Discussion Paper Series 2014-E-13

Monetary Policy, Financial Conditions, and Financial Stability

Tobias Adrian, Nellie Liang

In the conduct of monetary policy, there exists a risk-return tradeoff between financial conditions and financial stability, which complements the traditional inflation-real activity tradeoff of monetary policy. The tradeoff exists even if monetary policy does not target financial stability considerations independently of its inflation and real activity goals, as the buildup of financial vulnerabilities from persistent accommodative monetary policy when the economy is close to potential increases risks to future financial stability. We review monetary policy transmission channels and financial frictions that give rise to this tradeoff between financial conditions and financial stability, within a monitoring program across asset markets, banking firms, shadow banking, and the nonfinancial sector. We focus on vulnerabilities that affect monetary policies’ risk- return tradeoff including (i) pricing of risk, (ii) leverage, (iii) maturity and liquidity mismatch, and (iv) interconnectedness and complexity. We also discuss the extent to which structural and time-varying macroprudential policies can counteract the buildup of vulnerabilities, thus mitigating monetary policy’s risk-return tradeoff.

Keywords: risk taking channel of monetary policy; monetary policy transmission; monetary policy rules; financial stability; financial conditions; macroprudential policy

Views expressed in the paper are those of the authors and do not necessarily reflect those of the Bank of Japan or Institute for Monetary and Economic Studies.

Copyright © 2014 Bank of Japan All Rights Reserved.

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