This chapter explores interactions of monetary policy, price stability, and financial stability for a developing country. A new, parsimonious index of financial instability is introduced and the dates of financial stress in Pakistan are documented. The dynamic interactions are investigated via impulse responses (IRs) using the local projections. Building on an augmented Taylor rule, the authors segregate the IRs across business cycle. The authors find that the monetary policy (MP) shocks generate asymmetric responses: more effective during recessions than expansions. The impulses in MP dampen inflation and output during recessions while the financial stress increases, calling for a cautious policy approach to avoid trade-offs between twin objectives of price and financial stability. The MP tightens and the output falls in the event of a financial instability shock with no significant impact on inflation. The trade-off between two objectives during downturns is also manifest here. Finally, MP responds forcefully to inflationary shocks during expansions, but at the cost of worsening financial conditions.
Top1. Introduction
The price stability has been a mandate and focus of the central banks since late 1970’s. However, the onset of global financial crises (GFC) of 2008 re-oriented focus to the stability of financial sector alongside the objective of price stability. Macro-prudential policy interventions, which aim to build buffers of the financial system to withstand systemic shocks, gained currency to ensure stability of the sector. Post GFC, the twin objectives of maintaining price and financial stability were being smoothly achieved in a low interest rates and low and stable price environment until it was challenged recently. More specifically, the recent spate of global inflationary pressures in the wake of supply shocks due to COVID-19, accentuated further by the war in Ukraine, prompted central banks around the world to resort to a tighter monetary policy stance. An untoward consequence of this tightening was a spell of financial instability in early 2023 in major advanced economy, which led to collapse of some financial institutions (e.g., Silicon Valley Bank, Signature Bank etc.) (FSB, 2023). This has renewed the calls for a re-assessment of interaction between monetary policy and financial stability and whether any coordinated efforts are needed to tackle the issues.
The literature has mainly focused on the developed economies to test and contest the trade-off between price and financial stability. Few studies focus on a developing country like Pakistan. This chapter, therefore, aims to contribute to this trade-off literature for Pakistan. We try to assess whether there is any nexus between the twin goals of the central bank.
Historically, the financial crises of the early 1990s prompted many central banks to focus on financial stability. Many indeed were mandated to ensure the stability of the financial system (Cihák, 2006). Ensuring financial stability essentially involves assessing the systemic risks to the financial sector, pinning down the threats to its stability and proposing policy actions. In a sense, this became one of the twin objectives alongside monetary stability, i.e., price level stability. This is obvious from such publications as financial stability reviews (FSRs) by many central banks around the world (Oosterloo et al., 2007) and the focus, encouragement and guidelines by IMF, ECB and BIS (e.g., Basel Capital Accord for banks) in this area. Indeed, since March 2002, the IMF carries out assessment of global financial markets in its semi-annual Global Financial Stability Report (GFSR). This additional responsibility for the central bank comes because of the increased frequency of financial distresses, high costs associated with the instability (Kaminsky and Reinhart, 1999; Bordo et al., 2002), innovation, growth and the complexity of the new financial instruments and global integration of the financial system (Kaufman, 1986; Borio, 2006).
Similarly, the high inflation of the late 1970’s shifted the focus of major central banks towards bringing price levels down when they adopted ‘inflation targeting’ implicitly.1 That proved to be a success and inflation was substantially brought down by the mid-1980’s. This achievement was in major part due to the fact that concept and target i.e., the inflation, was studied and researched over a long period of time. Although not the same for all yet pretty much well defined: keep the growth rate of an index such as CPI, RPI, HICP etc. upto a particular threshold or within a range (see Issing, 2003; Allen and Wood, 2006; Frank et al., 2007, p-459). However, when it comes to defining the very concept of financial stability, there is no consensus among the scholars (both academics as well as practitioners). It has been defined from as simple, but insightful, as an ‘absence of instability’ (Crockett, 1996) to a ‘situation where the financial system is capable of allocating resources efficiently and is able to absorb the shocks’ (Houben et al., 2004).