1. Assessing the predictive power of measures of financial conditions for macroeconomic variables
Kostas Tsatsaronis
Head of Financial Institutions
Bank for International Settlements
Bank of Greece, 4 February 2010 1

2. Real and financial sector interactions
Real sector
Financial sector

3. Real and financial sector interactions
Take the “real” sector point of view
How does the financial sector influence the macroeconomic picture?
Forecasting: better understand business cycle
Modelling: stylised facts about interaction between business and financial cycle
Policy:
Information content of financial variables
The reaction function of monetary policy

4. Objective
Question: Can we summarise the links between financial conditions and the macroeconomy in a single simple measure?
Yardstick: How do measures of financial conditions fare as forecasters of macroeconomic variables in the one-to-two year horizon.
Variables: GDP Gap, Investment, inflation
Countries: United States, Germany, United Kingdom

5. Methodological approach
Non-model driven econometrics
Data intensive but not a predominately structural approach
Establish stylised facts
Examine different economies

6. Results
Financial conditions factors have important information content
Financial conditions factors have independent information content:
Information is complementary to asset prices
Financial conditions factors have more information content for real variables than for inflation
Financial conditions factors perform better at longer horizons

7. Summarising financial conditions
Distil common information from a large number of variables into small number of factors
Stock and Watson (2002)
Focus exclusively on financial variables
Use as many as possible
Representing as broad an array of financial sector activity as possible
Keep the balance between prices and quantities

8. Summarising financial conditions
Statistical procedure creating latent factors (Principal Components)
Int. rates + spreads
Asset prices
Credit
Performance of financial institutions
~ 40 variables
F1 , F2 , F3 , …
Focus: top-6 latent factors ~ 50% of total variance 8

9. Data Bank assets and liabilities & income statements Interest rates
Exchange rates
Equity market indicators
Real estate indicators
Flow of funds variables
Balance of payments variables
Other

10. Data handling Deal with stationarity Perform normalisation
Quarterly interpolation of annual series
Project annual series onto annualised factors
Use mapping to interpolate into quarterly
Flow and stock variables
Level ad first differenced series

12. Forecasting Financial conditions
Specification: lag and factors selection to optimise BIC (trade-off between goodness of fit and parsimony)

15. Results Financial conditions factors have information content
Significant coefficients
Output and investment: good Inflation: not so good
Overall forecasting performance quite good:
R2 range 40-85%
Not so sharp decline in longer horizon
Small number of factors
Explain 20% of variance
Stable set across horizons

16. Horse race against asset prices
Is the informational content of the financial factors essentially the same as that of the yield curve and equity prices?
Horse race regression (encompassing)

17. “Horse race” against selected asset prices: predicting the output gap
Table 3
“Horse race” against selected asset prices: predicting the output gap US
Germany UK
k=4
k=8
R-sq adj
61%
42%
50%
44%
91%
75%
Excl. PCs
0.121 --
0.003
0.001
0.0003
0.0001
Excl. Other
0.035
0.419
0.011
0.971
0.0000

18. A Financial Conditions Index?
The linear combination of the principal components represents a relationship among financial variables that is correlated forward with real variables:
Positive values are good for the economy
Negative values are harmful

19. A Financial Conditions Index?
The weights of the original data are fairly constant across different lags
One could construct an FCI using only contemporaneous values of the original series and then take lags of this composite series

20. Future work Expand the set of countries in the analysis
Examine for threshold and asymmetric effects in the relationship between financial and real variables
How stable is the composition of the FCI?
Out of sample performance