts later evolution of financial imbalances. The exercise is important because policy implications are far-reaching.

Findings

When policy reacts more to financial overheating, imbalances tend to moderate later. This is so despite holding interest rate levels fixed. A more countercyclical reaction also predicts more stable financial markets. Systematic policy responses thus matter for safeguarding financial stability.

Abstract

This paper examines whether monetary policy reaction function matters for financial stability. We measure how responsive the Federal Reserve's policy appears to be to imbalances in the equity, housing and credit markets. We find that changes in these policy sensitivities predict the later development of financial imbalances. When monetary policy appears to respond more countercyclically to market overheating, imbalances tend to decline over time. This effect is distinct from that of current and anticipated interest rate levels - the risk-taking channel. The evidence highlights the importance of a "policy reaction function" channel of monetary policy in shaping the financial cycle.

JEL codes: E50, E52, G00, G01, G12.

Keywords: policy reaction function channel, asset price booms, credit booms, monetary policy, financial cycles, time-varying models.