07 June 2023

SUERF - ECB's Schnabel: Monetary and financial stability – can they be separated?

A fundamentally sound, well-regulated financial sector protects central banks from any form of financial dominance. Governments and supervisors are therefore essential to enable monetary policymakers to focus on their primary mandate of price stability.

Since central banks around the world started their sharp hiking cycles, there have been repeated episodes of financial distress in different regions of the globe. This raises the question of what the risk of financial instability implies for monetary policy at a time when stubbornly high inflation suggests a need for further tightening. Using examples of recent history, this note argues that even in high-inflation periods, separation between monetary and financial stability considerations can be ensured if financial disturbances are caused by market dysfunction and liquidity issues rather than solvency concerns. 

Over the past years, we have seen a fundamental change in the macroeconomic environment.1 After years of low inflation and low interest rates, inflation has come back with a vengeance, reaching double-digit rates in some countries.

After some initial hesitation, central banks around the world have responded forcefully to the inflationary threat, leading to a rapid and broadly synchronised tightening of monetary policy across advanced and emerging economies (Figure 1, left-hand side). In the euro area, too, the pace of rate hikes has been unprecedented (Figure 1, right-hand side).

Figure 1: Synchronised tightening across economies amid unprecedented pace of rate hikes

This rapid change has caught many by surprise. In December 2021, market participants still expected policy rates to remain in negative territory until the end of 2024, virtually unchanged relative to the end of 2019 (Figure 2). The unexpected sharp rise in interest rates has exposed fragilities in the financial system that had built up over the long period of low interest rates, adding to the uncertainty caused by the pandemic and Russia’s war of aggression against Ukraine.

Figure 2: Rapid hiking cycle has caught market participants by surprise

The rise in financial stress is visible in the ECB’s composite indicator of systemic stress (CISS), which started to soar in tandem with long-term interest rates (Figure 3, left-hand side). Implied volatility in the bond market also rose well above its longer-term average, driven to a large extent by uncertainty about future monetary policy, while implied volatility in stock markets remained contained (Figure 3, right-hand side).

Figure 3: Rise in financial stress amid heightened bond market volatility

Since the start of the unexpected sharp hiking cycle, we have witnessed repeated episodes of financial distress in different parts of the world.

Many of them are in one way or another related to the quickly changing interest rate environment.2 Historically, global interest rate hiking cycles often coincided with bank or other financial distress (Figure 4).3

Figure 4: Historical global hiking cycles have often coincided with financial distress

For central banks, this raises the question of what the risk of financial instability implies for their policy choices at a time when inflation, and underlying inflation in particular, remains stubbornly high, suggesting the need for further policy tightening....

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