Macroeconomic effects of financial stress and the role of monetary policy: a VAR analysis for the euro area

This paper analyses an otherwise standard macro-financial VAR model for the euro area that includes - apart from conventional measures of output, inflation and monetary policy - a composite indicator of systemic financial stress, namely the CISS index, and total assets of the ECB balance sheet capturing the stance of unconventional monetary policy. I find that the CISS contributes significantly to the dynamics of the macroeconomy and exerts a strong influence on monetary policy when looking at both policy rates and the ECB balance sheet. The significance of the CISS appears robust to the inclusion of a broad set of real and financial control variables. Based on tests of direct versus indirect (Granger-)causality patterns proposed in Hsiao (1982), I also find that unlike unconventional policy as measured by ECB balance sheet growth, the policy rate does not seem to react directly to variations in financial stress but rather indirectly through the impact of financial stress on macroeconomic conditions. These different patterns of reaction are broadly consistent with the ECB’s “separation principle”. The estimated effects of the ECB’s standard and non-standard policy measures on inflation and economic growth are moderate, although an easier stance in both policy tools helps calm down financial stress.