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Introduction

"So, of course, monetary policy does, famously, work with long and variable lags. The way I think of it is, our policy decisions affect financial conditions immediately. In fact, financial conditions have usually been affected well before we actually announce our decisions. Then, changes in financial conditions begin to affect economic activity ... within a few months." -Chair Powell's Press Conference, 21 September 2022

Monetary policy operates by changing financial conditions, which then transmit to the real economy with long lags. Since central banks reach the economy through financial markets, understanding their policy decisions and the macroeconomic consequences necessitates a framework in which central banks closely interact with markets to achieve their objectives. In this article we review our recent work that illuminates the relationships between monetary policy, financial markets, and business cycles.

A Dual-Absorption Problem

Our analysis starts by emphasising the dual-absorption problem faced by central banks, as depicted in Figure 1. The top row indicates the goods-absorption problem highlighted in macroeconomics, while the bottom row indicates the risk-absorption problem emphasised in finance. Aggregate asset prices (financial conditions) provide a bridge for spillovers across the two rows. Asset prices are primarily determined in risk markets but have a significant impact on aggregate demand. An increase in stock and house prices raises consumer wealth and spending, while higher bond prices (lower interest rates) decrease the cost of capital and boost investment and expenditure on durable goods. Moreover, a currency depreciation stimulates domestic demand through expenditure switching effects and increases the price of imported goods.

In our model, as in practice, the central bank steers aggregate demand by influencing aggregate asset prices, through both conventional and unconventional policies. Therefore, even though the central banks’ objectives are stated in terms of the goods-absorption problem (to close the output gap and stabilise inflation), its tools operate via the riskabsorption channel. Thus, our framework is useful for understanding both why and how central banks affect asset prices, and why markets closely monitor the central banks’ potential actions. Additionally, our framework helps to explain the interactions between the two absorption problems, specifically how changes in asset prices can induce or exacerbate macroeconomic fluctuations.

Risk-Premium Shocks and Speculation

In Caballero and Simsek (2020, 2019), we outlined the broad framework and focused on how financial market risk-offs and speculation could contaminate the real economy when the central bank is constrained by an effective lower bound (ELB). To illustrate the key mechanisms in our model, consider the Global Financial Crisis (GFC), which followed a period of high asset prices. Suppose asset valuations decline, perhaps because investors recognise the risks that they previously overlooked and demand a greater risk premium. The macroeconomic impact of this shock depends on the central bank’s response. If the central bank is unconstrained, it cuts the interest rate enough to stabilise asset prices, which in turn stabilises aggregate demand and protects the economy from the risk premium shock. However, if the central bank is constrained, such as by an ELB, the risk premium shock decreases asset prices, which leads to a reduction in aggregate demand and exacerbates the recession. Additionally, financial speculation during the boom phase amplifies these effects. In boom years, optimists tend to overexpose themselves to aggregate risks. When the bust arrives, optimists lose a disproportionate share of their wealth, and financial markets become dominated by pessimists. This compositional change further lowers asset prices and aggregate demand beyond the initial risk premium shock. In this context, implementing macroprudential policies that restrict speculation in boom years can mitigate the asset price declines during recessions and improve macroeconomic stability. Our analysis suggests that the housing market speculation leading up to the GFC, combined with the lack of appropriate macroprudential policies, exacerbated the recession.

Although the focus of these papers was on the constraint imposed by an ELB, their implications can be extended to other types of constraints on monetary policy. For example, the central bank might also be constrained by a managed floating (or fixed) exchange rate regime as well as financial stability concerns.

Financial Market Interventions

The COVID-19 shock primarily affected the real economy (the top row of Figure 1), with the virus and subsequent lockdowns causing significant declines in both aggregate demand and supply. However, the shock also had a significant impact on financial markets (the bottom row of Figure 1), with financial distress indicators spiking and reaching levels not seen since the GFC. Equally dramatic was the fast reversal of financial distress following the Federal Reserve’s announcement of unprecedented financial market interventions (as demonstrated in Chart 1).

To explain this episode, in Caballero and Simsek (2021a) we extend our framework to incorporate the pervasive heterogeneity in risk tolerance that we see in financial markets: we split investors into risk-tolerant agents (“banks’’) and risk-intolerant agents (“households”). In this environment, the “banks” naturally take on leverage and are more exposed to an aggregate shock. Thus, a sudden and large real shock such as COVID-19 disproportionately hits the “banks”. As these agents scramble to unload assets, the market’s effective risk tolerance falls. With a central bank constrained by the ELB, the initial decline in risk tolerance triggers a downward spiral in asset prices and risk tolerance. The decline in asset prices reduces aggregate demand and exacerbates the recession induced by the COVID-19 shock. In this context, a central bank’s purchase of risky assets is an extremely powerful tool, since it reverses the downward spiral and mitigates the recession. Our results suggest that the Federal Reserve’s aggressive interventions early in the recession prevented a financial crisis and set the stage for the rapid recovery that followed.

More broadly, our work highlights two key points. First, balance sheet shocks that severely impair the financial system's risk-absorption capacity warrant central bank riskabsorption interventions, even if the central bank's primary focus is aggregate demand management rather than financial stability. Second, the goal of monetary policy is to promote healthy absorption of the risk supply while maintaining asset prices at levels suitable for aggregate demand management. The central bank can use traditional interest rate policies or unconventional methods to influence the risk absorption. The selection of policy is less crucial and depends on the circumstances that the policymakers face at the time of the intervention.