Financial Conditions Targeting in a Multi-Asset Open Economy

We analyze monetary policy responses to noisy financial conditions in an open economy where exchange rates and domestic asset prices affect aggregate demand. Noise traders operate in both markets, and specialized arbitrageurs have limited risk-bearing capacity. Monetary policy creates cross-market spillovers: by adjusting the interest rate to stabilize one market, the central bank influences volatility in the other. We show that targeting a financial conditions index (FCI) — a weighted average of exchange rates and domestic asset prices — delivers substantial macroeconomic benefits. FCI targeting commits the central bank to respond to unexpected movements in financial conditions beyond what discretionary monetary policy implies. These stronger responses improve diversification across markets: each market becomes more exposed to external shocks but less exposed to its own. This reduces volatility in both markets and activates the recruitment effect from Caballero et al. (2025b) in each market — lower variance induces arbitrageurs to trade against noise, further dampening volatility. Foreign exchange (FX) targeting can also be effective when the exchange rate is the primary source of noise, with benefits that increase as the economy becomes more open. In this case, FX targeting recruits arbitrageurs to stabilize the FX market, reducing volatility and dampening the macroeconomic impact of noise. However, FX targeting also raises volatility in non-targeted markets through anti-recruitment effects, limiting its effectiveness relative to FCI targeting, especially when domestic asset markets also matter for financial conditions and are comparably noisy.