European Central Bank publishes discussion paper on monetary policy and financial stability trade-offs

The European Central Bank has published a discussion paper setting out a conceptual framework and the quantitative toolkit its staff use to assess interactions between monetary policy and financial stability. The paper explains that short-term trade-offs arise when inflation is high while the financial system is under stress, and medium-term trade-offs arise when inflation is low while leverage and other financial vulnerabilities are building. It is presented as staff research and does not represent the views of the ECB. The paper reiterates that macroprudential policy and supervision are the first line of defence against financial stability risks, but says monetary policy still needs to account for side effects where risks spill over or resilience is limited. It describes the ECB’s use of indicators such as the Composite Indicator of Systemic Stress and the Systemic Risk Indicator, alongside models spanning time-series analysis, bank balance-sheet and stress-testing tools, credit risk models, micro-econometric approaches and DSGE frameworks with banking and sovereign risk channels. Using this framework, the paper says the euro area had returned by the first quarter of 2025 to a no-trade-off region, with inflation close to target, low systemic stress and low measured imbalances, and that staff projections did not point to a near-term re-emergence of either short-term or medium-term trade-offs. The paper adds that the toolkit is being expanded on an ongoing basis to support the ECB’s regular in-depth assessment of the interaction between monetary policy and financial stability in its monetary and financial analysis.