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Knowledge @ Wharton: Why Financial Stability Is Vital to Monetary Policy Moves

Central banking policies that aim to stabilize credit spreads deliver all-around gains, according to a paper by Wharton experts.

Published with permission from Knowledge @ Wharton, Wharton's online business journal.

In framing monetary policy, the Federal Reserve should go beyond its dual mandate to promote maximum employment and price stability, and formally recognize financial stability as the third leg of its mandate, according to a new research paper by Wharton experts.

“The financial sector is absolutely crucial to the transmission of monetary policy; you can’t have a healthy, successful economy with a financial sector that doesn’t work,” said Joao Gomes, Wharton professor of finance and economics. Gomes co-authored the paper, titled “Monetary Policy and Financial Stability,” with Sergey Sarkisyan, a doctoral candidate in Wharton’s finance department.

Gomes and Sarkisyan made their case with a model that combined “financial frictions with wage and price rigidities” to study how monetary policy should respond to financial market conditions. Of the various metrics of financial stability, they chose credit spreads for their study because data on that is available daily, unlike others that have time lags. They used “defaultable long-term corporate bonds” to measure credit spreads and debt overhangs. Widening credit spreads indicate corporate distress and the likelihood of defaults.

The study’s findings buttressed the case for monetary policy “that credibly responds to, and seeks to stabilize, fluctuations in credit spreads … [and] is generally welfare-improving,” the paper stated. In fact, if central banks respond strongly to changes in credit spreads, it is “no longer necessary or desirable” for monetary policy to explicitly target inflation, the authors asserted.

At most central banks around the world, the policy objectives are to “keep inflation low and achieve some version of maximum employment,” Gomes said. “If you can stabilize the financial system, you can prevent a big financial crisis that could undermine all your other objectives.”

Gomes expanded on why central banks must add financial stability to their policy considerations. “There are moments where we have to set everything aside and just worry the most about financial stability. Financial crises are among the worst possible disasters that can hit an economy. They are far worse than normal recessions. They’re catastrophic in how they create damage — not just to the economy, but to the entire society.”

Aligning Interest Rates With Financial Stability

As it happens, the Fed has factored in financial stability in recent years in its policy moves, Gomes noted. “To some extent, we’re modeling [in our study] what the Fed is already doing. It’s just that the Fed is not admitting that it does consider financial stability. It should be more systematic about it and should acknowledge the importance of financial stability in setting its policy goals.”

Gomes recalled that the Fed had acted strongly after the COVID outbreak in March 2020 to ensure financial stability. “Unemployment was fine, and inflation was fine, but the financial markets were conveying this huge information that the economy will be stressed and that it will need a lot of stimulus.” The Fed in its COVID response lowered interest rates to historically low levels and infused significant liquidity into the system.

Financial stability was the key driver of central bank actions in other settings, too. Monetary policy around the world during the recoveries that followed the 2008 and 2020 recessions was “extremely restrained,” the paper stated. “Despite evidence of rising economic growth and inflation expectations, central banks increased interest rates only reluctantly and very slowly.” In the U.S., the Fed justified that stance by citing concerns about how sharp interest rate increases could cause defaults and financial stress, the paper added.

Those shifts by central banks in recent years show that they have deviated from the “Taylor Rule,” an interest-rate forecasting model which links policy rates to changes in inflation and gaps in maximum employment, the paper noted. American economist John Taylor articulated the Taylor Rule in a 1993 paper.

The rise in inflation in 2021–2022 also demonstrated that central banks, however, do not follow the Taylor Rule precisely, the paper noted. In fact, the Fed responded more to widening credit spreads, and “has indeed become much less willing to target inflation when financial markets are in distress,” it added.

Gomes explained why it is important that the Fed formally acknowledges that it factors in financial stability in framing monetary policy. “You see these ad hoc decisions made on the spur of the moment in a crisis, instead of being a systematic policy statement,” he said. In fact, the Fed seemed to go to the other extreme. “One of the things the Fed is really adamant about is that it does not follow the financial markets. Fed governors will say that they do not care about financial markets.”

That reluctance to acknowledge the importance of financial stability was evident also during the Silicon Valley Bank collapse in March 2023, Gomes said. “The Fed was in denial about the SVB crisis; it was a denial by omission. Of all the things they listed they were doing, there was just zero comment on this. The issue of financial stability is not addressed at all in the discussions.”

Tracking Financial Instability

Is financial stability a concern now? Gomes pointed out that the biggest drop in bank lending occurred in the last two weeks of March 2023, but added that it doesn’t necessarily warrant a panic. He noted that while credit standards at banks haven’t moved much after the SVB collapse, banks have reported to the Fed that those standards have gotten tougher since last November.

Policymakers are “definitely watching” the emerging situation in the financial markets, Gomes noted. He also cited Treasury Secretary Janet Yellen’s comments at a press conference on April 11 ahead of the spring meetings of the World Bank and the International Monetary Fund: “I’ve not really seen evidence at this stage suggesting a contraction in credit, although that is a possibility.”

According to Gomes, who will also be speaking at the inaugural Wharton Global Allocators Summit about the effects of rising interest rates and inflation, the prevailing environment does give reason for policymakers to pause. “We have created a lot of stress to the financial sector,” he said, referring to the sharp increases in interest rates over the past year. “Pausing on interest rates to see how these interest rate hikes have worked is the right thing to do.” He pointed out that while corporate debt defaults are an important indicator of stress, a slowdown in bank lending is an early warning sign of trouble ahead. “If banks become nervous about advancing more loans because they are concerned about their survival, that alone will slow down the economy.”

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