Monetary policy and financial stability: Evidence from a new macroeconomic environment

This research investigates the impact of a tighter monetary policy on financial stability within a novel macroeconomic environment, with a particular focus on the banking sector. The study uses a Vector Autoregressive (VAR) model to analyze the dynamic and contemporaneous relationships among various economic variables, incorporating time series data up to January 2024. The research is contextualized within the post-pandemic economic landscape, where significant monetary interventions by the Federal Reserve were necessitated by pandemic-induced economic disruptions. These interventions included lowering the federal funds rate and purchasing large quantities of government and mortgage-backed securities, which injected substantial liquidity into the economy. However, the pandemic also altered consumer spending patterns, leading to supply-demand mismatches and a subsequent inflation surge. This paper shows that, despite the unprecedented economic conditions, conventional monetary policy tools, specifically changes in the federal funds rate, remain effective in cooling inflation. The results indicate that, while inflation rates decrease following a contractionary monetary policy shock, the labor market is unresponsive to the Fed’s tightening as the unemployment rate decreases. The contractionary shock also leads to increased financial market risk and volatility, tighter credit conditions, and reduced stock returns. Furthermore, the banking sector experiences a decrease in loan volumes and an increase in non-performing loans. Banks’ balance sheets are adversely affected, with declines in the capital adequacy ratio, liquidity ratio, and tier 1 leverage ratio. Our research highlights the importance of considering the economic context when assessing monetary policy effectiveness and its implications for financial stability. • The study examines the relationship between monetary policy and financial stability in the US post-pandemic cycle, characterized by high inflation, tight labor markets, significant fiscal spending, and global supply shortages. • Contractionary monetary policy reduces inflation, but the labor market remains resilient. • Monetary tightening raises financial market risk, volatility, tighter credit conditions, and reduces stock returns. • Tighter monetary policy negatively impacts bank capital requirements and the lending channel. • Results confirm the persistent efficacy of traditional monetary tools, specifically changes in the federal funds rate, even in an unprecedented macroeconomic environment.