European Central Bank working paper finds a 1 percentage point rise in inflation can double systemic banking crisis probability

The European Central Bank published an ECB Working Paper assessing whether inflation itself, rather than the accompanying interest rate response, causally affects financial stability. Using historical evidence, the authors find that inflation shocks are associated with a higher likelihood of systemic banking crises, and that this effect persists after controlling for the confounding role of monetary policy. The paper reflects the authors’ views and not necessarily those of the ECB. Across 18 advanced economies from 1870 to 2020, the analysis compares outcomes for countries with pegged and base currencies to isolate inflation’s direct effect when monetary policy shocks are shared. It finds the destabilising effect holds for both demand- and supply-driven inflation. A second approach instruments inflation using exogenous oil supply shocks for 1975 to 2020, estimating that a 1 percentage point rise in inflation roughly doubles crisis probability from its sample average, and corresponds to a 4.6 percentage point increase in the probability of crisis in the next year in the linear probability model. The link is stronger in countries with high mortgage-to-GDP ratios and low wage growth, consistent with a redistribution channel in which inflation erodes real incomes and impairs household debt servicing; the effect is also amplified where central bank financial independence is lower and where banks rely more on fragile funding structures.