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Does Financial Stability Matter to the Fed in Setting US Monetary Policy?

Mikhail Oet () and Kalle Lyytinen

Review of Finance, 2017, vol. 21, issue 1, 389-432

Abstract: The Taylor rule presents a traditional approach to guiding and evaluating contemporary monetary policy as a function of inflation and economic slack. While the responsibilities of the Federal Reserve (Fed) include price stability and long-run growth, its mission has grown to include financial stability. Surprisingly, the question of whether financial stability ought to be considered as an element of monetary policy is hotly contested. This study aims to determine whether policymakers’ discussions of financial stability and other factors systematically explain deviations of observed policy rates from the rates implied by the Taylor rule. To this end, we conduct content analysis of the Fed’s monetary policy discussions to discover actual topics that enter into policy. We offer two main findings: First, discussion themes extracted from released Federal Open Market Committee meeting minutes provide explanatory power beyond standard Taylor rule variables. Second, additional explanatory power is provided by a tri-mandate policy rule that accounts for changes in the economic and financial system as moderated by the evolving preferences of the policymakers. We show that a discussion-based thematic model with financial stability dominates Taylor-type rules during normal times. Moreover, the tri-mandate policy model with financial stability dominates Taylor-type rules in zero lower bound conditions. Taken together, these findings reveal that financial stability has mattered to the Fed continuously and remains critical in setting monetary policy in zero lower bound.

Keywords: Financial stability; Monetary policy; FOMC discussions; Taylor rule; Tri-mandate; Content analysis (search for similar items in EconPapers)
JEL-codes: D78 E44 E52 E58 E63 G14 (search for similar items in EconPapers)
Date: 2017
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Handle: RePEc:oup:revfin:v:21:y:2017:i:1:p:389-432.