Prudential policy tightening – whether ahead of or during monetary policy tightening – helps to reduce the likelihood of financial stress.
Since mid–2021, central banks have rapidly tightened monetary policy against the backdrop of historically high debt levels and a strong increase in inflation. Experience over the past five decades reveals that, under broadly similar circumstances, monetary policy tightening could usher in financial stress. We find that prudential policy tightening, whether before or during monetary tightening, helps to avoid such stress. Tighter prudential policy therefore reduces the risk of financial dominance and provides central banks with more policy headroom to fight inflation. 1
Since mid–2021, central banks have rapidly tightened monetary policy against the backdrop of multi–decade high debt levels and strong inflationary pressures (Graph 1). This has raised questions about the possible impact on financial stability. So far, the financial system has proved resilient, but existing vulnerabilities could constrain central banks' fight against inflation – so–called financial dominance.
We examine whether prudential policy can increase monetary policy's room for manoeuvre. Based on five decades of data for advanced and emerging market economies, we explore the conditions under which monetary tightening may usher in stress and whether prudential tightening reduces the likelihood of such an outcome. We contribute to the literature by analysing prudential tightening specifically in the context of monetary tightening episodes and by considering various indicators of stress.2
We find that prudential policy tightening helps to prevent financial dominance. Such measures are especially helpful when monetary tightening takes place against the background of strong inflationary pressures, which would induce a more intense tightening, or higher private debt. These are also two key features of today's macro–financial backdrop.
Key takeaways
- Monetary policy tightening is more likely to usher in financial stress down the road when rate hikes occur amid high private debt levels or strong inflationary pressures.
- Prudential policy tightening – whether ahead of or during a monetary tightening – helps to reduce the likelihood of financial stress.
- This provides central banks with more room for manoeuvre in their fight against inflation – it reduces "financial dominance".
The remainder of this special feature proceeds as follows. The first section identifies past monetary tightening episodes. It also analyses the odds of financial stress during such episodes and whether these odds are higher when the macroeconomic environment is comparable with the current one (Graph 1). The second section analyses the impact of prudential measures on the odds of financial stress, with a focus on whether their impact varies if they are taken before or during monetary tightening. The final section draws the policy implications.
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