The Policy Window: The Impact of Financial Stress in the UK

Ahmad Hassan Ahmad, Christopher Martin and Costas Milas

No 17/14, Department of Economics Working Papers from University of Bath, Department of Economics

Abstract: We investigate the impact of financial stress on output, inflation and monetary policy in the UK since 1992 using a nonlinear Bayesian VAR model that distinguishes between regimes of low- and high-financial stress. We find that (a) the UK was in the high-stress regime during the financial crises of 1998–2001 and 2007–2012 but was in the low-stress regime in the rest of the “great moderation” period; (b) positive shocks to financial stress in the high-stress regime lead to sharp and sustained falls in the output gap, inflation and the policy rate; (c) financial stress shocks have little impact in the low-stress regime; (d) the impact of other macroeconomic shocks is stronger in periods of high financial stress; (e) increased financial stress reduced inflation and the output gap by up to 2 percentage points in 2008–2010; (f) financial stress can be monitored against the estimated threshold beyond which it has adverse effects; (g) there is a “policy window” of at least 4 months in which policymakers can respond to increased financial stress before it affects the wider economy.

Date: 2014
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