Monetary Policy, Inflation, and Crises: New Evidence from History and Administrative Data

Abstract

We show that U-shaped monetary policy rate dynamics are strongly associated with financial crisis risk. This finding holds both in long-run cross-country macro data covering many crises and monetary policy cycles, and in detailed micro, administrative data covering the post-1995 period in Spain. In the macro data, we find that pre-crisis monetary policy follows a U shape, with policy rates first cut and then increased over the 7 years before the onset of the crisis. This U shape holds across a wide variety of crisis definitions, short-term rate measures, and becomes stronger after World War 2. Differently, even though inflation and real rates show some of these dynamics before a crisis, these results are much less robust. The patterns are also much weaker when it comes to long-term rates and non-crisis recessions. We show that monetary policy rate hikes (both raw, and instrumented using the trilemma IV of Jordà et al, 2020) increase crisis risk, but, different to previous studies, we show that this effect is driven by rate hikes which were preceded by a series of cuts. To understand why U-shaped monetary policy is linked to crises, we show that the initial loosening of policy is followed by high growth in credit and asset prices, putting the economy into a vulnerable financial "red zone''. After the subsequent monetary tightening these vulnerabilities materialize, leading to larger-than-usual declines in credit, asset prices, and real activity. To dig into the underlying mechanisms, we use administrative data on the universe of bank loans and defaults during the 1990s and 2000s boom-bust cycles in Spain. Consistently, we find that U-shaped monetary policy increases the probability of ex-post loan defaults, but effects are much stronger for ex-ante riskier firms and for banks with weaker balance sheets. Overall, our paper shows that monetary policy dynamics have important implications for financial stability.