Monetary Policy and the Financial Cycle: International Evidence

We evaluate to what extent inflation-targeting central banks appear to have used their interest rate policies to respond to financial imbalances beyond the reaction via the conventional Taylor-rule variables. First, we use the multivariate structural time series model to extract financial cycles for Australia, Canada, Japan, New Zealand, Sweden, the United Kingdom, and the United States. We then estimate time-varying monetary policy reaction functions extended for the financial cycle. We interpret the responses to the financial cycle as attempts to lean against the wind of financial imbalances. The historical decompositions of interest rates reveal that most central banks raised interest rates in response to asset prices and credit booms in the past, including in the years preceding the global financial crisis. The interest rate response to financial cycles is more pronounced with ex-post than with pseudo real-time data. Finally, we document that the financial crisis of 2008 had less of an impact on credit and real housing prices in countries where the interest rate responses to financial cycles were accompanied by macroprudential measures.