The reaction function channel of monetary policy and the financial cycle
Résumé
This paper examines whether monetary policy reaction function matters for financial stability. We measure how responsive
the Federal Reserve’s policy appears to be to imbalances in the equity, housing and credit markets. We find that changes
in these policy sensitivities predict the later development of financial imbalances. When monetary policy appears to respond
more countercyclically to market overheating, imbalances tend to decline over time. This effect is distinct from that of current
and anticipated interest rate levels – the risk-taking channel. The evidence highlights the importance of a “policy reaction
function” channel of monetary policy in shaping the financial cycle.
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