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Financial conditions and the macroeconomy: a two-factor view

Author

Listed:
  • Marco Jacopo Lombardi
  • Cristina Manea
  • Andreas Schrimpf

Abstract

We construct a new financial conditions index for the United States based on a dynamic factor model applied to a broad set of financial prices and yields. The resulting two latent factors capture, respectively, the general level of safe interest rates and an overall measure of perceived and priced financial risk. Analysing the interaction between these factors and the macroeconomy, we find that: (i) both factors are affected significantly by monetary policy; (ii) positive shifts in both factors lead to a persistent contraction in economic activity; (iii) relative to the safe interest rates factor, the risk–related factor exhibits stronger predictive power for economic activity. Our results are consistent with both the demand and the credit channels of monetary policy being at work, and emphasize that isolating movements in safe interest rates from shifts in perceived financial risk is essential to accurately assess the transmission of financial conditions to economic activity.

Suggested Citation

  • Marco Jacopo Lombardi & Cristina Manea & Andreas Schrimpf, 2025. "Financial conditions and the macroeconomy: a two-factor view," BIS Working Papers 1272, Bank for International Settlements.
    • Handle: RePEc:bis:biswps:1272
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    More about this item

    Keywords

    financial conditions; monetary policy; financial accelerator; dynamic factor model;
    All these keywords.

    JEL classification:

    • C38 - Mathematical and Quantitative Methods - - Multiple or Simultaneous Equation Models; Multiple Variables - - - Classification Methdos; Cluster Analysis; Principal Components; Factor Analysis
    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • G10 - Financial Economics - - General Financial Markets - - - General (includes Measurement and Data)

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