The Financial Stability Dark Side of Monetary Policy
64 Pages Posted: 23 May 2016 Last revised: 26 May 2016
Date Written: May 25, 2016
Market risk premia play an important role in the transmission of monetary policy. If the transmission were to work asymmetrically for positive and negative shocks, monetary authorities would face a problematic trade-off: a temporary stimulus could boost the economy in the short run, but at the same time sow the seeds of a painful medium-run market reversal (the "financial stability dark side" of monetary policy of Stein, 2014). We study the relation between interest rates, credit spreads and output in the U.S. using monthly data and a range of nonlinear dynamic models. We find clear signs of a reduced form asymmetry, but no evidence in support of the causal mechanism that underpins the 'dark side' argument: spreads rise noticeably ahead of economic slowdowns but they do not appear to cause them directly, particularly if they move in response to monetary shocks. This suggests that the asymmetry is best interpreted as a purely predictive relation, with markets being particularly sensitive to bad economic news; and that it creates no complications for monetary policy or for the exit strategy from monetary accommodation.
Keywords: risk premia; asymmetry; monetary policy; financial stability; local projections
JEL Classification: C32, E32, F34
Suggested Citation: Suggested Citation