Trade-offs between price and financial stability can occur when inflation is above target and financial stress is rising. Use of central bank liquidity tools and other financial stability policies may, under some circumstances, allow central banks to maintain their inflation fighting stance, while addressing financial stress. However, challenges in deploying these tools and specific country characteristics may hinder central banks’ ability to achieve both price and financial stability. In such circumstances, central banks should account for financial stress increasing downside risks to activity, allow for slower disinflation using monetary policy flexibility, and communicate that deviations from the medium-term inflation target are temporary. Countries with weak central bank credibility, high exposure to exchange rate movements, and limited fiscal space face extra challenges in managing these trade-offs and might have to rely on foreign exchange interventions, macroprudential policies, capital flow measures, and international liquidity tools.

Recent events have reignited concerns about the financial stability implications of monetary policy. We show empirically that monetary tightening exacerbates financial stress after supply shocks, through declines in asset prices, bank equity and increased run risks. We then develop a tractable model in which intermediaries face occasionally binding leverage constraints and endogenous risks of runs, while producers face price adjustment frictions. Interest rate tightening, by lowering asset prices, exacerbates both financial distortions when intermediaries’ equity is sufficiently low. We use the model to characterize the constrained efficient use of interest rate policy, credit policy, equity injection, macroprudential policy and deposit insurance during periods of supply-driven inflation and fragility. When other tools are costly, optimal monetary policy tightening should be less aggressive in the presence of financial fragility. If other tools were not costly, the right combination of tools could perfectly separate financial stability from price stability objectives.