## Executive Summary — Navigating Trade-Offs between Price and Financial Stability in Times of High Inflation (sdnea2025003)

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### Key findings and empirical evidence
- Trade-off: Interest rate hikes to fight inflation can weaken financial intermediaries and generate or exacerbate financial stress with adverse effects on output.
- Empirical sample and outcomes:
  - Sample: 170 monetary policy tightening episodes across 36 advanced and emerging market economies between 1971 and 2017.
  - Banking crises: 20 episodes were followed by a banking crisis.
  - Typical crisis onset: 18–24 months after the start of the tightening cycle.
- Recent operational examples of separation using non-rate tools:
  - March–April 2023 US regional bank stress (SVB): the Federal Reserve did not reverse policy rate hikes but introduced the Bank Term Funding Program and the FDIC extended insurance coverage to uninsured depositors of certain institutions.
  - September 2022 UK LDI crisis: the Bank of England undertook temporary gilt purchases and did not lower the monetary policy rate.
- Policy trade-offs are more acute for economies with low central bank credibility, large exchange rate exposures, and limited fiscal space.

### Transmission channels: how tightening raises financial stress
- Valuation channel: Higher policy rates reduce valuation of long-term assets and liabilities through cash-flow and discount-rate effects.
- Profitability and funding channels: Tighter financial conditions raise term and risk premiums and increase costs of servicing, refinancing, or issuing new debt, including deposits.
- Asset-quality channel: Rising rates raise borrower defaults and credit losses.
- Liquidity and runs: Higher rates increase liquidity risk as short-term liability holders shift to higher-yielding instruments; margin calls can rapidly drain intermediaries’ liquidity.
- Amplifiers of stress:
  - High nonfinancial sector debt, loose credit standards, high financial sector leverage, and duration/liquidity mismatches.
  - Systemic importance and interconnectedness of institutions.
  - Low prior rates, sharp or persistent rate increases, and supply-driven inflation episodes.

### Policy response framework and stress scenarios
- Objective: Strive for separation—allow monetary policy to focus on price stability while using non-rate tools to address financial stress—when costs of non-interest-rate tools are low.
- Four qualitative stress scenarios and policy implications:
  - Scenario 1 — No Stress:
    - Financial markets function; separation feasible; interest rates can focus on inflation.
  - Scenario 2 — Modest to Moderate Stress (constrained intermediation):
    - Recalibrate stance (less aggressive tightening); use repos and standing facilities.
    - Deploy targeted liquidity and prudential/resolution tools if credit supply is impaired.
  - Scenario 3 — Heightened Stress (risk of financial panics):
    - Monetary policy should factor financial stability risks and allow more gradual disinflation.
    - Tools: long-term liquidity support, central bank asset purchases, emergency lending, expanded depositor protection, fiscal backstops.
    - Communication: stress temporary nature of rate deviations and reaffirm medium-term commitment to inflation target.
  - Scenario 4 — Full-Fledged Financial Crisis:
    - Broad deployment of liquidity and solvency tools plus fiscal support; interest rate cuts to avoid deflation and ease financial stress.
- Real-time granularity: Accurate, timely measures of financial stress are critical to distinguish scenarios and calibrate responses.

### Central bank tools: principles, design, and key challenges
- Liquidity tools:
  - Lending operations: standing facilities, repos, temporary targeted facilities, emergency liquidity assistance (ELA), bilateral swap lines.
  - Asset purchases in secondary markets to address market liquidity (market-maker-of-last-resort role).
- Principles for deployment:
  - Collateralized lending, transparent eligibility, appropriate pricing to limit moral hazard and protect central bank balance sheet.
  - Time-limited, targeted interventions; require fiscal backstops when solvency risk is material.
  - Prefer market-wide secured lending where feasible; apply haircuts.
  - Distinguish asset purchases for financial-stability aims from price-stability operations; accompany with clear communication.
- Immediate and medium-term costs:
  - Calibration, implementation, and exit difficulty; stigma associated with facility use.
  - Moral hazard and encouragement of excessive risk-taking.
  - Exposure of central bank to financial losses and political pressures.
  - Asset purchases can reduce market liquidity and distort risk premiums; unwinding poses “cliff edge” risks.

### Nonbank financial intermediation (NBFI): specific considerations
- Scale and systemic relevance:
  - NBFI share of global financial assets: about 49 percent at the end of 2023.
  - Diverse entities: insurance companies, pension funds, open-ended funds, private credit, hedge funds, broker-dealers, financial market infrastructures.
- Operational challenges for lending to NBFIs:
  - Heterogeneity, weak or varying prudential frameworks, data gaps, difficulty assessing solvency, higher moral hazard risk.
  - Central banks may need operational readiness, legal frameworks, and adequate collateral definitions to lend safely.
- Jurisdictional developments (examples cited in the source):
  - Legal and facility initiatives to enable emergency liquidity to specific nonbank segments are being introduced or considered in multiple jurisdictions.
- Policy priorities:
  - Close data gaps; enhance monitoring, supervision, and regulation of systemic NBFI segments.
  - Ensure cross-agency and cross-border coordination; pre-position operational frameworks before stress episodes.

### Prudential, resolution, and fiscal frameworks: complementary roles
- Prudential policy:
  - Strong capital and liquidity buffers, macroprudential frameworks, and willingness to use releasable tools reduce the likelihood of needing monetary accommodation.
  - During stress, releasable capital and liquidity requirements can be eased to reduce deleveraging pressures.
- Resolution frameworks:
  - Effective resolution regimes reduce contagion risk and improve trade-offs during tightening.
  - Operationalization gaps remain for systemic and NBFI resolution; public backstops and cross-border arrangements need strengthening.
- Fiscal policy:
  - Fiscal backstops and willingness to provide indemnities are critical when solvency is uncertain.
  - Fiscal space constraints limit scope for government support; interventions create valuation and credit risk and can be sizable (example: Swiss government guarantees during Credit Suisse–UBS transaction about 25 percent of GDP).
  - Principles: use fiscal tools to backstop liquidity provision or avert systemic crises; cost and contingent liabilities should be monitored and published; build fiscal buffers in normal times.

### Special considerations for emerging markets and small open economies
- Amplified trade-offs due to:
  - Low central bank credibility (poorly anchored expectations, limited independence).
  - Large exposures to exchange rate risk (foreign-currency debt on borrower and bank balance sheets).
  - Limited fiscal space (constrains recapitalization and fiscal backstops).
- Policy toolkit adjustments under the Integrated Policy Framework:
  - FXIs (foreign exchange interventions) to counter cyclical depreciation when stress is modest to moderate.
  - MPMs (macroprudential measures) and releasable buffers.
  - CFMs (capital flow management measures), tightening outflow CFMs in crises while recognizing circumvention and reputational costs.
  - Use international liquidity tools and multilateral support (swap lines, IMF) when domestic instruments are constrained.

### Model-based and policy implications
- Stylized two-period New Keynesian model with banks and run mechanics highlights:
  - Rate hikes can weaken banks’ balance sheets, bind leverage constraints, amplify shocks through financial accelerator, and increase run probability.
  - Absent effective non-rate tools, optimal policy calls for less aggressive rate hikes to balance price stabilization and financial-stability preservation.
  - Effective, low-cost liquidity and solvency tools can allow “separation” where interest rate policy focuses on price stability.

### Historical episodes — illustrative evidence and lessons
- Selected historical statistics and responses:
  - Savings and Loan crisis (US, late 1970s–1980s): about 747 S&L banks closed; cost to taxpayers: $124 billion.
  - Continental Illinois (1983–84): federal funds rate increased 3 percentage points; FDIC injected $1.5 billion subordinated debt; banks provided a $5.5 billion line of credit.
  - LTCM (1998): consortium provided $3.6 billion of new equity; Fed eased rates from 5.5 percent to 4.8 percent over late 1998.
  - Global Financial Crisis (2004–08 episode): federal funds rate rose from 1 percent in June 2004 to 5.3 percent in July 2007; subsequent large rate cuts and non-rate interventions followed.
  - 2023 US regional bank crisis: federal funds rate increased by about 450 basis points by early March 2023; policy responses included receivership, expanded deposit guarantees, Bank Term Funding Program (backstopped by US Treasury), and liquidity from Federal Home Loan Banks.
  - Türkiye (2000–01): central bank purchased debt securities to recapitalize insolvent state-owned banks totaling 21 quadrillion Turkish liras (approximately $21 billion); CPI reached 68.5 percent by end-2001.
  - Nordic crises (early 1990s): loan losses rose sharply (examples: Norway 0.7 percent in 1987 to 6 percent in 1991; Finland 0.5 percent in 1989 to 4.7 percent in 1992; Sweden 0.3 percent in 1989 to 7 percent in 1992); fiscal support sizable (Finland 10 percent of GDP; Norway 2.6 percent of GDP; Sweden 5.2 percent of GDP).

### Communication, credibility, and implementation guidance
- Communication strategy:
  - Emphasize temporary nature of any rate-path recalibration and reaffirm medium-term commitment to inflation target to keep expectations anchored.
  - Transparently explain trade-offs, criteria for non-rate tool use, and exit strategies.
- Operational readiness:
  - Pre-establish eligibility, collateral frameworks, and coordination protocols among central bank, supervisory authorities, treasury, and international partners.
  - Design liquidity programs to be self-liquidating where feasible and accompanied by fiscal backstops when solvency risk is material.

### Conclusions and policy priorities
- Separation is feasible when financial-system resilience is strong and non-rate tools are effective and low-cost; otherwise, monetary policy should internalize financial-stability risks and consider a more gradual disinflation path.
- Priority reforms to lower barriers to separation:
  - Strong prudential and supervisory frameworks with adequate capital and liquidity buffers.
  - Robust resolution regimes and well-defined financial safety nets.
  - Sound fiscal positions to provide credible backstops.
  - Enhanced regulatory, supervisory, and data frameworks for NBFIs and operational readiness for targeted liquidity support.
- When preconditions are unmet, central banks should weigh financial stability risks in their policy reaction function, use complementary tools cautiously, and communicate clearly to preserve credibility.

*sdnea2025003 — Executive Summary (Staff Discussion Notes).*

### Executive Summary ......................................................................................................

### Executive Summary

### Key findings
- Central banks may face a trade-off between price and financial stability when they tighten monetary policy to fight inflation; interest rate hikes may weaken financial intermediaries and generate or exacerbate financial stress with adverse effects on output.
- In a sample of 170 monetary policy tightening episodes across 36 advanced and emerging market economies between 1971 and 2017, 20 episodes were followed by a banking crisis, with the onset of the crisis typically occurring 18–24 months after the start of the tightening cycle.
- Recent episodes show that central banks can, in some cases, avoid compromising price stability by deploying non-interest-rate tools: for example, during March–April 2023 depositor runs on Silicon Valley Bank (SVB) and other US regional banks the Federal Reserve did not reverse policy rate hikes but introduced the Bank Term Funding Program and the FDIC extended insurance coverage to uninsured depositors of certain institutions; during the September 2022 UK LDI crisis the Bank of England undertook temporary gilt purchases and did not lower the monetary policy rate.
- When stress is modest, repos and standing facilities can address liquidity-related stress and central banks may recalibrate their stance so that inflation and output remain on the same path as before financial conditions tightened.
- In more severe stress, separation between price and financial stability objectives will likely require additional tools such as long-term liquidity support and asset purchases to buttress financial stability while allowing monetary policy to focus on price stability.
- When stress is high and illiquidity and insolvency become intertwined, fiscal support on top of liquidity support becomes critical; emergency lending by a central bank should be accompanied by a government indemnity if the solvency of the counterparty is uncertain, and direct fiscal interventions may be necessary during acute stress.
- Use of non-interest-rate tools and other policies can involve sizable costs and challenges: difficulties in calibrating, implementing, and unwinding interventions; exposure of the central bank to political pressures if it incurs large financial losses; weakening of market discipline; encouragement of excessive risk-taking; and impairment of market development.
- Strong prudential and fiscal frameworks reduce the risk of facing trade-offs and facilitate separation: adequate capital and liquidity buffers, appropriate regulatory and supervisory frameworks for nonbanks to enable collateralized lending, robust resolution frameworks, financial safety nets, and adequate fiscal buffers.
- When separation is not possible, central banks should allow for more gradual disinflation while clearly communicating to keep inflation expectations anchored; less aggressive tightening is consistent with de jure or de facto flexible inflation targeting for central banks with dual price and output stability objectives, emphasizing commitment to price stability and the temporary nature of deviations.
- Navigating trade-offs is more challenging for economies with low central bank credibility, large exposures to exchange rate risk, and limited fiscal space; these economies may need to use foreign exchange interventions (FXIs), macroprudential measures (MPMs), and capital flow management measures (CFMs), guided by the Integrated Policy Framework (IPF), and seek liquidity support from multilateral institutions such as the IMF.

### Transmission channels: how monetary tightening affects financial stress
- Monetary policy tightening affects financial institutions via effects on asset prices, financial conditions, and asset quality.
- Higher policy rates tend to reduce the valuation of assets and liabilities on intermediaries’ balance sheets by affecting cash flows and the yield curve used to discount these flows.
- Tighter financial conditions affect profitability by impacting term and risk premiums and altering the spread between the return on new assets and the costs of servicing, refinancing, or issuing new debt, including deposits.
- Monetary policy tightening can deteriorate asset quality if borrowers find it more difficult to repay loans following the increase in the policy rate, leading to credit losses for financial institutions.

### Policy responses and scenarios
- No Stress / Modest Stress:
  - Recalibrate policy stance so tighter financial conditions imply a more restrictive environment if the policy rate path remained unchanged.
  - Use repos and standing facilities to address liquidity-related stress.
- Modest to Moderate Stress (constrained intermediation capacity):
  - Deploy additional central bank measures (for example, long-term liquidity support and asset purchases) to buttress financial stability while allowing policy rates to focus on price stability.
- Heightened Stress (risk of financial panics):
  - Combine central bank liquidity tools with prudential and resolution actions; consider government indemnities for emergency lending where solvency is uncertain.
- Full-Fledged Financial Crisis:
  - Fiscal support on top of liquidity support becomes critical; direct fiscal interventions may be necessary.

### Central bank tools: principles and challenges
- Principles:
  - Use collateralized lending, transparent eligibility criteria, and appropriate pricing to limit moral hazard and protect the central bank balance sheet.
  - Pair emergency liquidity with fiscal indemnities when solvency risk is material.
- Challenges and costs:
  - Calibration, implementation, and exit are difficult; interventions can expose central banks to political pressures and potential losses.
  - Non-interest-rate tools can weaken market discipline, encourage excessive risk-taking, and hinder market development.
- Challenges specific to lending to NBFI entities:
  - Requires appropriate regulatory and supervisory frameworks for nonbanks as a precondition for expanding central bank toolkits to provide collateralized lending to such institutions.

### Complementary policies and institutional frameworks
- Prudential policy:
  - Strong prudential and supervisory frameworks with adequate capital and liquidity buffers limit financial risks associated with monetary tightening and help contain moral hazard concerns.
- Resolution frameworks:
  - Robust frameworks for resolution and financial safety nets backed by adequate fiscal buffers are critical to ensure authorities can act when needed.
- Fiscal policy:
  - Fiscal backstops and willingness to provide indemnities or direct support are central when solvency concerns arise.

### Additional considerations for emerging markets and small open economies
- These economies may face amplified trade-offs due to:
  - Low central bank credibility.
  - Large exposures to exchange rate risk.
  - Limited fiscal space.
- Policy toolkit adjustments:
  - Use FXIs, MPMs, and CFMs guided by the Integrated Policy Framework.
  - Seek liquidity support from multilateral institutions such as the IMF to mitigate trade-offs.

_ sdnea2025003 – Executive Summary_

### 9. Higher policy rates can adversely affect intermediaries’ balance sheet through exposing

### 9. Higher policy rates can adversely affect intermediaries’ balance sheet through exposing them to valuation losses on long-term bonds and by raising the cost of funding

### Key transmission channels and direct effects
- Financial intermediaries’ assets have often longer duration than their liabilities, exposing them to valuation losses when long-term rates rise.
- Banks’ market power and hedging can dampen some effects, but duration mismatches can nonetheless undermine confidence in solvency and prove highly disruptive (example cited: SVB episode in the US).
- Higher policy rates reduce aggregate demand, weakening firm and household cashflows and causing defaults to rise.
- Higher real interest rates and constrained bank credit reduce consumption and investment.
- Tighter financial conditions increase interest payments for debt contracted at floating rates, lowering household and firm cashflows.
- Lower asset prices reduce borrowers’ wealth, creditworthiness, and ability to borrow.
- Higher policy rates increase liquidity risks: short-term liability holders may withdraw funds for better returns in money market funds; intermediaries may face redemptions or runs as losses on fixed-income portfolios raise solvency concerns.
- Margin calls can drain intermediaries’ liquidity when brokers require more funds or collateral as asset prices fall.

### Amplification factors that raise likelihood and severity of stress
- High nonfinancial sector debt, loose credit standards, financial sector leverage, and liquidity and duration mismatches increase the probability and severity of stress.
- Structural characteristics such as systemically important institutions and interconnectedness amplify propagation.
- High nonfinancial sector debt: when debt is at floating rates or requires frequent refinancing, interest expenditures can surge, raising default risks; higher leverage increases likelihood of negative equity if asset prices drop.
- High public debt can trigger financial stress when domestic banks hold substantial domestic sovereign debt, creating a harmful cycle between public and banking sector instability.
- Monetary tightening is more likely to generate financial stress when debt-to-GDP and debt service ratios are high at the time of tightening.
- Higher leverage among financial intermediaries can force deleveraging, causing fire sales and further asset price declines (spillovers across institutions holding similar assets).
- Duration and liquidity mismatches (long-maturity lending funded by short-term liabilities) increase chances of losses and forced asset sales at discounts, amplifying price declines (historical examples: US Savings and Loan crisis in the 1980s; 2023 regional bank crisis).
- Systemic importance and interconnectedness matter: failure of a large institution can have system-wide repercussions; small institutions can also transmit stress via direct exposures or common asset holdings (example: 1998 Long-Term Capital Management).
- Monetary tightening following supply-driven inflation is more likely to cause financial stress than tightening following demand-driven inflation because supply shocks require larger output/employment reductions to bring inflation down.
- Financial stress is more likely when tightening follows a period of persistently loose monetary policy: low rates push up asset prices and foster risk-taking; bond price responses are nonlinear and larger when rates increase from low levels.
- Sharp increases in policy rates, or rates that stay high for long, elevate risk: surprise effects, insufficient hedging, liquidity stress for short-term funded institutions, increased retail deposit funding costs, and higher loan loss provisions.

### Empirical sample and stylized evidence (figure notes)
- The figure analysis is based on a sample of 170 monetary policy tightening episodes (defined as tightening periods with at least four consecutive rate hikes) in response to an inflation surge between January 1970 and December 2017 in 21 advanced economies and 15 emerging market economies.
- Crises are defined using the Laeven and Valencia (2020) database; a tightening episode belongs to the crisis subsample if a banking crisis started in the three-year window following the first interest rate hike.

### Framework for policy response when inflation is high
- Objective: strive for separation between price and financial stability objectives when costs of non-interest-rate tools are low; when these costs are higher, full separation may not be optimal.
- If financial stability tools are not costly, they should be used to resolve financial stresses and allow interest rate policy to focus on inflation (illustrated by Figure 2: dotted lines denote full separation, keeping policy rate unchanged suffices to keep inflation unchanged).
- If non-interest-rate tools are prohibitively costly or unavailable, interest rates need to be reduced relative to baseline to accommodate financial stress, causing inflation to overshoot its target (solid lines in Figure 2).
- Reality lies between extremes: tools entail costs and implementation challenges, but impediments are generally not prohibitive. Policymakers should trade off benefits (targeting source of stress) and costs (moral hazard, fiscal risks).
- As financial vulnerabilities rise, use of other tools should be expanded in size and scope; interest rate policy should become less aggressive to avoid worsening vulnerabilities and to account for increasing costs of other tools.

### Four stress scenarios and policy implications (qualitative)
- Scenario 1 — No stress: financial markets function normally; the financial system is solvent. Separation is feasible and interest rates can focus on inflation.
- Scenario 2 — Modest to moderate stress (examples: 2000 dot-com bubble burst; 1980s US Savings and Loan crisis): financial sector constrained in capacity to intermediate due to vulnerabilities (low capital and/or liquidity), but systemic panics are contained. Partial use of non-interest-rate tools and some accommodation in interest rates may be appropriate.
- Scenario 3 — Heightened risk of panic and contagion (example: 2023 US regional bank crisis): shifts in investor sentiment could trigger systemic runs; larger use of liquidity, prudential, fiscal, and resolution tools needed; interest rate policy may need to be less aggressive.
- Scenario 4 — Full-fledged financial crisis (example: Global Financial Crisis): severe disruptions in intermediation and output contraction; broad and sizable deployment of tools and policy accommodation likely required.
- Real-time and accurate measures of financial stress are critical, particularly to distinguish moderate from heightened stress given differences in appropriate responses.

### Tools for navigating price and financial stability trade-offs (Box 1)
- Central bank liquidity tools:
  - Lending operations: standing facilities, discretionary lending (repos), temporary facilities targeted to specific markets or intermediaries, emergency liquidity assistance with conditions, and bilateral swap line arrangements for foreign currency liquidity.
  - Asset purchases: central banks can purchase assets in secondary markets to address market liquidity issues (acting as market maker of last resort).
- Prudential tools:
  - Macroprudential instruments: countercyclical capital buffer, liquidity-related measures (reserve requirements), borrower-based tools (ceilings on debt-service-to-income ratios), and stressed debt-service-to-income ratio tools where loans are mainly at flexible rates.
  - Microprudential capital and liquidity requirements strengthened since the global financial crisis; jurisdictions have introduced macroprudential add-ons (risk weights above minimums, higher requirements for large exposures).
  - Liquidity coverage ratio and other buffers designed to be used during stress without supervisory intervention; calibration of macroprudential tools may be adjusted when systemic risks materialize.
- Fiscal tools:
  - Financial support: loans, guarantees, equity injections, purchases of illiquid/impaired assets to clean up balance sheets; fiscal backstops to central bank liquidity provision.
  - Deposit insurance and government guarantees: protect small depositors; under highly stressed conditions, temporary guarantees on a wider set of liabilities may be needed to ensure continued financing (excluding capital, subordinated debt, and other loss-absorbing liabilities).
- Resolution tools:
  - Toolkit includes powers to assume control of institutions, enforce resolution via sale/merger/transfer of assets and liabilities, implement loss absorption by creditors (conversion to equity or write-downs, “bail-in”), temporarily acquire ownership (“bail-out”), and support resolution through temporary stay on early termination rights under financial contracts.

*Staff Discussion Notes: Navigating Trade-Offs between Price and Financial Stability in Times of High Inflation (INTERNATIONAL MONETARY FUND).*

### 23. When the financial system is well-capitalized, liquid, and hedged against interest rate

### 23. When the financial system is well-capitalized, liquid, and hedged against interest rate changes, central banks can focus solely on price stability and macroeconomic objectives when setting interest rate policy.

### Well-capitalized, liquid, and hedged financial system (Paragraph 23–24)
- When buffers are large, raising interest rates to address inflation is unlikely to cause significant financial stability concerns because liquidity and solvency risks are minimal.
- Appropriate interest rate policy depends on:
  - Policymakers’ mandates.
  - Assessment of the monetary policy stance relative to the neutral interest rate.
  - Trade-offs between price stability and output stability determined by the source of shocks (demand versus supply).
- Demand shocks that move inflation and output in the same direction do not create a trade-off; supply shocks that move them in opposite directions do create trade-offs.
- Interest rate tightening should be calibrated to:
  - Severity of inflationary pressures.
  - Risk of inflation expectations becoming unanchored.
  - Policymakers’ tolerance for temporary deviations from the inflation target in case of supply shocks.
- No broad-based liquidity or solvency support is needed to achieve separation, but vigilance is required to prevent buildup of financial risk.
- Essential supporting frameworks:
  - Robust macroprudential policy for resilience.
  - Strong supervision and resolution frameworks to manage idiosyncratic vulnerabilities.

### B. Modest to Moderate Stress: Constrained Intermediation Capacity (Paragraphs 25–27)
- If financial stress is modest and tighter financial conditions compress aggregate demand:
  - Price and financial stability can be achieved with a less aggressive rate hike and possibly standard liquidity tools.
  - Tighter financial conditions dampen aggregate demand, allowing smaller policy recalibrations (including forward guidance) to maintain inflation and output paths.
  - No inherent trade-off between price and financial stability in this subcase.
  - Communication costs and less predictable transmission of policy are challenges (FRB 2023b).
  - Policymakers can minimize interest rate recalibrations by using standard liquidity-management tools (standing facilities, repo operations), assuming low cost (Figure 2 panels 1 and 2, point B1).
- If stress adversely affects credit supply (in addition to demand effects):
  - Interest rate policy faces a trade-off: tightening reduces inflation but may restrict future productive capacity by limiting credit and raising risk premia.
  - If non-interest-rate tools were costless, they could fully resolve financial stress and allow unchanged monetary policy.
  - Because non-interest-rate tools entail costs, policymakers should combine their use with a less aggressive monetary stance to account for supply-side effects (Figure 2 panel 1, point B2’).
  - Targeted deployment of additional tools is recommended:
    - Liquidity issues: standard and emergency liquidity facilities.
    - Solvency issues: early intervention, intensive supervision, resolution tools (liquidation, deposit transfers, bail-in powers).
    - Relaxing macroprudential policies can loosen balance sheet constraints and support lending while avoiding fire sales.

### C. Heightened Stress: Risk of Financial Panics (Paragraphs 28–32)
- Widespread vulnerabilities can trigger nonlinear feedback loops, runs, and panic-induced crises; separation becomes more elusive.
  - Feedback loops: deleveraging → liquidity drying up → further deleveraging.
  - Panic and runs usually triggered by solvency concerns.
- Trade-offs:
  - Aggressive tightening might keep inflation near target if panic is contained but raises the likelihood of systemic crisis, causing inflation and output to fall well below target.
  - Lower policy rates may avert runs but permit higher inflation.
  - Stress severity makes other tools costlier and separation suboptimal.
- Recommended monetary approach:
  - Monetary policy should take financial stability risks into greater account and allow for a more gradual disinflation path (Figure 2, point C’).
  - This is consistent with de jure or de facto flexible inflation targeting with dual price and output stability objectives.
  - Degree of flexibility depends on financial system vulnerabilities, likelihood that tighter policy triggers crisis, and availability/costs of other tools.
- Communication:
  - Clearly explain that short-term rate recalibrations are temporary and do not undermine medium-term commitment to the inflation target.
  - Articulate rationale: tighter policy could trigger financial crisis; deviations are due to exceptional vulnerabilities and downside growth risks.
  - Use flexibility cautiously to avoid damaging central bank credibility and unanchoring expectations, which could increase premiums and long-term rates.
- Tools likely needed and examples:
  - Long-term liquidity support and central bank asset purchases to support asset prices and intermediaries’ balance sheets (BoE intervention during the 2022 UK LDI crisis; emergency lending during 1984 Continental Illinois failure).
  - Emergency lending and expanded depositor protection under exceptional circumstances (2023 US regional bank crisis: FDIC systemic risk exception).
  - Fiscal backstops to ensure deposit insurance credibility and protect central bank balance sheets (US Treasury earmarked $25 billion to backstop a Federal Reserve lending facility during the recent US regional bank crisis).
  - Resolution tools and fiscal support for solvency-driven stresses; private solutions prioritized where possible (1998 LTCM consortium organized by the Federal Reserve). Where private solutions cannot be found, apply resolution powers; exceptional acute systemic threats may require public support recouped from the industry.

### D. Full-Fledged Financial Crisis (Paragraphs 33–36)
- Severe financial crisis in a context of inflationary pressures (examples: Nordic banking crises early 1990s; GFC) can produce:
  - Deleveraging, impaired balance sheets, market illiquidity, higher risk premiums.
  - Credit crunch causing sharp output contraction amplified by precautionary saving and poor expectations.
- Downturn may offset initial inflationary pressures so that inflation falls despite the original shock (as in the GFC).
- Policy response:
  - Aggressively deploy wide range of other tools to address financial stability (Figure 2, panel 2, point D’):
    - Liquidity tools to sustain intermediation capacity and credit flow.
    - Solvency tools: restructuring, resolution, and, if needed, fiscal interventions.
  - Interest rate cuts to avoid deflation and ease financial stress (Figure 2 panel 1, point D’):
    - Lower rates support aggregate demand and prevent medium-term undershooting of inflation target.
    - Lower rates reduce debt service burdens, support asset prices, and improve creditworthiness.
    - Example: at the onset of the GFC, the Federal Reserve cut rates to zero and expanded non-interest-rate interventions (Term Asset-Backed Securities Loan facility).

### Central Bank Liquidity Tools: Principles and Challenges (Paragraphs 37–41)
- General considerations:
  - Deployment should follow well-accepted principles and address specific challenges for lending to NBFI entities.
  - Reducing the cost of using tools helps central banks achieve separation.
- A. Principles for deployment (Paragraphs 38–41)
  - Bagehot’s principles: lend early and without limit to illiquid but solvent firms, against good collateral, and at high rates (Bagehot 1873; Tucker 2009).
    - Pricing should discourage normal-time use but not deter use during stress.
  - Lending operations should:
    - Support only well-regulated entities.
    - Be targeted and temporary.
    - When solvency is uncertain or credit risk significant, require a fiscal backstop (IMF 2023a).
  - Asset purchases should:
    - Be initiated by the central bank (not Treasury).
    - Be in the secondary market.
    - Ensure market neutrality to reduce price distortions.
    - Be accompanied by clear communication on objectives and rationale.
    - Require fiscal backstops because risky asset purchases can generate losses and compromise central bank solvency (Adrian and others 2021).
  - Market-wide lending has advantages over asset purchases:
    - Secured lending is common for financial stability and reduces misperception about monetary policy stance.
    - Fewer balance sheet implications; central bank can apply haircuts to limit counterparty risk.
    - Can be targeted to stressed market segments, reducing moral hazard (Hauser 2023; IMF 2023a).
  - Some tools more conducive to separation:
    - Assurance of elastic liquidity via overnight facilities and long-term lending may assuage market pressures without large-scale injections.
    - Contingent targeted asset purchase frameworks (e.g., ECB’s OMT and TPI) can provide implicit liquidity insurance that reduces need for actual purchases.
    - Unsterilized large-scale asset purchases and broad repo injections can significantly affect the yield curve and jeopardize separation; such operations need swift unwinding and clear ex ante communication.
    - Asset purchases for financial stability should be time-limited and explicitly distinguished from price-stability goals (Adrian and others 2024).
- B. Challenges and costs
  - Central bank lending to NBFIs presents specific challenges (not exhaustively listed here in the provided text).
  - Efforts to reduce these costs are important for enabling central banks to come closer to separation.

*STAFF DISCUSSION NOTES Navigating Trade-Offs between Price and Financial Stability in Times of High Inflation — INTERNATIONAL MONETARY FUND*

### 42. Lending operations and asset purchases come with short-term costs and challenges.

### 42. Lending operations and asset purchases come with short-term costs and challenges.

### Immediate practical issues during heightened financial stress
- Determination of solvency:
  - Central banks should lend only to institutions that are financially sound, but policymakers may struggle to establish compliance with prudential requirements (notably solvency requirements) in times of heightened financial stress.
  - In the context of ELA, an additional difficulty is that solvency should be assessed on a forward-looking basis.
- Collateral availability:
  - The central bank may find itself unable to extend sufficient funding due to the inadequacy of eligible collateral held by potential beneficiaries.
- Stigma:
  - Discount window borrowing can carry a stigma because of associated perceived financial weakness (Aramonte, Schrimpf, and Shin 2022).
  - Example: US market rates rose well above the Federal Reserve facilities’ interest rates during 2007–08, indicating reluctance to access these facilities (Cecchetti and Disyatat 2010).
  - Emergency Liquidity Assistance can entail stigma because it comes with conditions, enhanced supervision, and additional scrutiny.
- Calibration and targeting:
  - High uncertainty during stress periods can complicate the choice of tools and the right amount of liquidity provision, especially in case of persistent inflationary pressures.

### Medium-term costs and adverse side effects
- Moral hazard:
  - The expectation of generous central bank liquidity provision during stress episodes can incentivize risk-taking (Goodhart 2007, Schwartz 1992).
  - Even if lending at a penalty rate, coupled with liquidity requirements that imposes a degree of self-insurance should encourage financial institutions to maintain enough liquidity (Mishkin 2007).
- Risks to central banks’ balance sheets:
  - Lending against lower-quality collateral or purchases of risky assets exposes central banks to financial losses.
  - Lending to less well-supervised entities increases counterparty risk, requiring relatively more conservative haircuts.
- Lower market liquidity and asset price distortion:
  - Large-scale asset purchases by central banks can reduce market liquidity by removing assets from the market (Aldridge, Cimon, and Vala 2023; Boneva, Islami, and Schlepper 2021).
  - Such purchases can persistently distort risk premiums (Steeley 2015, Barbon and Gianinazzi 2019).
- Difficulty ending and unwinding interventions:
  - Ending an intervention may raise concerns about “cliff edge” effects and too fast or premature unwinding could lead to a resumption of stress.
  - Central banks may face political pressures to continue support despite lacking a good financial stability reason to do so.
  - Well-designed liquidity programs should therefore be “self-liquidating” as stress abates.

### C. Challenges Specific to Lending to NBFI Entities
- NBFI sector description and systemic relevance:
  - The NBFI sector is diverse, of growing importance globally, with a heterogenous regulatory framework across different types of entities.
  - The NBFI share of global financial assets was about 49 percent at the end of 2023 (FSB 2024a).
  - Distinguishing feature: absence of deposit contracts, so NBFI generally do not have access to liquidity backstops by the central bank or deposit insurer.
  - Entities include insurance companies, pension funds, open-ended investment funds, private equity funds, hedge funds, private credit firms, finance companies, some financial technology firms, nonbank broker dealers, and financial market infrastructures (clearing and settlement corporations, payment systems).
  - Regulatory frameworks vary: insurance companies typically have strong prudential frameworks and consolidated supervision; capital market institutions are subject to investor protection rules, prudential rules, and disclosure requirements.
- When central banks may need to consider lending to NBFIs:
  - Where segments of the NBFI sector are systemic, central banks may need to provide liquidity in heightened stress.
  - NBFI can be a source of or amplifier of financial stress with broader consequences to the economy (IMF 2023a).
  - Examples:
    - March 2020 “dash for cash” (UK): demand for liquidity by various NBFI entities surged and destabilized markets (Czech and others 2021).
    - September 2022 LDI crisis (UK): demand surged and destabilized markets (Hauser 2023).
  - In both cases, central bank tools for lending to banks were insufficient because banks did not (or could not) on-lend to NBFI relevant entities in sufficient amounts, requiring the BoE to improve liquidity in the gilt market through asset purchases.
  - This suggests that, in some jurisdictions, being able to target some NBFI segments could be considered to address system-wide liquidity needs.

### Specific challenges in lending to NBFI entities
- Large number and heterogeneity:
  - Very different business models compared to banks; systemic impact often arises from activities and interconnectedness rather than individual entities.
  - These features make liquidity provision to NBFI entities more daunting.
- Generally less intrusive prudential regulation and supervision:
  - Rapid growth and systemic importance have outpaced prudential frameworks; work is ongoing to enhance resilience (FSB 2022).
- Data gaps:
  - Significant data gaps remain that hinder assessment and monitoring of vulnerabilities (IMF 2023a).
  - Direct measures of interconnectedness among NBFI entities are difficult to collect; indirect measures (such as common exposures) are seldom available.
- Greater difficulty in determining solvency:
  - Some NBFI entities hold illiquid and hard-to-value assets (loans to SMEs, crypto assets), blurring the distinction between liquidity and solvency during stress.
- Greater risk of moral hazard:
  - Some nonbanks’ business models (e.g., hedge funds) involve high degrees of risk taking.
  - Central bank liquidity support could weaken market discipline, encourage greater risk taking due to explicit or implicit guarantees, and incentivize regulatory arbitrage.

### Policy attention and operational readiness for NBFI-related risks
- Closing data gaps while enhancing monitoring, supervision, and regulation:
  - Develop best practices on the collection, use, and sharing of data on nonbanks to improve supervision effectiveness (FSB 2024b).
  - Adequate data coverage would help financial supervisors mitigate NBFI vulnerabilities and enable central banks to maximize effectiveness of policy support.
- Close coordination among regulatory and supervisory bodies:
  - Clear division of labor and cooperation between central bank, relevant regulatory and supervisory bodies, and the treasury is essential for swift and effective policy intervention.
  - Coordination can protect the central bank from political pressure (Dobler and others 2016) and improve preemptive risk identification (IMF 2023a).
  - Cross-border cooperation is needed given NBFI global interconnectedness.
- Strengthening or developing operational frameworks for lending to well-regulated and systemic NBFI segments:
  - Central banks should work on operational readiness to lend to these intermediaries once pre-conditions are met (adequate data, comprehensive supervisory and regulatory framework).
  - This includes assessment of the availability of highly liquid collateral.
- Jurisdictional legal and operational developments (examples cited in the text):
  - Chile passed a law in 2023 to allow provision of emergency liquidity to central counterparties (BCC 2023).
  - In January 2025, the BoE opened the Contingent Non-Bank Financial Institution Repo Facility for applications; it will be activated only during episodes of severe gilt market dysfunction and will lend to participating insurance companies, pension schemes, and liability-driven investment funds (BoE 2025).
  - South African Reserve Bank is considering introducing an NBFI repo facility during times of stress or market dysfunction (SARB 2024).
  - The European Central Bank is exploring offering liquidity to some nonbanks such as life insurers and pension funds (Wilkes 2024).
  - Section 13(3) in the Federal Reserve Act allows the Federal Reserve to lend to nonbank financial institutions provided that the lending facilities are market wide arrangements and do not specifically target individual financial institutions.

### Challenges in deploying other policy tools
- Scope of central bank toolkit is limited; other tools can reduce financial stress but face significant deployment challenges.

A. Prudential policy
- Role:
  - Strong prudential policy frameworks can lower the risk that monetary policy tightening results in significant financial stress and improve trade-offs facing policymakers (IMF 2014a, 2015).
  - Progressive strengthening of prudential frameworks after the GFC helped systems better withstand sharp policy hikes during 2021–23 and helped explain why emerging market economies did not experience the capital outflows that were widely feared.
- Use in tightening episodes:
  - Prudential tools, including macroprudential measures, can be relaxed in stress to reduce deleveraging pressures and lower the risk of adverse feedback loops between intermediaries’ balance sheets, credit availability, and asset prices from fire sales.
- Types of tools:
  - Capital-related tools: Releasable capital tools (broad-based countercyclical capital buffers, systemic risk buffers, sectoral buffers) can be used to increase capital headroom and support credit provision.
  - Liquidity-related measures: Releasable reserves requirements can be relaxed to relieve liquidity stress, avoid fire sales, and help meet systemwide redemption pressures. Banks may use their liquidity buffers in times of stress, consistent with international standards.
- Challenges for macroprudential policy:
  - Regulatory gap, leakages, and asset substitution: Incomplete perimeter and cross-border/domestic leakages can reduce effectiveness (IMF 2014a); asset substitution can happen when banks shift risk to maintain previous exposure (Biljanovska and others 2023).
  - Fear of market stigma: When buffers are not explicitly released, stigma can make banks reluctant to use them (Saporta 2022).
- Making macroprudential policy more effective:
  - Macroprudential authority should have willingness and ability to act, with good coordination between macroprudential and monetary policy (IMF 2014a).
  - Expand macroprudential perimeter to include NBFI areas with systemic impact.
  - Address cross-border regulatory arbitrage via enhanced international cooperation across standard setting bodies (IMF 2023a).

B. Resolution framework
- Importance:
  - An effective resolution regime is critical to reduce the risk that institution-specific liquidity or solvency problems morph into systemic threats, improving trade-offs associated with tightening monetary policy.
  - Strong resolution frameworks reduce contagion risks and help maintain confidence in payments and financial systems.
- Remaining challenges:
  - Resolution of systemic institutions: It is not always feasible to gauge in advance which institutions can turn systemic (US 2023 regional bank crisis); crisis preparedness needs to target the entire banking sector, on a proportional basis (Adrian 2024).
  - Fiscal support in exceptional circumstances: Policymakers may need to balance acute risks to financial stability against moral hazard and fiscal costs of bailouts; fiscal resources may be needed when imposing extensive private losses would cause severe spillovers (e.g., US authorities invoked statutory systemic risk exception to protect uninsured depositors of two regional banks in March 2023).
  - Public funds should be the exception and structured to mitigate costs, occur alongside loss sharing with private stakeholders, and be time-bound with restructuring plans to restore long-term viability.
  - Full operationalization of the resolution toolkit: Need to operationalize resolution options (transfer, sale of business, bail-in) and establish public sector backstop funding mechanisms to support bank resolution (FSB 2023).
  - NBFI resolution: Resolution regimes for some relevant NBFI entities are inexistent or underdeveloped in many jurisdictions (IMF 2023a).
  - Cross-border issues: Resolving multinational institutions is complicated by gaps in information sharing and additional legal complexity.

*Source: sdnea2025003 - 42. Lending operations and asset purchases come with short-term costs and challenges.*

### 55. Continuing to address these challenges will help further strengthen resolution frameworks.

### 55. Continuing to address these challenges will help further strengthen resolution frameworks.

### C. Fiscal Policy

- Despite strong regulation, supervision, and resolution frameworks, fiscal interventions may still be necessary during acute financial stress episodes. 29
- Fiscal support may be needed for:
  - direct interventions (including to support systemic NBFI segments under some circumstances),
  - to backstop unconventional policy actions by central banks,
  - to help avoid systemic financial crises.

- Fiscal space is critical:
  - Purchasing troubled assets, injecting equity, and providing loans or subordinated debt often require issuing new public debt, putting government solvency at risk if fiscal space is limited and adding a new source of financial instability.
  - These operations expose governments to valuation risk and credit risk.
  - Government guarantees can be costly if called (Battersby and others 2022). 30
    - Example: The sizeable guarantees (about 25 percent of GDP) provided by the Swiss government during the acquisition of Credit Suisse by UBS illustrate significant contingent liabilities (Adrian and Dobler 2024).

- Risks to weigh when evaluating fiscal support:
  - Long-lasting effects and footprint: Larger government interventions can distort private sector decision-making in the long term; divesting financial sector holdings acquired during a crisis can take years (Dell’Ariccia and others 2022).
  - Public ownership and oversight issues: Ownership and oversight of financial institutions present governance and risk management challenges for which the government may be ill equipped.
  - Deployment complexity: Defining eligibility criteria and financial terms may be difficult if governments lack adequate financial sector expertise.

- Principles for deploying fiscal tools:
  - Deploy fiscal tools only to provide backstop to central bank liquidity provision or to avert a systemic financial crisis.
  - If fiscal support is provided, the associated fiscal costs and contingent liabilities should be costed, monitored, and recorded in fiscal accounts.
  - Countries should regularly publish a statement of fiscal risks that includes updates of government interventions to ensure transparency (Everaert and others 2009, IMF 2009). 31
  - Maintain sound fiscal policies to build buffers in normal times.

### Additional Challenges for Some Emerging Market and Small Open Economies

- Country characteristics that intensify trade-offs between price and financial stability:
  - Low central bank credibility:
    - Often stems from a lack of monetary policy independence, increasing the likelihood of government debt monetization.
    - Results in poorly anchored inflation expectations, fueling inflation and weakening monetary policy transmission.
    - Central bank liquidity interventions can worsen inflationary pressures if perceived as taken under government pressure (Bianchi and Melosi 2022).
  - Exposure to exchange rate risk:
    - High foreign currency debt on borrowers’ balance sheets, and currency mismatches on banks’ balance sheets, can increase default rates and intermediary losses after significant domestic currency depreciation.
    - Depreciation can be triggered by a currency run when liquidity and solvency stresses are present and investors lack confidence in policymakers.
  - Limited fiscal space:
    - Countries with inefficient spending or inadequate tax revenue collection have more limited fiscal space.
    - Such weak fiscal structures combined with fragile financial systems can lead to debt intolerance (Reinhart and others 2003) and limit capacity to borrow or provide fiscal backstops.

- Policy implications when central banks face low credibility:
  - Little room to alter the interest rate path to contain financial stress; may need to tighten more aggressively to address inflationary pressures and signal commitment to price stability. 32
  - Broad-based liquidity and solvency support may be limited by factors such as limited fiscal space.
  - Liquidity provision tools without credible fiscal backstops or clear time bounds may de-anchor inflation expectations and worsen price–financial stability trade-offs.
    - Example: Colombia’s largely unfunded recapitalization of financial institutions in the 1980s contributed to high inflation (see Annex 1).

- Exchange rate exposure and monetary policy constraints:
  - In countries with significant exposure to exchange rate changes, central banks have less room to deviate from the price stability objective.
  - A more accommodative policy stance during a global tightening cycle may lead to capital outflows and large depreciation, increasing debt service burdens for borrowers with unhedged foreign currency liabilities. 33
  - Depreciation reduces collateral prices and tightens borrowing constraints, exacerbating financial stress (Bianchi and Mendoza 2020).

- Fiscal space limitations and inflationary consequences:
  - Limited fiscal space may render some tools ineffective or inflationary if funded by monetary financing. 34
    - Example: During the 2000–01 financial crisis in Türkiye, the government recapitalized insolvent state-owned banks with debt securities purchased by the central bank; the resulting monetary expansion and sharp depreciation led to a resurgence of inflation (Figure 5).
  - Limited fiscal space makes separation (between monetary and fiscal roles) less feasible.

- Compounded challenges:
  - When low credibility, exchange rate exposure, and limited fiscal space coexist, central banks’ ability to navigate price–financial stability trade-offs is significantly curtailed.
  - Historical example: Brazil’s Real Plan in 1994 achieved rapid disinflation through sharp interest rate hikes and tightened reserve requirements but reduced bank profitability and led to liquidation of many institutions (Annex 1).

- Tools to expand monetary policy scope in these contexts:
  - FXIs (Foreign Exchange Interventions):
    - Can be deployed when financial stress is modest to moderate to counteract cyclical depreciation pressures and alleviate burdens of unhedged FX liabilities in shallow or temporarily illiquid FX markets.
    - Likely insufficient during heightened systemic stress or full-fledged financial crisis.
  - MPMs (Macroprudential Measures):
    - Releasing capital buffers during heightened stress can help absorb losses and maintain banks’ lending capacity.
    - Relaxing reserve requirements on FX deposits can mitigate FX liquidity stresses, but excess liquidity should be sterilized to avoid worsening inflation.
  - CFMs (Capital Flow Measures):
    - Tightening outflow CFMs could be desirable in crises or panics, particularly when shocks are large and persistent and risk depleting international reserves (IMF 2012).
    - CFMs are less applicable when stress is modest to moderate due to potential costs.
  - These tools should follow consideration under the Integrated Policy Framework. 35

- Limitations and costs of these tools:
  - FXIs may amplify speculative attacks if reserves are insufficient and the exchange rate level is unsustainable (IMF 2023c).
  - Outflow CFMs may be circumvented and entail long-term economic and reputation costs (Chang, Fernandez, and Martinez 2024).
  - Use only when financial stress is systemic (and outflow CFMs only in crisis or near crisis); tools should be temporary and lifted once confidence is restored.
  - These tools should be part of a broader policy framework and should not prevent warranted macroeconomic policy adjustments.

- Role of international safety nets:
  - A strong international safety net is vital when domestic tools are constrained.
  - Foreign currency swap lines and international lender of last resort facilities provide liquidity to domestic central banks, allowing them to lend to domestic financial intermediaries and meet short-term foreign currency obligations.
  - International swap lines can help lower borrowing costs, alleviate financial stress (Bahaj and Reis 2022), and enhance credibility of FXIs, reducing the risk of runs against the local currency.

### Conclusions

- Nature of trade-offs:
  - Trade-offs between price and financial stability can occur when inflation is above target and financial stress is rising.
  - Most recent episodes of monetary tightening have not led to financial stress, but future episodes could require very tight monetary policy that adversely affects financial markets and intermediaries and risk a full-fledged financial crisis.

- Policy options by stress severity:
  - When financial stress is modest and not driven by solvency concerns:
    - Central banks can use standard liquidity tools and lower their policy rate path without jeopardizing price stability in response to tightened financial conditions—no trade-off between price and financial stability.
  - When stress is more severe:
    - Keeping monetary policy focused on price stability may require deploying additional central bank tools such as long-term liquidity support and asset purchases.

- Limits of central bank liquidity tools:
  - Liquidity tools cannot address solvency issues.
  - When private recapitalization is unavailable or insufficient, resolution tools and government solvency support may be necessary.
  - Macroprudential policy can be relaxed to soften stress impacts on the economy.

- Challenges reducing scope for separation:
  - Difficulties in calibrating, implementing, and unwinding nonstandard central bank interventions.
  - Medium-term side effects: moral hazard and risks to central bank balance sheets.
  - Lending to NBFI entities remains a formidable challenge.
  - Resolution frameworks still have gaps and operational problems.
  - Fiscal support raises immediate fiscal risks and public debt concerns; lack of fiscal space limits feasibility and raises governance and moral hazard issues.
  - Macroprudential policy may not target all systemic risks ex ante or may lack releasable buffers.

- When limitations are significant:
  - Monetary policymakers should consider financial stability risks and may allow for a more gradual disinflation path to avoid adverse events.
  - This approach is consistent with de jure or de facto flexible inflation targeting regimes with dual price and output stability objectives.
  - In times of financial stress with significant downside risks to activity, those risks should play a bigger role in the policy reaction function.
  - The extent of permitted deviation from the inflation target should depend on financial system vulnerabilities, the likelihood that tighter policy would trigger a crisis, and the cost of other tools.

- Communication and credibility:
  - Clear communications are critical to keep medium-term inflation expectations anchored and to defend financial stability.
  - When incorporating financial stability considerations, central banks risk being perceived as abandoning medium-term price stability; communications must stress commitment to price stability and that deviations are temporary and due to exceptional financial vulnerabilities.

- Efforts to lower barriers to separation:
  - Strong prudential policy and supervisory frameworks with adequate capital and liquidity buffers (ideally in place before stress emerges) are critical to limit financial stability risks associated with monetary tightening and to achieve separation.
  - Robust frameworks for resolution and financial safety nets, and sound fiscal policies to build fiscal buffers in normal times, are essential.
  - Enhanced regulatory and supervisory frameworks for nonbanks are a precondition for central banks to provide liquidity support to such intermediaries while containing risks and minimizing political economy risks (“picking winners and losers”).
  - Once preconditions are met, central banks should contemplate expanding their toolkit to lend to these entities.

*Staff Discussion Notes — Navigating Trade-Offs between Price and Financial Stability in Times of High Inflation (excerpt).*

### 74. Countries with low central bank credibility, large exposures to exchange rate changes, and

### 74. Countries with low central bank credibility, large exposures to exchange rate changes, and restricted fiscal space face additional challenges to navigate the trade-offs

### Key policy tools and caveats
- Where financial stress could lead to capital outflows and a large currency depreciation, the following measures may improve trade-offs between price and financial stability:
  - Foreign exchange interventions
  - Macroprudential policy measures
  - Capital flow management measures
  - International liquidity tools
- Foreign exchange interventions and capital flow management measures require careful calibration given their potential limitations and costs.
- In particular, banks should hold capital against interest rate risk in the banking book.

### Historical episodes highlighting tensions between price and financial stability (selected findings)
- General theme: Since the early 1970s, monetary tightening interacting with financial vulnerabilities has repeatedly created tensions between price stability and financial stability.

- Savings and Loan (S&L) crisis (United States, late 1970s–1980s)
  - S&Ls’ market share in new mortgage loans fell from 50 percent during the 1970s to 26 percent during the first quarter of 1981.
  - 80 percent of S&Ls recorded losses in 1981.
  - The sector recorded negative equity by mid-1982.
  - About 747 S&L banks were closed.
  - Cost to taxpayers: $124 billion.

- Continental Illinois bailout (United States, monetary tightening cycle of 1983–84)
  - The federal funds rate was increased by 3 percentage points from mid-1983 and reached 11.5 percent in mid-1984.
  - FDIC approved an injection of $1.5 billion in the form of subordinated debt.
  - A group of 24 major US banks provided a $5.5 billion line of credit.
  - The FDIC protected all depositors of the bank regardless of the $100,000 limit on deposit insurance prevailing at the time.

- Long-Term Capital Management (LTCM) episode (1998)
  - The Federal Reserve organized a consortium of financial institutions that provided $3.6 billion in new equity to ensure an orderly unwinding.
  - The Federal Reserve cut the federal funds rate from 5.5 percent to 5.3 percent in September 1998 and to 4.8 percent in November 1998.
  - Real GDP growth averaged 4.4 percent (year over year) during the first three-quarters of 1998 and 4.9 percent in 1998Q4.
  - CPI inflation rose from 1.5 percent in September 1998 to 2.3 percent in April 1999, and reached 3 percent in early 2000.

- Global Financial Crisis (GFC) initial phase (United States, 2004–2008)
  - FOMC raised the federal funds rate from 1 percent in June 2004 to 5.3 percent in July 2007.
  - After market turmoil in August 2007, the FOMC lowered the federal funds rate by 50 basis points to 4¾ percent on September 18, 2007, and cut further subsequently.
  - The FOMC cut the federal funds rate target by a further 75 basis points to 2¼ percent in mid-March (year specified in source).

- 2023 US regional bank crisis
  - The Federal Reserve increased the federal funds rate by about 450 basis points by early March 2023.
  - Failures and stress (e.g., Silicon Valley Bank) were linked to fragile business models, significant shortcomings in interest rate risk and liquidity management, large uninsured deposits, and losses in long-dated investment securities.
  - Policy responses included placing SVB and Signature Bank under receivership, full FDIC guarantee of deposits at those banks, creation of the Bank Term Funding Program (backstopped by the US Treasury), and additional liquidity from the Federal Home Loan Banks.

- Penn Central bankruptcy (United States, 1970)
  - Penn Central had more than $84 million outstanding in commercial paper.
  - Total outstanding nonbank commercial paper fell by about 7 percent during the first week of the crisis.
  - Three weeks after the Federal Reserve’s package of measures was announced, total borrowed reserves by commercial banks more than doubled.

- Nordic banking crises (early 1990s)
  - Loan losses (percent of total loans) rose markedly:
    - Norway: from 0.7 percent in 1987 to 6 percent in 1991.
    - Finland: from 0.5 percent in 1989 to 4.7 percent in 1992.
    - Sweden: from 0.3 percent in 1989 to 7 percent in 1992.
  - Short-term rates were far over double digits in the early 1990s.
  - The Swedish central bank raised its interest rate from 12 percent in July 1992 to 500 percent in September 1992 to defend the krona; policymakers later let the krona float and cut rates.
  - Fiscal support associated with crisis resolution was substantial: 10 percent of GDP in Finland, 2.6 percent of GDP in Norway, and 5.2 percent of GDP in Sweden.

- Australia (turn of the 1990s)
  - Monetary tightening exposed credit and property-related vulnerabilities after a credit boom.
  - Regulatory measures, supervisory actions, and clear public communications helped stop runs on smaller institutions without the Reserve Bank of Australia providing emergency liquidity support.
  - The Reserve Bank of Australia started cutting its policy rate from January 1990 in response to slowing economic growth.

- Euro area post-COVID-19 high-inflation episode
  - Sharp rises in inflation and consequent rate expectations triggered sharp rises in euro area sovereign bond yields and financial stress indicators in mid-2022.
  - On July 21, 2022, the ECB launched the Transmission Protection Instrument (TPI) to prevent financial market fragmentation and ensure smooth transmission of monetary policy across the euro area while seeking to avoid interference with the appropriate monetary policy stance.
  - The TPI permitted purchases of public sector securities only in jurisdictions that fulfilled a list of eligibility criteria ensuring sound and sustainable fiscal and macroeconomic policies.
  - The mere option of activating the TPI appears to have helped halt disorderly rises in sovereign spreads; following the announcement, sovereign spreads remained range-bound and rather insensitive to shifts in rate expectations.

### Policy lessons and trade-offs illustrated by episodes
- Monetary tightening to restore or preserve price stability can exacerbate financial vulnerabilities where banks, nonbank financial institutions, or specific market segments have:
  - Large maturity mismatches
  - High reliance on short-term wholesale funding
  - Poor interest rate risk management
  - High concentrations in stressed sectors (e.g., real estate, energy)
- Policy responses to financial stress have included:
  - Direct liquidity provision and lender-of-last-resort facilities (discount window, Section 13(3) authorities, emergency lending programs)
  - Deposit guarantees and targeted insurance measures
  - Organized private sector recapitalizations and lines of credit
  - Introduction of targeted market-stabilizing instruments (e.g., TPI)
  - Regulatory, supervisory, and communication measures that can, in some cases, restore confidence without direct liquidity injections
- Design considerations:
  - Tools intended to preserve financial stability should be calibrated to minimize interference with the monetary policy stance where possible (example: TPI eligibility criteria).
  - Measures such as FX interventions and capital flow management can be useful but entail potential costs and limitations and thus require careful calibration.
  - Strengthening bank capital against interest rate risk is critical, especially when rapid tightening is possible.

*International Monetary Fund — STAFF DISCUSSION NOTES Navigating Trade-Offs between Price and Financial Stability in Times of High Inflation (Annex 1: historical episodes).*

### 11. The 2000–01 financial crisis in Türkiye illustrates the challenging trade-offs faced by

### 11. The 2000–01 financial crisis in Türkiye illustrates the challenging trade-offs faced by

### Case study: Türkiye (2000–01)
- Pre-crisis vulnerabilities:
  - High inflation, political instability, and a fragile banking sector with large unhedged foreign currency liabilities and a high share of nonperforming loans (Serdengeçti 2006).
- Policy stance prior to collapse:
  - Exchange rate stabilization program introduced in 1999 featuring a crawling peg exchange rate, fiscal austerity measures, tighter monetary policy, and various banking sector reforms (Özatay and Sak 2003).
- Crisis trigger and immediate financial outcomes:
  - Political crisis in February 2001 caused overnight interest rates to spike to 6,200 percent and led to the collapse of the pegged exchange rate system.
  - Government response: substantial liquidity injection into the financial system despite inflationary risks, involving issuance of debt securities to recapitalize insolvent state-owned banks which the central bank purchased, totaling to 21 quadrillion Turkish liras (approximately $21 billion) (Serdengeçti 2006).
  - Inflationary aftermath: consumer price index reached 68.5 percent by the end of 2001.

### Related historical episodes (brief summaries)
- Brazil, 1994:
  - Rapid disinflation under the Real Plan (currency introduced July 1, 1994) followed contractionary fiscal and monetary measures.
  - Interest rates rose from 5,572 percent at end-1993 to 15,406 percent at the time the new currency was introduced.
  - Marginal reserve requirements climbed to 100 percent of demand deposits in July 1994.
  - Inflation fell from a peak of 4,922 percent year over year in June 1994 to 33 percent one year later.
  - Financial stability costs: banks' profit margins collapsed as inflation dropped, leading to increased nonperforming loans, bank failures, mergers, foreign takeovers, and liquidations of several small banks.
- Colombia, 1982:
  - Late 1970s coffee price boom contributed to high inflation; policymakers raised reserve requirements, imposed interest rate controls, limited foreign debt increases, and introduced capital controls, raising lending costs and reducing banks’ profitability (Hernandez, and Caballero-Argáez, and Tovar 2022).
  - From 1977 to 1981 coffee prices fell dramatically while international interest rates rose; banking crisis erupted in 1982 with two major banks liquidated and taken over by the government.
  - Further bailouts in 1986–1987: four more banks rescued.
  - By 1987 the government acquired almost a third of the banking system’s assets, estimated between 3 to 6 percent of GDP (Hernandez, Caballero-Argáez, and Tovar 2022).
  - Resulting increase in government debt, largely financed by direct central bank loans, contributed to high inflation through the 1980s (Perez-Reyna and Osorio 2018).

### Stylized model with trade-offs between price and financial stability (Annex)
- Model structure:
  - Two-period New Keynesian framework with banks and banking panics, based on Capelle and Teoh (2025) and Gertler, Kiyotaki, and Prestipino (2020).
  - Households: log-linear preferences U = log C1 − v(C1) + β log C2 − v(l2); save in bank deposits D2, long-term government bonds LH2, and capital KH2; face quadratic management costs in holdings of LH2 and KH2.
  - Firms: differentiated goods producers with CES aggregation; intermediate producers face quadratic price adjustment cost in period 1 (θ1 > 0, θ2 = 0).
  - Financial intermediaries: collect deposits D2 and invest in capital KF2 and long-term government bonds LF2; face a leverage constraint φ1 N1 ≥ QL1 LF2 + QK1 KF2 where maximum leverage φ1 is exogenous; run probability ξ(N1*) > 0 when N1* ≤ 0 and zero otherwise; runs lead to liquidation KF2 = 0 and transfers of investments to households.
  - Central bank/government tools: nominal interest rate R2, asset purchases KG2, equity injections NG; fiscal policy passive with lump-sum taxes T1, T2 chosen to satisfy central bank-government budget constraint.
- Key equilibrium relations:
  - Phillips curve arising from first-period nominal rigidities: (ε1−1)(ε1/ε1−1 W/P1 α)(Y1/K)^(1−α)/α −1 = θ π1(π1 + 1).
  - Euler equation for intertemporal consumption: C2 = β R2 C1.
  - No-arbitrage conditions linking R2 to returns on long-term bonds and capital and to asset prices (R2 = 1 + rL − βL P2 L_H2 QL1 = 1 + rK2 − βK P2 K_H2 QK1 in the model notation).
- Financial frictions and run mechanics:
  - Leverage constraint binding amplifies shocks via financial accelerator, forcing asset liquidation, raising cost of capital and generating output losses (Annex Figure 2.1).
  - Bank runs cause full liquidation, spike risk premia, and large economic losses (Annex Figure 2.2).

### Policy implications from the model
- Costs of rate hikes:
  - Interest rate increases weaken banks’ balance sheets, can bind leverage constraints, amplify shocks via financial accelerator, increase cost of capital, and generate output losses.
  - Policy rate hikes raise the risk of systemic runs that would disrupt financial intermediation and depress aggregate demand.
- Optimal interest rate policy (absent other central bank tools):
  - Calls for less aggressive rate hikes than in a no-stress scenario to balance price stabilization against preserving banks’ health and credit supply (Figure 2).
  - Less aggressive hikes support asset prices and mitigate strains on intermediaries through mark-to-market and collateral channels, help maintain borrowers’ creditworthiness and banks’ asset quality (asset quality channel), and reduce liquidity risks from redemption and margin calls.
  - Calibration of deviation from no-stress policy should reflect the degree of financial vulnerabilities.
- Role of other instruments (liquidity and solvency tools):
  - Liquidity tools: asset purchases and ex post liquidity provision.
  - Solvency tools: equity injections and resolution frameworks.
  - These tools can help achieve “separation” allowing interest rate policy to focus on price stabilization; feasibility depends on effectiveness and costs (βL, βK).
  - When tools are effective and not costly (βL = βK = 0), full separation is achievable; when tools are costly, separation is partial and monetary policy should incorporate financial-stability considerations.
- Relation to literature:
  - Framework connects to literature on balance-sheet amplification and runs: Bernanke, Gertler, and Gilchrist (1999); Adrian and Shin (2009); Adrian and Duerte (2020); Gertler and Karadi (2011); Brunnermeier and Sannikov (2014); Gertler and Kiyotaki (2015); Boissay, Collard, and Smets (2016); Diamond and Dybvig (1983); Goldstein and Pauzner (2005); Gertler, Kiyotaki, and Prestipino (2016, 2020).

*INTERNATIONAL MONETARY FUND — STAFF DISCUSSION NOTES Navigating Trade-Offs between Price and Financial Stability in Times of High Inflation*

### References

### sdnea2025003 - References

### Central bank policy, liquidity provision, and lender-of-last-resort
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- Adrian, Tobias, and Marc Dobler. 2024. “More Work is Needed to Make Big Banks Resolvable.” IMF Blog, March 18.
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### Monetary policy, quantitative easing/tightening, and interactions with financial stability
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- Barbon, Andrea, and Virginia Gianinazzi. 2019. “Quantitative Easing and Equity Prices: Evidence from the ETF Program of the Bank of Japan.” Review of Asset Pricing Studies 9 (2): 210–55.
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- Gertler, Mark, and Peter Karadi. 2015. “Monetary Policy Surprises, Credit Costs, and Economic Activity.” American Economic Journal: Macroeconomics 7 (1): 44–76.
- Gertler, Mark, Nobuhiro Kiyotaki, and Andrea Prestipino. 2016. “Anticipated Banking Panics.” American Economic Review 106 (5): 554–59.
- Gertler, Mark, Nobuhiro Kiyotaki, and Andrea Prestipino. 2020. “A Macroeconomic Model with Financial Panics.” Review of Economic Studies 87 (1): 240–88.
- Du and coauthors (2024) and Adrian et al. (2024) appear among sources addressing lessons from recent rounds of quantitative easing and tightening.

### Financial stability, macroprudential policy, and bank resolution
- Battersby Bryn, Raphael Espinoza, Jason Harris, Gee Hee Hong, Sandra Lizarazo Ruiz, Paolo Mauro, and Amanda Sayegh. 2022. “The State as Financier of Last Resort.” IMF Staff Discussion Note, No. 2022/003, International Monetary Fund, Washington, DC.
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- Dell’Ariccia, Giovanni, Maria Soledad Martinez Peria, Deniz O. Igan, Elsie Addo Awadzi, Marc C. Dobler, and Damiano Sandri. 2018. “Trade-offs in Bank Resolution.” IMF Staff Discussion Note No. 18/02, International Monetary Fund, Washington, DC.
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- Financial Stability Board (FSB). 2024c. “Key Attributes of Effective Resolution Regimes for Financial Institutions, Revised Version.” Basel.
- G30 Working Group on the 2023 Banking Crisis. 2024. “Bank Failures and Contagion: Lender of Last Report, Liquidity, and Risk Management.” Group of Thirty, Washington, DC.
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- Miettinen, Paavo, and Erlend Nier. Forthcoming. “Rethinking Macroprudential Capital Buffers.” IMF Departmental Paper, International Monetary Fund, Washington DC.
- Capelle, Damien, and Ken Teoh. 2025. “Optimal Interest Rate Tightening with Financial Fragility.” IMF Working Paper, International Monetary Fund, Washington, DC.
- Dell’Ariccia et al. (2018) and Dobler, Moretti, and Piris Chavarri (2020) address lessons for managing systemic banking crises and resolution trade-offs.

### Non-bank financial intermediation, market liquidity, and NBFI vulnerabilities
- Aramonte, Sirio, Andreas Schrimpf, and Hyun Song Shin. 2022. “Non-Bank Financial Intermediaries and Financial Stability.” BIS Working Paper No. 972, Bank of International Settlement, Basel.
- Biljanovska, Nina, Sophia Chen, Gaston Gelos, Deniz Igan, Maria Soledad Martinez Peria, Erlend Nier, and Fabian Valencia. 2023. “Macroprudential Policy Effects: Evidence and Open Questions.” IMF Departmental Paper, International Monetary Fund, Washington, DC.
- Czech, Robert, Bernat Gual-Ricart, Joshua Lillis, and Jack Worlidge. 2021. “The Role of Non-Bank Financial Intermediaries in the ‘Dash for Cash’ in Sterling Markets.” BoE Financial Stability Paper No. 47, Bank of England, London.
- Chen, Ruo, and Esti Kemp. 2023. “Putting Out the NBFire: Lessons from the UK’s Liability-Driven Investment (LDI) Crisis.” IMF Working Paper No. 210, International Monetary Fund, Washington, DC.
- South African Reserve Bank (SARB). 2024. “Repo Facility to Assist Non-bank Financial Institutions with Liquidity during a Market Dysfunction.” Draft Discussion Paper, SARB Financial Stability Department, Pretoria.
- Wilkes, Samuel. 2024. “ECB Official Open to Offering Liquidity Aid to Non-Banks.” Central Banking, October 4.
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### Banking crises, historical case studies, and empirical evidence
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### Financial theory, models, and microfoundations
- Brunnermeier, Markus, and Lasse Heje Pedersen. 2009. “Market Liquidity and Funding Liquidity.” The Review of Financial Studies 22 (6): 2201–38.
- Brunnermeier, Markus, and Yuliy Sannikov. 2014. “A Macroeconomic Model with a Financial Sector.” American Economic Review 104 (2): 379–421.
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- Goldstein, Itay, and Ady Pauzner. 2005. “Demand-deposit Contracts and the Probability of Bank Runs.” The Journal of Finance 60 (3): 1293–327.
- Brimmer, Andrew F. 1989. “Central Banking and Systemic Risks in Capital Markets.” Journal of Economic Perspectives 3 (2): 3–16.
- Buiter, Willem, Stephen Cecchetti, Kathryn Dominguez, and Antonio Sanchez Serrano. 2023. “Stabilizing Financial Markets: Lending and Market Making as a Last Resort.” Reports of the Advisory Scientific Committee No. 13, European Systemic Risk Board, Frankfurt.

### IMF institutional and policy publications cited
- International Monetary Fund (IMF). 2009. “Fiscal Implications of the Global Economic and Financial Crisis.” IMF Staff Position Note No. 09/13, Washington, DC.
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- International Monetary Fund (IMF). 2012b. The Liberalization and Management of Capital Flows: An Institutional View. Washington, DC.
- International Monetary Fund (IMF). 2012c. The Interaction of Monetary and Macroprudential Policies — Background Paper. Washington, DC.
- International Monetary Fund (IMF). 2014a. Staff Guidance Note on Macroprudential Policy. Washington, DC.
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- International Monetary Fund (IMF). 2015. Monetary Policy and Financial Stability. Washington, DC.
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- International Monetary Fund (IMF). 2019. Financial Soundness Indicators Compilation Guide. Washington, DC.
- International Monetary Fund (IMF). 2020. Towards an Integrated Policy Framework. Washington, DC.
- International Monetary Fund (IMF). 2022. Review of the Institutional View on the Liberalization and Management of Capital Flows. Washington, DC.
- International Monetary Fund (IMF). 2023a. “Nonbank Financial Intermediaries: Vulnerabilities amid Tighter Financial Conditions” (Chapter 2). In Global Financial Stability Report. Washington, DC, April.
- International Monetary Fund (IMF). 2023b. “A New Look at Global Banking Vulnerabilities” (Chapter 2). In Global Financial Stability Report. Washington, DC, October.
- International Monetary Fund (IMF). 2023c. Integrated Policy Framework – Principles for the Use of Foreign Exchange Intervention. Washington, DC.

*Source: Navigating Trade-Offs between Price and Financial Stability in Times of High Inflation — Staff Discussion Note No. SDN/2025/003*

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_Source: https://www.imf.org/-/media/files/publications/sdn/2025/english/sdnea2025003.pdf_