Monetary policy and financial stability: empirical evidence from Central and Eastern European countries

The international financial and economic crisis highlights that central banks should go beyond their traditional emphasis on low inflation to adopt an explicit goal of financial stability. Our paper addresses this highly topical issue of macro-prudential framework with the focus on effectiveness of monetary policy in affecting some financial stability indicators, in the experience of several Central and Eastern European countries during 2003M01-2012M06. Using a Structural Vector Autoregressive model and impulse response function, we analyze the impact of short-term interest rates upon industrial production, loan to deposit ratio for the banking system, stock prices and exchange rate (proxy variables for financial stability). We want to test if the interest rate is conducive to financial stability. Our empirical results show that the effectiveness of the short-term interest rate in affecting selected asset prices depends on monetary policy strategy. In the case of the Czech Republic, Hungary, Poland and Romania, the interest rate instrument used for inflation targeting is conducive to financial stability. Among countries with a fixed exchange rate regime, only in Bulgaria does transmission of the foreign interest rate impulse to domestic variables promote financial stability. Additionally, our results show that in Latvia and Lithuania adjustments to the monetary policy of the European Central Bank (ECB) are not in accordance with country-specific conditions. The paper contributes to a policy debate on the design of macro-prudential polices in the aftermath of the boom-bust cycle experienced by the Central and Eastern European countries in the second half of the last decade.