Threshold effects of financial stress on monetary policy rules: AÂ panel data analysis

- Advanced economy central banks react nonlinearly to stock market and banking stress.
- Weak evidence of threshold effects of financial stress in emerging economies.
- Cross-sectional dependence can affect the size of the interest rate response.

This study tests for the state-dependent response of monetary policy to increases in overall financial stress and financial sector-specific stress across a panel of advanced and emerging economy countries. We use a factor-augmented dynamic panel threshold regression model with (estimated) common error components to deal with cross-sectional dependence. We find strong evidence of advanced economy countries' aggressive monetary policy loosening in response to stock market and banking stress but only in times of high financial market volatility. By comparison, evidence of threshold effects of financial stress is generally weak for emerging market countries' interest rate decisions.