Forecast Targeting and Financial Stability: Evidence from the European Central Bank and Bank of England

Abstract

• This paper studies whether financial market stability is included in central bank mandates. • Financial stability matters to monetary policy makers for both the ECB and BOE. • Ex-post and forward-looking Taylor (1993) Rule are adopted. • A forward-looking Tri-mandate Taylor Rule explains the nominal interest rates path. • Our framework is particularly good-fit in the aftermath of the financial crisis. This paper investigates whether financial markets stability matters in setting monetary policy in the case of the European Central Bank and Bank of England. We show that our Tri-mandate Taylor rule better explains the deviations of the observed policy rate from the implied interest rates for both central banks. The forward-looking version shows that the monetary policy conducted by the ECB is largely affected by the US financial market stability, while only the domestic financial market stability affects the BOE. Lastly, we show that the preferences of monetary policy makers have shifted in the aftermath of the 2008 financial crisis.