The Case for a Financial Conditions Index
The effect of the short-term interest rate on GDP—known as the "IS curve"—is a central relationship in standard macroeconomic models. But we show that the IS curve for the US has broken down empirically over the past few decades. This breakdown provides a natural motivation for considering a financial conditions index (FCI). Our FCI is defined as a weighted average of riskless interest rates, the exchange rate, equity valuations, and credit spreads, with weights that correspond to the direct impact of each variable on GDP.
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We can decompose the IS curve into 1) the response of GDP to the FCI and 2) the response of the FCI to the federal funds rate. The GDP-FCI link is largely unchanged; FCI changes remain highly significant predictors of real GDP changes. By contrast, the FCI-funds rate link has broken down and this is why the IS curve has broken down as well.
The latter finding does not mean that Fed officials are now unable to influence financial conditions, and ultimately GDP. We show that monetary policy innovations—measured as changes in Treasury yields in one-hour windows around FOMC announcements—remain highly significant predictors of FCI changes. So Fed officials can influence the FCI via monetary policy innovations, even though they cannot control it just by setting a path for the funds rate.
Concerns about reverse causation from GDP to the FCI look overdone. Although growth shocks—measured via data surprises—have significant effects on individual asset prices, these effects tend to offset one another in an FCI; in fact, they cancel out almost exactly in the case of the GS FCI.
Concerns about the sensitivity of the FCI to changes in the neutral funds rate r* also look overdone. To show this, we construct an "equilibrium" FCI that varies with perceived changes in r*. We find that movements in the equilibrium FCI account for only a small share of the year-to-year variation in the actual FCI.
Based on these results, we amend a standard New Keynesian macroeconomic model to include an FCI. This produces a Taylor-type rule which implies that the central bank should use its tools to ease the FCI (or keep it easy) when inflation and/or employment are below mandate-consistent levels, and vice versa.