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Financial stress: what is it, how can it be measured, and why does it matter?

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  • Craig S. Hakkio
  • William R. Keeton
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    Abstract

    The U.S. economy is currently experiencing a period of significant financial stress. This stress has contributed to the downturn in the economy by boosting the cost of credit and making businesses, households, and financial institutions highly cautious. To alleviate the financial stress and counteract its effects on the economy, the Federal Reserve has reduced the federal funds rate target substantially and undertaken unprecedented actions to support the functioning of financial markets. There will come a point, however, when the Federal Reserve needs to remove liquidity from the economy and unwind special lending programs to ensure a return to sustainable growth with low inflation. ; In past recoveries, the decision when to tighten policy was based mainly on the strength of business and consumer spending and the degree of upward pressure on prices and wages. An additional element in the current exit strategy will be determining if financial stress is no longer high enough to endanger economic recovery. As financial conditions begin to improve, the various measures of financial stress that the Federal Reserve monitors may give mixed signals. In this situation, policymakers would greatly benefit from having a single, comprehensive index of financial stress. Such an index could also prove valuable further down the road, when the Federal Reserve might again need to decide whether financial stress was serious enough to warrant special attention. ; Hakkio and Keeton present a new index of financial stress--the Kansas City Financial Stress Index (KCFSI). They explain how the components of the KCFSI capture key aspects of financial stress and show that high values of the KCFSI have tended to coincide with known periods of financial stress. They also show that the KCFSI provides valuable information about future economic growth.

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    Bibliographic Info

    Article provided by Federal Reserve Bank of Kansas City in its journal Economic Review.

    Volume (Year): (2009)
    Issue (Month): Q II ()
    Pages: 5-50

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    Handle: RePEc:fip:fedker:y:2009:i:qii:p:5-50:n:v.94no.2

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    Cited by:
    1. Kontonikas, Alexandros & MacDonald, Ronald & Saggu, Aman, 2013. "Stock market reaction to fed funds rate surprises: State dependence and the financial crisis," Journal of Banking & Finance, Elsevier, vol. 37(11), pages 4025-4037.
    2. Sarlin, Peter & Peltonen, Tuomas A., 2013. "Mapping the state of financial stability," Journal of International Financial Markets, Institutions and Money, Elsevier, vol. 26(C), pages 46-76.
    3. Jaromir Baxa & Roman Horvath & Borek Vasicek, 2011. "Time-Varying Monetary-Policy Rules and Financial Stress: Does Financial Instability Matter for Monetary Policy?," Working Papers 2011/03, Czech National Bank, Research Department.
    4. Sushanta K. Mallick & Ricardo M. Sousa, 2011. "The real effects of financial stress in the Euro zone," NIPE Working Papers 12/2011, NIPE - Universidade do Minho.
    5. Martin, Christopher & Milas, Costas, 2013. "Financial crises and monetary policy: Evidence from the UK," Journal of Financial Stability, Elsevier, vol. 9(4), pages 654-661.
    6. Louzis, Dimitrios P. & Vouldis, Angelos T., 2012. "A methodology for constructing a financial systemic stress index: An application to Greece," Economic Modelling, Elsevier, vol. 29(4), pages 1228-1241.
    7. Cevik, Emrah Ismail & Dibooglu, Sel & Kutan, Ali M., 2013. "Measuring financial stress in transition economies," Journal of Financial Stability, Elsevier, vol. 9(4), pages 597-611.
    8. Oet, Mikhail V. & Bianco, Timothy & Gramlich, Dieter & Ong, Stephen J., 2013. "SAFE: An early warning system for systemic banking risk," Journal of Banking & Finance, Elsevier, vol. 37(11), pages 4510-4533.
    9. Cardarelli, Roberto & Elekdag, Selim & Lall, Subir, 2011. "Financial stress and economic contractions," Journal of Financial Stability, Elsevier, vol. 7(2), pages 78-97, June.
    10. Cevik, Emrah Ismail & Dibooglu, Sel & Kenc, Turalay, 2013. "Measuring financial stress in Turkey," Journal of Policy Modeling, Elsevier, vol. 35(2), pages 370-383.

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