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  4  See, for example, Tobias Adrian and Hyun Shin, manuscript in preparation for the forthcoming Handbook of Monetary Economics, volume 3, currently circulated as Federal Reserve Bank of New York Staff Reports, No. 398, October 2009. 5  The work of Vasco Curdia and Michael Woodford referenced above is one step in this direction. 4  BIS Review 23/2010  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?
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.