Financial cycles, characterized by long-term fluctuations in credit and house prices, have profound implications for macro-financial stability. This study explores how systematic monetary policy can shape these cycles, offering insights into its potential to mitigate financial instability. Using U.S. data, we demonstrate that monetary policy can dampen financial cycles, particularly by counteracting house price movements, and show that such an approach could have significantly reduced the volatility of the U.S. housing market during the 2000s. As central banks increasingly incorporate financial stability into their mandates, this research provides a valuable framework for understanding the interplay between monetary policy and financial cycles.

The concept of the financial cycle has gained prominence since the 2008 financial crisis. Unlike traditional business cycles, which involve concurrent fluctuations in macroeconomic aggregates lasting approximately 1.5 to 8 years, financial cycles are defined by synchronized fluctuations in credit aggregates and asset prices, particularly house prices, spanning around 8 to 20 years. These cycles are critical for central banks as they are important for macroeconomic stability and guide financial regulation. Despite their significance, the interaction between monetary policy and financial cycles has not been sufficiently explored. This paper seeks to address this gap by investigating the primary drivers of financial cycles and examining the extent to which monetary policy influences and interacts with these cycles.

A data-driven approach to understanding financial cycles

The paper employs a vector autoregressive (VAR) model to analyze US data from 1969 to 2019. This model identifies the primary “innovation” or shock driving the co-movement of credit and house prices at medium frequencies (8 – 20 years). The study finds that financial-cycle innovations account for 60 % of the variation in credit growth and 86 % of the variation in house price growth at medium frequencies. 

By isolating this financial-cycle innovation, the study examines its propagation through the economy. An expansionary financial-cycle innovation leads to increases in credit, house prices, output, and inflation, while the short-term interest rate decreases. Although the effects on the real economy are similar in magnitude to those of an expansionary monetary policy shock, financial variables respond much more strongly to the financial-cycle innovation.

Through counterfactual scenarios, the study demonstrates that optimal monetary policies targeting house prices or credit gaps have the potential to significantly stabilize financial variables. For example, a “leaning against the wind” policy – designed to counteract house price movements – could reduce house price volatility by 20 %, while also contributing to the stabilization of inflation and output. These findings underscore the potential for monetary policy to play a proactive role in mitigating financial instability.

Lessons from the 2000s housing boom and bust

The paper revisits the US housing boom of the early 2000s, a period that was marked by rapid increases in house prices and credit, followed by a severe financial crisis. We argue that systematic monetary policy could have mitigated this boom-bust cycle. For example, under a counterfactual policy that targeted house prices, real house prices would have risen by 20 percentage points less during the boom and fallen by only 18 % during the crisis, compared to the observed decline of 33 %. However, this stabilization would have come at the cost of slightly lower output and inflation during the boom years.

These findings suggest that monetary policy played a role in amplifying the housing boom by maintaining low interest rates for too long. A more proactive approach, incorporating house price developments into policy decisions, could have reduced the economy's vulnerability to financial shocks.

Conclusion

This study underscores the critical role of monetary policy in shaping financial cycles. By systematically responding to house price movements or credit gaps, central banks can reduce financial volatility and enhance economic stability. The findings have significant implications for policymakers, particularly considering the lessons from the 2008 financial crisis. By demonstrating that monetary policy can shape financial cycles, the paper contributes to the ongoing debate about the coordination of monetary and macroprudential policies.