William C Dudley: Financial conditions indexes - a new look after the
financial crisis
Remarks by Mr William C Dudley, President and Chief Executive Officer of the Federal
Reserve Bank of New York, at the annual US Monetary Policy Forum, University of Chicago
Booth School of Business, New York, 26 February 2010.
* * *
Thank you for having me to speak as a panelist today. As always my views are my own and
do not necessarily reflect those of the Federal Open Market Committee (FOMC) or the
Federal Reserve System.
I am glad that Narayana Kocherlakota is here as well as I don't think I qualify as the most
"objective" person to be a panelist on this particular topic. After all, I have long been a
proponent of using a financial conditions framework to think about the economic outlook and
monetary policy. When I was working as the chief U.S. economist at Goldman Sachs, we
built one of the earliest financial conditions indexes, the Goldman Sachs Financial Conditions
Index (GSFCI).
I am going to divide my remarks today into two parts. First, I will discuss why a financial
conditions framework is useful when thinking about the economic outlook and monetary
policy. Second, I will discuss the paper, "Financial Conditions Indexes: A New Look after the
Financial Crisis," by Jan Hatzius, Peter Hooper, Frederic Mishkin, Kermit L. Schoenholtz and
Mark W. Watson, in some detail - evaluating its considerable strengths and pointing out
some areas where additional work would be useful.
There are a number of reasons that a financial conditions framework is likely to be useful
when evaluating the economic outlook and the conduct of monetary policy. Most important,
monetary policy works its magic through its effect on financial conditions; it does not operate
directly on real economic variables. That is because the level of the federal funds rate
influences other financial market variables such as money market rates, long-term interest
rates, credit spreads, stock prices and the value of the dollar, and it is these variables that
influence real economic activity.1 This means that if the linkage between the fed funds rate
and this broader constellation of financial indicators is not stable or completely predictable,
then knowing what is happening to the fed funds rate is not sufficient to predict economic
activity. The instability of the linkage between the fed funds rate and financial conditions
indicators means that these indicators provide additional information about real activity and
also are relevant in deciding the appropriate fed funds rate target. In contrast, if the
transmission mechanism from the fed funds rate to financial conditions and onward to real
economic activity were completely predictable, then there would be no need to focus on
financial conditions as an intermediate target variable. The level and path of the fed funds
rate matters, but it also matters how this gets transmitted to the real economy through the
financial sector.
Over the past 15 years, there have been two important instances in which the relationship
between the fed funds rate and financial conditions have diverged significantly. The first was
the late 1990s technology stock market bubble and its aftermath. The second was the
mid2000s credit market bubble that culminated in the recent financial crisis. During these
episodes, the relationship between the fed funds rate and financial conditions was
particularly unstable. As a result, developments in the financial markets became very
important in the conduct of monetary policy.
In this respect, I would note that financial conditions indicators have implications for "Taylor
Rule" formulations for monetary policy. As you all know, Taylor-type rules provide a
shorthand metric for the appropriate stance of monetary policy. In such rules, the fed funds rate is
set at a level equal to the equilibrium real fed funds rate, plus the inflation objective, plus the
weighted deviation of output from its potential and of the inflation objective from actual or, if
forward looking, expected inflation. Often, analysts and economists assume that the
equilibrium real fed funds rate is equal to 2 percent, its long-term historical value. Although,
in principle, such rules allow the equilibrium rate to be time varying, it typically is assumed to
be constant.
I have always been uncomfortable with this usage of a 2 percent equilibrium real rate
assumption because it ignores the possibility that the equilibrium rate changes in response to
technology shocks or in response to changes in how monetary policy is transmitted via the
financial system to the real economy. For example, in the late 1990s, when trend productivity
growth shifted upward, it seemed logical that this would also push up the equilibrium
shortterm real interest rate. That is because higher productivity growth, by raising the return on
capital, spurs greater investment, thereby driving the equilibrium rate higher. Similarly, if
stock prices rose sharply in response to higher productivity growth, this should also lead to a
higher equilibrium real rate through the effect of greater stock market wealth on consumer
spending. Higher stock prices meant that financial conditions were easier. This needed to be
offset by a somewhat higher fed funds rate target.
Financial conditions also appear to have become more important in terms of their influence
on business cycles. On the one hand, the fed funds rate has been more stable and the range
of the fed funds rate over the cycle has been smaller. However, on the other hand, relative to
what has happened to the fed funds rate target, financial conditions have become more
volatile. The hypothesis that Ed McKelvey and I put forward in 1997 in response to evidence
of the so-called "Great Moderation" seems to be well supported by the past two economic
downturns and their aftermaths:
Put simply, longer stretches of economic growth imply greater leverage and complacency
and thus, greater financial problems when recessions do occur. In brief, longer U.S. business
cycles logically lead to four linked consequences - more financial leverage, longer bouts of
balance sheet repair, more subdued recoveries and longer periods of decline in inflation and
interest rates during the early stages of recovery.2
If the economy is more stable, then market participants will have more appetite for risk. This
works fine during the expansion stage, when growth is relatively stable. However, when a
recession finally arrives, it is a bigger shock than when recessions were more frequent. This
surprise results in a more substantial adjustment in financial conditions. Ironically, the
increased stability of the business cycle during the expansion phase appears to increase the
volatility and importance of financial conditions when recessions do occur.
At this stage, incorporating indicators of financial conditions into forecasting and into
evaluating the conduct of monetary policy probably requires relying on constructing a "rough
and ready" index. Macroeconomic models - especially dynamic stochastic general
equilibrium models - do not incorporate robust financial sectors. Instead, these models have
implicitly assumed that the monetary transmission mechanism and the financial
intermediation process always works smoothly and predictably.3
Events of the past decade confirm that financial conditions matter and that the fed funds rate
is not a sufficient statistic with which to assess the impact of monetary policy on the real
economy. Of course, this is not news to the Federal Reserve, which has explicitly taken
financial conditions into account in its conduct of monetary policy. This is evident in the
transcripts of the FOMC meetings that are publicly available and the numerous references to
financial conditions in the FOMC minutes that go back more than a decade.
An analysis of the FOMC minutes over the past decade indicates that references to financial
conditions have been frequent, especially recently. Exhibit 1 illustrates the percentage of
paragraphs in the minutes (excluding the directive and some other paragraphs associated
with administrative matters such as the election of the chairman) that mention the phrase
"financial conditions." As can be seen, there have been frequent references over the past
decade. One peak occurred in 2000 when the stock market peaked and began to deflate.
Thereafter, references fell off a bit until rising sharply again recently. Clearly, the recent
financial crisis has underscored the importance of financial conditions.
Today's paper makes clear the importance of financial conditions. The paper's analysis of
the many financial conditions indexes that have been constructed as proxies for overall
financial conditions finds that many of these indexes have done better than the fed funds rate
or other single-variable financial indicators as predictors of real economic activity.
However, as the paper also makes very clear, the indexes that have been developed are still
very rudimentary. In particular, most financial conditions indexes are ad hoc and incomplete.
In their review of the existing financial condition indexes, the authors find considerable
differences across the indexes in the way that they are constructed and in terms of the
variables included.
In addition, there is another difficulty. As the financial system changes over time, both in
terms of structure and in terms of financial products, the financial variables that we might
determine to be important are also changing. For example, in the wake of the recent financial
crisis, the variables that the paper's authors call "neoclassical" - such as the yield curve and
stock market prices - appear to have become less important relative to the variables that the
authors term "non-neoclassical" - such as quantity and survey measures of credit availability.
Variables that would work best 10 years ago as forecasting tools may no longer be very
useful. As the structure of the financial system changes, the identity of variables that capture
financial conditions naturally changes.
Let me now discuss the paper in more detail. I will do this in two steps. First, I will discuss the
considerable contributions of the paper. Second, I will talk about where the paper might be
extended and other areas of future research that might seem appropriate.
In general, I liked the paper. I think it makes some important contributions in how to construct
a more complete and robust financial conditions index. In particular, I thought the paper
makes two important points:

Financial conditions should measure financial innovations, not changes in financial
variables that are due to past changes in economic activity. The endogenous
components of financial conditions should be removed in the construction of a
financial conditions index.

Both neoclassical (yield curve and stock prices) and non-neoclassical (credit
availability) variables should be included. The GSFCI that I helped to develop only
included neoclassical indictors and I think that was (and is) a shortcoming.
The authors deserve considerable credit for constructing a financial conditions index (FCI)
that is more rigorous and complete than any that have been developed in the past -
44 financial variables divided across five categories. Moreover, this is not just innovation for
its own sake. The new FCI does a better job than single-factor models in forecasting real
gross domestic product (GDP).
So what are the shortcomings of this approach? First, including 44 variables may generate
good results more because the additional variables add greater flexibility to soak up
variability in real GDP, rather than providing a more solid theoretical underpinning. As the
authors note, the variables were selected, in part, on the basis of what we know today about
which variables are likely to be important. But this type of selection process - even if
conducted on a pseudo real-time basis - introduces selection bias, which the authors do
admit could be important.
Second, despite the inclusion of a large number of variables, some important ones may still
be missing. In particular, leverage variables - such as the leverage ratio of the major
securities dealers - may be an important component of financial conditions. The work of
Tobias Adrian and Hyun Shin suggests that the increase in leverage of the major securities
was a major factor that fueled the asset bubble preceding the recent crisis. If this was indeed
the case as seems likely, this type of variable should also be included in a financial
conditions framework.4
Third, as the authors note, the resulting FCI is complex; it is difficult to estimate, update and
to communicate what the results mean. I think FCIs have value as heuristic devices in
highlighting what is important. One loses that benefit when the number of variables becomes
large and the indexes become complex.
Fourth, it would be interesting to know how financial conditions indexes for other countries
and regions would differ. The authors focus only on the United States. Thus, it is difficult to
know whether the value of financial conditions indexes are specific to the United States or
should be applied more broadly.
Fifth, I thought the paper could have gone further in exploring the implications of its results.
The focus of the paper is on how to construct a financial conditions index that does a good
job of forecasting economic activity. The paper does not tackle the implications for monetary
policy stemming from developments in financial conditions as measured by the new FCI. If
financial conditions evolve in an unanticipated way, how should this influence the conduct of
monetary policy?
In particular, the authors note that during the 2003-06 period, financial conditions tightened
less than expected given the rise in the fed funds rate and, during the 2007-08 period
tightened even as the Federal Reserve slashed its fed funds rate target. These results raise
a number of interesting questions. In particular, does the behavior of the new FCI imply that
the Federal Reserve should have tightened more aggressively during the 2003-06 period or
eased more aggressively during the 2007-09 period? The paper's results seem to imply this,
but it would be interesting to see whether this is the case or not.
It also would be useful to know how qualitatively important these differences are. If the
differences are worth only a few basis points on the fed funds rate, then having a good
indicator of financial conditions is not going to be a very important input in the formulation of
monetary policy. In contrast, if a shift in financial conditions implies that the fed funds rate
path was "off" by a hundred basis points relative to what actually occurred, then this
obviously has big implications for monetary policy. The development of equilibrium models
that incorporate financial conditions in a meaningful manner might prove helpful in answering
these types of questions.5
In addition, I would like to know how the various linkages have changed over time. Is the
linkage between the fed funds rate and financial conditions as measured by the new FCI
loosening over time or not? If so, why is this happening? Is it due to financial market
innovation or the growth in share of the non-bank financial sector? I also would like to know
how the linkage between financial conditions and the real economy is changing over time. If
this is happening, what are the implications for macroeconomic stability and monetary
policy?
Finally, I would like to know about the dynamic properties of the new FCI. Are particularly
high (expansive) readings dangerous and should they be taken as suggestive of asset
bubbles? Should the Federal Reserve try to prevent such occurrences because loose
financial conditions precede episodes of financial instability? In this respect, when financial
conditions become unusually expansive, is the fed funds rate the right tool to use to constrain
or counteract such expansiveness? Or would it be better to use macroprudential tools such
as leverage limits or loan-to-value requirements on residential real estate to keep financial
conditions from becoming unusually expansive in the first place? I could imagine
circumstances in which macroprudential tools might be used to tighten up the relationship
between the fed funds rate and financial conditions. Would the use of such tools be helpful in
achieving greater macroeconomic stability?
At this stage, there are many more questions than answers. I would strongly encourage the
authors and others to continue their work on financial conditions and in exploring how
developments in the financial sector influence both the real economy and monetary policy.
The financial crisis has demonstrated that financial market developments matter greatly. The
paper successfully makes the case that it would be useful to have a good set of summary
statistics to serve as benchmarks to keep track of such developments. It also would be useful
to have a better understanding of how shifts in financial conditions should be considered in
the ongoing conduct of monetary policy.
Exhibit 1
The percentage of paragraphs in the FOMC minutes that mention the phrase "financial
conditions," excluding the directive and paragraphs associated with administrative matters
such as election of the chairman.