Financial Conditions Indexes: A fresh look after the financial crisis

J.Hatzius, P.Hooper, F.S.Mishkin, K.L.Schoenholtz & M.W.Watson

Presented by:
Rishabh Shukla
IGIDR Finance Research Group

October 8, 2015

J.Hatzius, P.Hooper, F.S.Mishkin, K.L.Schoenholtz & M.W.Watson (Presented

Financial Conditions
by: Rishabh
Indexes:
Shukla
A fresh
IGIDR
look
Finance
after the
Research
financial
Group)
crisis

October 8, 2015

1/1

Objective

Objective: To analyze the link between financial conditions and economic activity
by constructing a Financial Conditions Index(FCI) for United States.

J.Hatzius, P.Hooper, F.S.Mishkin, K.L.Schoenholtz & M.W.Watson (Presented

Financial Conditions
by: Rishabh
Indexes:
Shukla
A fresh
IGIDR
look
Finance
after the
Research
financial
Group)
crisis

October 8, 2015

2/1

Layout of the paper

What is FCI and what does it measure?

Limitations of existing FCIs
Selection of financial variables
Prediction Tests with single variable financial indicators
Principal Components Analysis methodology
Testing for FCI robustness
Possible sources of instability in the FCI

J.Hatzius, P.Hooper, F.S.Mishkin, K.L.Schoenholtz & M.W.Watson (Presented

Financial Conditions
by: Rishabh
Indexes:
Shukla
A fresh
IGIDR
look
Finance
after the
Research
financial
Group)
crisis

October 8, 2015

3/1

What is FCI and what does it measure?

FCI summarizes the information about the future state of the economy contained in
the current financial variables.
Ideally FCIs should measure financial shocks, which are exogenous shifts in financial
conditions.
So, true financial shocks must be distinguished from endogenous reflection of past
economic activity in the variablesused for constructing FCI.
Thus, FCIs aim to predict more than what past economic activity alone could tell
about financial conditions.
However, FCIs are not underpinned by a structural model and are thus vulnerable to
the Lucas crtitique.

J.Hatzius, P.Hooper, F.S.Mishkin, K.L.Schoenholtz & M.W.Watson (Presented

Financial Conditions
by: Rishabh
Indexes:
Shukla
A fresh
IGIDR
look
Finance
after the
Research
financial
Group)
crisis

October 8, 2015

4/1

Limitations of previous FCIs

limited span of historical financial series

narrowness of the underlying series in terms of markets covered
financial variables are unpurged of endogenous movements related to business cycles

J.Hatzius, P.Hooper, F.S.Mishkin, K.L.Schoenholtz & M.W.Watson (Presented

Financial Conditions
by: Rishabh
Indexes:
Shukla
A fresh
IGIDR
look
Finance
after the
Research
financial
Group)
crisis

October 8, 2015

5/1

Selection of financial variables

During the GFC,

Price signals became less reliable as markets siezed up.
Non-price credit conditions tightened dramatically, such as stricter terms and
reduced availability.
Credit flows slowed abruptly.
In order to capture these effects,
The authors include a sample of bank and non-bank credit variables in a variety of
markets.
Survey indicators of bank lending conditions from the Fed.
Historical Coverage
This paper employs 45 series which go back to the beginning of 1970s.
However the underlying series are of different lengths leading to an unbalanced data
panel.

J.Hatzius, P.Hooper, F.S.Mishkin, K.L.Schoenholtz & M.W.Watson (Presented

Financial Conditions
by: Rishabh
Indexes:
Shukla
A fresh
IGIDR
look
Finance
after the
Research
financial
Group)
crisis

October 8, 2015

6/1

Prediction tests with single variable financial indicators

Certain financial indicators can be used as leading indicators of movements in real

economic activity.
These financial variables are determined after taking into account each variables
auto-regressive structure.
The in-sample regression specification used to test this is :
yt+h yt = 0 +

py
X
i=1

i yt+1i +

px
X

i xt+1i + et+i

i=1

where yt indicates the real activity indicator like logarithm of real GDP and xt
denotes financial indicators like the first difference of the federal funds rate.

J.Hatzius, P.Hooper, F.S.Mishkin, K.L.Schoenholtz & M.W.Watson (Presented

Financial Conditions
by: Rishabh
Indexes:
Shukla
A fresh
IGIDR
look
Finance
after the
Research
financial
Group)
crisis

October 8, 2015

7/1

Results of the prediction tests

J.Hatzius, P.Hooper, F.S.Mishkin, K.L.Schoenholtz & M.W.Watson (Presented

Financial Conditions
by: Rishabh
Indexes:
Shukla
A fresh
IGIDR
look
Finance
after the
Research
financial
Group)
crisis

October 8, 2015

8/1

PCA methodology

This paper uses PCA and employs 45 financial series to build the FCI.
Let Xit denote the i th financial indicator and Yt denote the vector of macroeconomic
indicators then
Xit = Ai (L)Yt + it ,
where it is uncorrelated with current and lagged values of Yt
it represents the financial variable purged of its relation with current and lagged Y.
If it can be decomposed as

it = i Ft + uit ,
where Ft is a kX1 vector of unobserved financial factors and uit captures unique
variation in it which is uncorrelated with Ft and Yt .
Thus Ft measures the co-variation or co-movement in the financial indicators.
Finding Ft is the key goal of the PCA methodology.

J.Hatzius, P.Hooper, F.S.Mishkin, K.L.Schoenholtz & M.W.Watson (Presented

Financial Conditions
by: Rishabh
Indexes:
Shukla
A fresh
IGIDR
look
Finance
after the
Research
financial
Group)
crisis

October 8, 2015

9/1

Testing for FCI robustness using balanced panel approach

An unbalanced panel uses a longer history of financial variables.

A balanced variant of the new FCI was created 1980 onwards.
The baseline FCI outperfomed the narrower version over 1990s and 2000s.
However, during 1980s the balanced panel variant outperformed significantly.

J.Hatzius, P.Hooper, F.S.Mishkin, K.L.Schoenholtz & M.W.Watson (Presented

Financial Conditions
by: Rishabh
Indexes:
Shukla
A fresh
IGIDR
look
Finance
after the
Research
financial
Group)
crisis

October 8, 2015

10 / 1

Testing for FCI robustness using decomposition tests

The 45 financial series are decomposed into five categories, namely:

interest rate levels and spreads
asset prices
stock and flow quantities
surveys
second moments

No single component stands out as consistently better relative to other components.

The overall FCI does better than any of its major components and also compared to
the best single financial indicators.
Thus, pooling of a large number of financial variables leads to significant
benefits in prediciton.

J.Hatzius, P.Hooper, F.S.Mishkin, K.L.Schoenholtz & M.W.Watson (Presented

Financial Conditions
by: Rishabh
Indexes:
Shukla
A fresh
IGIDR
look
Finance
after the
Research
financial
Group)
crisis

October 8, 2015

11 / 1

Testing for FCI robustness using purging

Purging the underlying variables of macro influences yields better results during
early 1990s and all of 2000s.
During 2009 Q2-2009 Q4, the unpurged index is esentially neutral. This shows that
financial conditions were near their historical average.
However, during the same span the purged index suggested that financial conditions
remain a drag on future real activity.
Thus, the perged index is better able to predict the real economic activity.

J.Hatzius, P.Hooper, F.S.Mishkin, K.L.Schoenholtz & M.W.Watson (Presented

Financial Conditions
by: Rishabh
Indexes:
Shukla
A fresh
IGIDR
look
Finance
after the
Research
financial
Group)
crisis

October 8, 2015

12 / 1

Possible sources of instability in the FCI

Both the evolution of financial conditions and their underlying causes need to be
understood in order to use FCIs effectively.
Purging the index of macroeconomic influences yields substantially better results in
some periods compared to others.
The periods of success are periods of considerable financial distress like the dot-com
bubble burst of early 2000s and more severe financial crises in recent years.
FCIs do better in predicting real activity during periods dominated by exogenous
financial disturbances than single variable indicator models.

J.Hatzius, P.Hooper, F.S.Mishkin, K.L.Schoenholtz & M.W.Watson (Presented

Financial Conditions
by: Rishabh
Indexes:
Shukla
A fresh
IGIDR
look
Finance
after the
Research
financial
Group)
crisis

October 8, 2015

13 / 1

References

References

Bernanke, B. (1990), On the Predictive Power of Interest Rates and Interest Rate
Spreads, New England Economic Review, November, pages 51-68.
Swiston, A. J. (June 2008). A U.S. Financial Conditions Index: Putting Credit
Where Credit is Due, IMF Working Paper.

J.Hatzius, P.Hooper, F.S.Mishkin, K.L.Schoenholtz & M.W.Watson (Presented

Financial Conditions
by: Rishabh
Indexes:
Shukla
A fresh
IGIDR
look
Finance
after the
Research
financial
Group)
crisis

October 8, 2015

14 / 1