The U.S. financial system wields dominant influence over the national and global economies. Moreover, securities and derivatives markets play a greater role relative to banks and compared to other developed countries. Medium-term shifts in financial conditions, rather than short-term changes, should be consequential for economic growth and monetary policy. Therefore, a timely and consistent measurement of U.S. financial conditions is crucial for macro trading strategies. A broad econometric measure of U.S. financial conditions based on risk, liquidity and leverage is produced and regularly updated by the Chicago Fed.

Dudley, William (2017), “The importance of financial conditions in the conduct of monetary policy”, Remarks at the University of South Florida, 30 March 2017,
and as background: Brave, Scott and R. Andrew Butters (2011), “Monitoring financial stability: A financial conditions index approach”, Federal reserve Bank of Chicago, Economic Perspectives, 2011/1.

The post ties in with the lecture on macroeconomic trends, particularly the section on best practices for tracking macroeconomic trends.
The below are excerpts from the papers. Emphasis and cursive text have been added.

Why U.S. financial conditions matter

Financial conditions in the United States play an important role in influencing economic conditions. Because movements in financial markets are a major factor influencing broader financial conditions, it is necessary to understand how financial market developments can affect the economic outlook and, therefore, the appropriate setting of monetary policy…The setting of monetary policy, in turn, affects market developments and financial conditions. This two-way feedback is an important feature of the interaction between financial conditions and monetary policy.” [Dudley, 2017]

“The most well-known [monetary policy] rule—the Taylor Rule—does not explicitly take financial conditions into account in terms of its monetary policy prescription. In that rule, the federal funds rate depends only on the deviations of output from its potential and inflation from the Federal Reserve’s 2 percent objective, and on the level of the real short-term interest rate consistent with a neutral stance of monetary policy. Because the interactions can shift between financial conditions and the economic outlook—as well as between financial conditions and the federal funds rate—the absence of financial conditions in this rule can cause it to perform poorly as a guide for monetary policy.
However…there is no mechanical link between policy rates and financial conditions that monetary policymakers can systematically rely upon to set policy…The FOMC does…care about financial conditions not for themselves, but instead for how they can affect economic activity and ultimately our ability to achieve the statutory objectives of the Federal Reserve—maximum employment and price stability…Financial conditions affect households’ and firms’ saving and investment plans, and, therefore, play a key role in influencing economic activity and the economic outlook.” [Dudley, 2017]

How financial conditions influence U.S. monetary policy

Divergences between short-term interest rates and financial conditions often appear to be larger and more persistent in the United States than in most other advanced economies. There are several reasons for this. First, the U.S. financial system depends less on its banking system to intermediate financial flows than in other countries… Second, in contrast to most other countries, U.S. residential housing is financed mainly by 30-year fixed-rate mortgages, rather than—as is the case in most other countries—adjustable-rate mortgages with rates that much more closely track their central banks’ short-term interest rate targets. Third, the equity market plays a much more important role in the United States than elsewhere. The total market capitalization of the U.S. equity market is considerably higher than in the euro area and Japan.” [Dudley, 2017]

“We should care much more about longer-term movements in financial conditions than about higher-frequency, transitory movements…It is also important not to overreact to every short-term wiggle in financial markets…Consider the U.S. equity market in 1987. The S&P 500 index began the year at 242, shot up to a peak of 337 in August (an increase of almost 40 percent) and plummeted to a trough of 225 in October (a fall of 33 percent). When the stock market fell more than 20 percent on October 19th—which came to be known as “Black Monday”—many feared that the decline would lead to a recession. After all, that crash was the largest-ever one-day percentage decline of the U.S. stock market. But, no recession occurred. Importantly, households sustained their spending despite the sharp decline in household wealth. This happened, in part, because household spending had not yet responded much to the sharp run-up in stock prices earlier in the year.” [Dudley, 2017]

How to measure U.S. financial conditions

“Indexes of financial conditions are typically constructed as weighted averages of a number of indicators of the financial system’s health… We also develop an alternative index that separates the influence of economic conditions from financial conditions…Our goal is…to construct high-frequency indexes with broad coverage of measures of risk, liquidity, and leverage. By risk, we mean both the premium placed on risky assets embedded in their returns and the volatility of asset prices. In terms of liquidity, our measures capture the willingness to both borrow and lend at prevailing prices. Measures of leverage, in turn, provide a reference point for financial debt relative to equity.
In general, risk measures receive positive weights…whereas liquidity and leverage measures tend to have negative weights. This pattern of increasing risk premiums and declining liquidity and leverage is consistent with tightening financial conditions… Positive index values indicate tighter conditions than on average…It is common for financial conditions indexes to be expressed relative to their sample standard deviations.” [Brave and Butters, 2011]

Our financial conditions indicator [FCI] is constructed in a similar fashion to many coincident indicator models where the variation in a panel of time series is governed linearly by an unknown common source and an idiosyncratic error term…With the model in state-space form and initial estimates of the system matrices, the EM [expectation maximization] algorithm…can be used to estimate the latent factor… Using this method, we construct our weekly financial conditions index that takes into account both the cross-correlations of the indicators and the historical evolution of the index itself in determining the appropriate weights…To allow for historical comparisons and financial innovation, our method must also be able to incorporate time series of varying lengths and different frequencies… index. At each point in time, all of the available indicators are used to construct the index, ignoring those that are unavailable.” [Brave and Butters, 2011]

“We have segmented the financial indicators in our FCI…into three categories: money markets (28 indicators), debt and equity markets (27), and the banking system (45)…
The money markets category is made up mostly of interest rate spreads that form the basis of most other financial conditions indexes… we also include in this category measures of implied volatility and trading volumes of several money market financial products… widening spreads, increasing volatility, and declining volumes all constitute a tightening in money market conditions…
The debt and equity markets category comprises mostly equity and bond price measures capturing volatility and risk premiums in their various forms… In terms of equities, the largest positive weight in our FCI is given to…the VIX, which measures the implied volatility of the Standard & Poor’s (S&P) 500…In terms of bonds, credit spreads such as the high yield/Baa corporate and financial/corporate enter strongly here with large positive weights; so do spreads relative to Treasuries…
The banking system category contains mainly survey-based measures of credit availability as well as accounting-based measures for commercial banks and so-called shadow banks…The Federal Reserve Board’s Senior Loan Officer Opinion Survey questions on loan spreads and lending standards all enter strongly into our FCI…as do several other survey measures of business and consumer credit availability…The Credit Derivatives Research Counterparty Risk Index, measured as the average of the CDS spreads of the largest 14 issuers of CDS contracts, also receives a large positive weight.” [Brave and Butters, 2011]

“Computed over a long time horizon and from a large sample of financial indicators of different frequencies, these indexes provide a timely assessment of how tightly or loosely financial markets are operating relative to historical financial and economic conditions…We establish that it is possible to use our indexes to improve upon forecasts of measures of economic activity over short and medium forecast horizons.” [Brave and Butters, 2011]

For data and updatable charts of the U.S. national financial conditions index and the adjusted national financial conditions index click here.

“Focusing on the United States, financial conditions can be broadly summarized by five key measures: short- and long-term Treasury rates, credit spreads, the foreign exchange value of the dollar, and equity prices.” [Dudley, 2017]

 

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Ralph Sueppel is founder and director of SRSV Ltd, a research company dedicated to socially responsible macro trading strategies. He has worked in economics and finance for almost 25 years for investment banks, the European Central Bank and leading hedge funds.