This paper builds a network econometric model capable of analysing the impact of inflation on systemic risk. Its main contribution is the identification of a robust inverse relationship which reverses when controlling monetary policy. This reveals that the former effect is due to monetary policy reactions to inflation. It is further analysed whether this effect comes from overindebtness as in a Minsky moment. There is no evidence supporting it, which suggests that mechanisms other than excess credit underlie such a relationship. The results presented in this paper are of particular importance for understanding monetary policy reactions to current inflationary cycles.
Analogously to many other macro-financial linkages, the effects of inflation on systemic risk are, to a large extent, still unknown. This is the result of a disconnection between the interplay of the economy and financial markets which has dominated macroeconomic research in recent decades. However, the financial crisis of 2007–2009 made clear that there is a constant interaction between the economic system and financial markets (Diebold and Yılmaz, 2015, Abbas et al., 2019, Balcilar and Bekun, 2020, Cotter et al., 2020, Silva et al., 2017, Festić et al., 2011, Aliyu, 2012), highlighting the need to consider additional contagion channels rather than the traditional interbank market (Silva et al., 2018). Thus, many of the macro-financial variables depend the other dimension, potentially in a non-linear way, as it has been theoretically argued (Bernanke et al., 1999, Gertler and Kiyotaki, 2010, Mendoza, 2010, Brunnermeier and Sannikov, 2014) and empirically estimated (Giglio et al., 2016).
In particular, the effects of inflation on systemic risk are of special importance nowadays. After more than 20 years of relatively low inflation (see red line Fig. 1, quantified on the right axis), the study of the inflation-financial stability binomial have not been of upmost importance. Thus, some studies have analysed the impact of inflation on the performance of the financial sector (Boyd et al., 2001), financial development (Festić et al., 2011), and many have analysed the relationship between inflation and public debt (Bhattarai et al., 2014, Krause and Moyen, 2016, Cherif and Hasanov, 2018). However, the recent inflationary shock has caused “seismic waves” for the stability of the financial system, as contractive monetary policy stances have revealed, among other concerns, overexposures to interest rate risks by financial institutions. Therefore, discounting monetary policy, there may exist a relationship between inflation and systemic risk which could make controlling inflation a major concern not only for the correct functioning of the economy, but also for ensuring the stability of the financial system. As shown in Fig. 1, this correlation between inflation and systemic risk connectedness may exist a priori.
This paper has provided some inferences about the effects of inflation on systemic risk in a financial network of twelve countries. It has been found that, after controlling the monetary policy reactions to inflation, inflation increases systemic risk. Furthermore, in the time span considered (2000–2022), inflation increases more systemic risk than interest rates. This provides partial equilibrium evidence in favour of aggressive monetary policy interventions to preserve financial stability and not only to ensure the correct functioning of the economy during inflationary shocks. Indeed, if inflation increases more systemic risk than interest rates, there exists an incentive for the central bank to increase interest rates in presence of rising inflation, since the effect of the latter outweights the negative effect of the bank rate hike for financial stability.
It has been further tested whether the channel through which inflation increases systemic risk is excessive lending during economic booms as in a Minsky moment. However, evidence has not been found which reveals that mechanisms other than excess credit are behind the relationship. All the results presented in this paper are robust to several variable selections and econometric specifications, and extend to inflation expectations as well. Further research can be directed towards increasing the understanding of the relationship between inflation and systemic risk with monetary policy, since a substantial part of it appears to be happening through interest rates.