Report

Monetary policy, financial conditions, and financial stability

Abstract: We review a growing literature that incorporates endogenous risk premiums and risk taking in the conduct of monetary policy. Accommodative policy can create an intertemporal trade-off between improving current financial conditions and increasing future financial vulnerabilities. In the United States, structural and cyclical macroprudential tools to reduce vulnerabilities at banks are being implemented, but they may not be sufficient because activities can migrate and there are limited tools for nonbank intermediaries and for borrowers. While monetary policy itself can influence vulnerabilities, its efficacy as a tool will depend on the costs of tighter policy on activity and inflation. We highlight that adding a risk-taking channel to traditional transmission channels could significantly alter a cost-benefit calculation for using monetary policy, and that considering risks to financial stability?as downside risks to employment?is consistent with the dual mandate..

Keywords: risk-taking channel of monetary policy; monetary policy transmission; monetary policy rules; financial stability; financial conditions; macroprudential policy; leaning against the wind;

JEL Classification: E52; G01; G28;

Bibliographic Information

Provider: Federal Reserve Bank of New York

Part of Series: Staff Reports

Publication Date: 2016-07-01

Number: 690