Delving into the nexus: financial stress and asymmetric monetary policy response

During periods of heightened stress, financial stability considerations assume critical importance. However, central banks often exhibit an unsystematic response to financial sector imbalances, leading to asymmetric monetary policy actions. This pattern is particularly relevant for emerging market economies. Our study investigates the dynamics between financial stress and monetary policy response in India by constructing a comprehensive Financial Stress Index (FSI) to capture financial sector fluctuations. Initial analysis using Generalized Method of Moments reveals no significant relationship between financial stress and policy interest rates. We employ a Smooth Transition Regression model to probe further, confirming the central bank’s asymmetric response. Specifically, the central bank tends to delay monetary tightening during the build-up of financial stress, responding only after stress surpasses a critical threshold. Our findings suggest that a more symmetric adjustment of interest rates over the financial cycle could effectively mitigate stress build-up, enabling the central bank to maintain its focus on price stability while reducing post-crisis clean-up costs. The results remain robust across alternative FSI specifications and sub-sample analysis using Markov Switching Regression.