Central banks have engaged in a tightening cycle by raising rates, yet decided not to first reduce their balance sheets. We show that the scarcity of government bonds that followed the European Central Bank's Quantitative Easing efforts impeded the transmission of rate hikes to money market rates. When the ECB increased its policy rates by 50bp, the borrowing rate for loans collateralized by the most scarce bonds increased by only 30bp, in the repo market. We show that the lack of pass-through is priced in the yield of government bonds, which increased less for scarcer bonds. Heterogeneous bond holdings across institutions imply that the cost of (collateralized) funding varies significantly across European institutions.

How should monetary policy respond to deteriorating financial conditions? We develop and estimate a dynamic new Keynesian model with financial intermediaries and sticky long-term corporate leverage to show that active response to movements in credit conditions often helps to mitigate losses in aggregate consumption and output associated with macro fluctuations. A (credible) monetary policy rule that includes credit spreads is thus welfare-improving sometimes even obviating the need for explicit inflation targeting.

This paper investigates the stock market implications of the Federal Reserve's ability to control inflation, focusing on investor uncertainty and learning about it. Investor uncertainty about the Fed's ability to control inflation heightens stock market volatility and risk premium, particularly during pronounced monetary tightening and easing cycles. Moreover, investor learning generates an asymmetry that amplifies the impact of inflation surprises when the Fed tightens or loses its inflation control credibility, causing particularly high volatility and risk premium. Empirical tests support our model's predictions, highlighting the importance of investors learning about the Fed's ability to control inflation in shaping financial markets.