The Reaction Function Channel of Monetary Policy and the Financial Cycle
42 Pages Posted: 8 Oct 2019
Date Written: October 2, 2019
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.
Keywords: policy reaction function channel, asset price booms, credit booms, monetary policy, financial cycles, time-varying models
JEL Classification: E50, E52, G00, G01, G12
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