With year-on-year inflation rates reaching 10% in 2022, central banks in Europe and the United States started raising monetary policy rates to ensure price stability. The failure of Silicon Valley Bank (SVB) on March 10, 2023, however, laid bare the financial stability risks from hiking interest rates after a prolonged period of rate cuts. For example, the build-up of bank assets in a low interest rate environment may quickly expose banks to revaluation and liquidity risks once the interest rate cycle turns. The large duration risk exposure of SVB, and its reliance on uninsured deposits made it especially vulnerable to such risks, paving the way for its eventual demise. But new research suggests that SVB’s failure is far from a historical exception.

In BSE Working Paper Nº 1378, “Monetary policy, inflation, and crises: New evidence from history and administrative data,” Gabriel Jiménez, Dmitry Kuvshinov, José-Luis Peydró, and Björn Richter study the relationship between monetary policy rates and crisis risk, taking a long-run perspective. Their findings suggest, looking beyond individual rate hikes and cuts, that it is the full path of monetary policy that plays a key role. They show that most of the major banking crises in modern economic history have been preceded by a pronounced U-shape in monetary policy rates, and that rate hikes only materially increase crisis risk if rates were previously cut over a long time period.

Most major banking crises were preceded by U-shaped monetary policy

A U-Shaped monetary policy path is characterized by central banks first cutting policy rates, with the rate remaining low for some time before a series of hikes. Figure 1 shows the path of policy rates around some of the world’s major crises, including the Great Depression in the 1930s and the Global Financial crisis in 2007-2008. Even though the reasons for the rate cuts and hikes were different, all these crises were preceded by a U-shaped path of monetary policy. The authors show that this pattern is much more general by analyzing 17 countries over 150 years coving many crises and monetary policy cycles.

First, they show that historical banking crises are, on average, preceded by U-shaped monetary policy. Figure 2 plots the average path of monetary policy interest rates around 72 historical banking crisis episodes. The rates follow a U shape, with four years of cuts 7 to 3 years before the crisis followed by a series of rate hikes in the run-up to the crisis onset. This U shape holds across different crisis definitions and becomes stronger after World War 2. Furthermore, the authors do not find similarly consistent patterns for the pre-crisis paths of inflation, real interest rates, long-term rates, and a different pattern (increase but no U) for non-financial recessions. This means that this U-shaped path is specific to monetary policy rates, and to banking crisis episodes.

Then, the authors show that the frequency of banking crises over the following 3 years rises from an unconditional 10% to 20% when monetary policy rates follow a U shape over the previous 8 years (a rate cut from t-8 to t-3 followed by a raise from t-3 to t). In the 150-year sample of advanced economies, the majority of banking crises, and all severe banking crises after 1945, were preceded by U-shaped monetary policy. The authors further show, in a regression framework using raw and instrumented changes in monetary policy rates (with the instrument relying on the trilemma of international finance), that monetary policy rate hikes are associated with a material increase in crisis risk, but only if rates were previously cut over a long time period.

Credit and asset prices play an important role in the mechanism

To explain the mechanism behind the phenomenon, the authors investigate the relationship between U-shaped monetary policy paths, and credit and asset price cycles. For this, they use the Greenwood et al (2022) definition of a financial “red zone”, which is a situation when either the household or the business sector experiences large growth in both credit and asset prices. Previous research has shown that being in the red zone substantially increases crisis risk. In this paper, the authors show that the conduct of monetary policy plays a key role for an economy entering the red zone, and for the red zone transitioning into a crisis. They show that cutting rates during the initial phase of the U increases the probability of ending up in the red zone, and raising rates once in the red zone materially increases crisis risk. Similar patterns hold when the authors look at the impact of monetary policy cycles on credit and asset prices directly: cutting rates increases financial vulnerabilities, and raising rates after cuts materializes them.

In addition to the long-run cross-country data, the authors examine Spanish administrative data which contain detailed information on individual loans granted by banks, saving banks, and credit cooperatives in Spain after 1995. These financial institutions account for more than 95% of bank debt in the Spanish financial system. After controlling for individual bank and loan characteristics and a range of other unobserved and observed factors, the authors find that U-shaped monetary policy substantially increases the probability of default at the level of the individual loan. Importantly, these effects are much larger for loans to riskier firms, and loans extended by weaker banks, pointing to important heterogeneities in the transmission mechanism from monetary policy rate dynamics to banking system distress.

Credit booms should be deflated before the economy reaches the red zone

Both long-run and administrative data demonstrate that when the policy rate has been low for some time, the financial sector becomes more vulnerable to the reversal in the monetary policy cycle. A large part of this vulnerability stems from the increases in credit and asset prices that generally take place when monetary policy is loosened over a long time period. One way to reverse these vulnerabilities, often put forward in previous research, is for the central bank to “lean against the wind” and raise interest rates to deflate the credit and asset price booms. However, the authors’ results suggest that when monetary policy rates had been low for some time, allowing the vulnerabilities to build up, these actions could be counterproductive. Once in the red zone, rate hikes substantially increase, rather than reduce, crisis risk. Instead, deflating credit and asset price booms early, before the economy enters the red zone, appears more appropriate.

Sources

• Figure 1: Jiménez et al (2022). The level of the monetary policy interest rate around past important banking crises. Crisis dates are from Reinhart and Rogoff (2008).
  
• Figure 2: Jiménez et al (2022), data for 17 countries 1870-2020, average of 72 historical crisis episodes (24 post World War 2), from 7 years before to 7 years after the crisis. JST crisis dates are from Jordá et al (2016), and BVX crisis dates are from Baron et al (2021). Deep crises are those accompanied by low GDP growth.