Leaning Against Credit? Evidence that the Fed Incorporates Financial Stability Considerations into Monetary Policy

Abstract

There is a lively debate among academics and central bankers about whether monetary policy should "lean against the wind" by responding to asset-market booms with higher interest rates in order to promote financial stability. By constructing measures of sentiment in credit and equity markets, I find novel evidence that the Federal Reserve's interest rate policy has been responsive to financial stability considerations in addition to the dual mandate. Rather than leaning against the wind in general, the Federal Reserve appears to lean against credit, consistent with the documented impact of credit on financial stability. These findings show that actual Federal Reserve practice runs counter to the mainstream view that central bankers should steer clear of addressing financial stability concerns using monetary policy. Finally, I study the optimal conduct of monetary policy in a model where agents deviate from rational expectations. This exercise generates two salient conclusions: central banks should tighten monetary policy as they become increasingly uncertain about households' behavioral biases, and they can increase expected utility by leaning against the wind to quell overoptimism. Considered as whole, this paper highlights that there exists not only historical precedent, but also sound theoretical justification, for central bankers to lean against the wind.