Should Central bank deviate from its objective of price stability to promote financial stability?

Interesting BIS paper by Frederic Boissay, Fabrice Collard, Jordi Galí and Cristina Manea:

We study whether a central bank should deviate from its objective of price stability to promote financial stability. We tackle this question within a textbook New Keynesian model augmented with capital accumulation and microfounded endogenous financial crises. We compare several interest rate rules, under which the central bank responds more or less forcefully to inflation and aggregate output.

Our main findings are threefold.

First, monetary policy affects the probability of a crisis both in the short run (through aggregate demand) and in the medium run (through savings and capital accumulation).

Second, a central bank can both reduce the probability of a crisis and increase welfare by departing from strict inflation targeting and responding systematically to fluctuations in output.

Third, financial crises may occur after a long period of unexpectedly loose monetary policy as the central bank abruptly reverses course.

Third finding is a problem. Central banks typically lower interest rates following a financial crisis as seen post-2008 crisis. However whenever it reverses course it could lead to a crisis.

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