Monetary Policy, Private Debt and Financial Stability Risks

Can monetary policy be used to promote financial stability? We answer this question by estimating the impact of a monetary policy shock on private-sector leverage and the likelihood of a financial crisis. Impulse responses obtained from a panel VAR model of 18 advanced countries suggest that the debt-to-GDP ratio rises in the short run following an unexpected tightening in monetary policy. As a consequence, the likelihood of a financial crisis increases, as estimated from a panel logit regression. However, in the long run, output recovers and higher borrowing costs discourage new lending, leading to a deleveraging of the private sector. A lower debt-to-GDP ratio in turn reduces the likelihood of a financial crisis. These results suggest that monetary policy can achieve a less risky financial system in the long run but could fuel financial instability in the short run. We also find that the ultimate effects of a monetary policy tightening on the probability of a financial crisis depend on the leverage of the private sector: the higher the initial value of the debt-to-GDP ratio, the more beneficial the monetary policy intervention in the long run, but the more destabilizing in the short run

The Forward Guidance Puzzle

With short-term interest rates at the zero lower bound, forward guidance has become a key tool for central bankers, and yet we know little about its effectiveness. Standard medium-scale DSGE models tend to grossly overestimate the impact of forward guidance on the macroeconomy - a phenomenon we call the forward guidance puzzle. We explain why this is the case and describe one approach to addressing this issue