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. 1  In my comments, I am going to assume that inflation expectations are always well anchored so that I do not need to distinguish between the real and nominal fed funds rate. BIS Review 23/2010  1  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.
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.