Financial Stability and Monetary Policy

Abstract

We argue that although UK monetary policy can be described using a Taylor rule in 1992- 2007, this rule fails during the recent financial crisis. We interpret this as reflecting a change in policymakers’ preferences to give priority to stabilising the financial system. Developing a model of optimal monetary policy with preference shifts, we show this provides a superior empirical model over crisis and pre-crisis periods. We find no response of interest rates to inflation during the financial crisis, possibly implying that the UK abandoned inflation targeting during the financial crisis.

Full text

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Martin, C. and Milas, C., 2010. Financial Stability and Monetary
Policy. Working Paper. Bath, UK: Department of Economics,
University of Bath, (05/10).
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Financial Stability and Monetary Policy


Christopher Martin and Costas Milas

No. 05/10



BATH ECONOMICS RESEARCH PAPERS



Department of Economics

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Financial Stability and Monetary Policy

Christopher Martin
c.i.martin@bath.ac.uk
Department of Economics,
University of Bath, UK

and

Costas Milas
c.milas@keele.ac.uk
Economics Group,
Keele Management School, UK
and
Rimini Centre for Economic Analysis, Rimini, Italy

May 2010


Abstract
We argue that although UK monetary policy can be described using a Taylor rule in 1992-
2007, this rule fails during the recent financial crisis. We interpret this as reflecting a change
in policymakers’ preferences to give priority to stabilising the financial system. Developing a
model of optimal monetary policy with preference shifts, we show this provides a superior
empirical model over crisis and pre-crisis periods. We find no response of interest rates to
inflation during the financial crisis, possibly implying that the UK abandoned inflation
targeting during the financial crisis.

Keywords: monetary policy, financial crisis
JEL Classification: C51, C52, E52, E58

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1. Introduction
The global economic crisis that began in 2007 has presented a series of severe
challenges to monetary policy. Deep and rapid reductions in output have opened up
an output gap of over 5% in many countries. Profound shocks to the financial
system have disrupted the transmission mechanism linking monetary policy to the
real economy and created fears for the stability of the system. Objections have been
raised to low and stable inflation being the main aim of monetary policy and
dissatisfaction has been expressed with the New Keynesian and DSGE models that
provided the theoretical underpinning for that aim. In this context, it would not be
surprising if the behaviour of policymakers had changed during the crisis.
This paper explores the interest rate setting behaviour of monetary
policymakers in the UK during the financial crisis. We have three main findings.
First, although interest rates can be described using a simple Taylor rule in the
period before the crisis, the Taylor rule breaks down during the crisis. Second,
addition of “spread adjustments” to correct for the widening gap between policy rates
and libor and other unsecured borrowing rates that were a prominent feature of the
crisis does not solve the problem. Third, policymakers appear to cease targeting
inflation during the crisis and focus instead on setting low interest rates in order to
stabilise the financial system.
We develop a series of models of optimal monetary policy which we estimate
on monthly UK data for 1992-2009; our use of monthly data gives us enough
observations to estimate a policy rule in the crisis period. In section 2) we develop a
simple Taylor rule representation of optimal monetary policy. We show that
estimates of this model using a pre-crisis period that ends in early 2007 conform to
expectations with a response to inflation in excess of unity and a strong response to

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the output gap. Estimates that use the full sample that ends in 2010M1 are very
different. Although the crisis period represents only 15% of the sample, the estimate
on inflation becomes insignificant and the point estimate is negative. The response
to output remains significant but is more than halved.
Some writers, most prominently Curdia and Woodford (2009), have suggested
a “spread-adjusted” optimal monetary policy rule in the presence of credit frictions.
In essence this implies policymakers should respond to a widening of the spread
between policy rates and key borrowing rates such as the Libor rates by reducing
policy rates in order that the effective interest rates facing the private sector are
unchanged. This suggests that the rapid cuts in interest rates during the financial
crisis might be in response to widening spreads between policy rates and effective
borrowing rates and that including the determinants of these spreads in a policy rule
would result in an augmented spread-adjusted Taylor rule that provides a coherent
account of policymaking during the crisis. We investigate this hypothesis in section
3) where we estimate a series of policy rules that include measures of financial
market liquidity, the spread between unsecured and secured borrowing rates on
financial markets and an index of financial market stress as plausible determinants of
credit spreads. We find that estimates on these variables are insignificant in the pre-
crisis period but become significant and correctly signed when the crisis period is
added to the sample. However estimates on inflation in the full sample remain
insignificant, the response to output is again much reduced and there are marked
differences between estimated coefficients in pre-crisis and full sample estimates.
This evidence suggests there may have been a change in the behaviour of
policymakers during the financial crisis. To analyse this, in section 4) we develop a
model in which the objectives of policymakers differ between a no-crisis regime,