ECB models trade-offs between price and financial stability
A new European Central Bank discussion paper documents the models used to analyze the interactions and trade-offs between price and financial stability. It describes a conceptual framework and quantitative tools, including time series, balance sheet, credit risk, and DSGE models.
When stability goals collide
The paper outlines a conceptual framework for understanding short- and medium-term trade-offs between price and financial stability.
Short-term trade-offs arise when high inflationary pressure coincides with financial system stress, creating a conflict for monetary policy.
Medium-term trade-offs occur when low inflation requires looser monetary policy, potentially fostering excessive risk-taking and leverage.
While macroprudential tools are the primary defense, their limitations (e.g., non-bank spillovers, 'irrational exuberance') mean monetary policy must still consider financial stability side effects.
This integration reflects the ECB's 2021 Monetary Policy Strategy Review, which explicitly incorporated financial stability into its framework, emphasizing interdependence between economic and monetary-financial analysis.
The analytical toolkit
To quantify these trade-offs, the paper documents four main sets of models currently in use at the ECB.
These include time series models, which analyze dynamic relationships over time; balance sheet models, focusing on financial institutions' assets and liabilities; credit risk models, assessing default probabilities; and Dynamic Stochastic General Equilibrium (DSGE) models, which incorporate banking and financial frictions to simulate broader economic impacts.
These tools support the in-depth assessment of monetary policy and financial stability interactions, conducted regularly and considered at Governing Council meetings.
Ongoing efforts aim to expand this analytical toolkit further.
A necessary evolution
This paper highlights the ECB's proactive approach to integrating financial stability into its monetary policy framework, moving beyond a sole reliance on macroprudential tools.
The explicit documentation of quantitative models provides transparency and a robust foundation for navigating complex trade-offs.
This formal adoption underscores a critical shift towards a more holistic central bank policy in an increasingly interconnected financial landscape.