When Monetary Policy for Financial Stability Backfires: Communication with Strategic Banks

Abstract

We propose a model to study the consequences of incorporating financial stability into the central bank’s objectives when banks are strategic and policy surprises compromise their stability. In this setup, central banks underreact to economic shocks, consistent with the Federal Reserve’s behavior during the 2023 banking crisis. Moreover, policymakers’ financial stability concerns distort banks’ portfolio choices, inducing inefficiency. When the central bank has private information about its policy intentions, forward guidance entails an information loss, highlighting a trade-off between stabilizing markets through policy and communication. A central banker less concerned with financial stability reduces these inefficiencies. Finally, with repeated interactions, the central bank might leverage communication to discipline markets fully.