Looser, tighter, clearer: a new Financial Conditions Index for the euro area

Financial Conditions Indices (FCIs) are a widely used tool for assessing the broader monetary policy stance beyond the central bank’s direct control. This paper presents a novel vector autoregressive (VAR) model that includes key macroeconomic variables and maps financial variables into a single index, named Macro-Finance FCI. The VAR coefficients and the FCI weights are estimated jointly in one step, ensuring a model-consistent microfinance feedback. The model-implied long-run mean of the index provides a neutral benchmark to which financial conditions converge when inflation is at target and output is at potential. For the euro area, the proposed FCI incorporates nine asset prices – including risk-free rates, sovereign spreads, risk assets, and the exchange rate – and assigns a dominant role to nominal interest rates. It outperforms existing indices in out-of-sample forecasts of inflation and output. A structural identification of supply, demand, and financial shocks indicates that financial conditions require up to one year to transmit to the real economy and almost up to two years to inflation. JEL Classification: C32, E44, E52