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Financial Condition Index And Interest Rate Settings: A Comparative Analysis

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Listed author(s):
  • Alberto Montagnoli
  • Oreste Napolitano

Abstract

In the last thirty years, there has been a widespread move towards financial liberalisation, both within and across national borders. This economic development brought researchers to investigate the link between asset prices, inflation and the conduct of monetary policy. Starting from the seminal work of Alchian and Klein (1973) it is often argued that the forward-looking nature of asset prices makes them good proxies for the information left out of conventional inflation measures. It is also widely accepted that asset price inflation developments are closely associated with general inflation trends. This paper investigates the role of asset prices in the conduct of monetary policy in United States, Canada, Euro Area and United Kingdom. It has two focal points. First, we construct Financial Condition Indexes for four countries using the Kalman Filter algorithm. This methodology allows us to capture the changes of the weights associated with each financial variable in explaining the output gap over time. Second, we proceed by estimating forward-looking Taylor rules augmented for FCI. Our results suggest that the Financial Condition Index enter positively and statistically significant into the FED, Bank of England and Bank of Canada interest rate setting. This gives a positive view for the use of the FCI as an important short term indicator to guide the conduct of monetary policy in three out of four countries analyzed.

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Paper provided by D.E.S. (Department of Economic Studies), University of Naples "Parthenope", Italy in its series Working Papers with number 8_2005.

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Length: 59 pages
Date of creation: Dec 2005
Handle: RePEc:prt:wpaper:8_2005
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Find related papers by JEL classification:
  • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
  • E58 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Central Banks and Their Policies
  • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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  1. Michael M. Hutchison, 1994. "Asset Price Fluctuations in Japan: What Role for Monetary Policy?," Monetary and Economic Studies, Institute for Monetary and Economic Studies, Bank of Japan, vol. 12(2), pages 61-83, December.
  2. Michael D. Bordo & Olivier Jeanne, 2002. "Boom-Busts in Asset Prices, Economic Instability, and Monetary Policy," NBER Working Papers 8966, National Bureau of Economic Research, Inc.
  3. Ben S. Bernanke & Mark Gertler, 2001. "Should Central Banks Respond to Movements in Asset Prices?," American Economic Review, American Economic Association, vol. 91(2), pages 253-257, May.
  4. David Mayes & Matti Virén, 2000. "The exchange rate and monetary conditions in the Euro area," Review of World Economics (Weltwirtschaftliches Archiv), Springer;Institut für Weltwirtschaft (Kiel Institute for the World Economy), vol. 136(2), pages 199-231, June.
  5. Ben S. Bernanke & Mark Gertler, 1999. "Monetary policy and asset price volatility," Proceedings - Economic Policy Symposium - Jackson Hole, Federal Reserve Bank of Kansas City, pages 77-128.
  6. Ball, Laurence, 1999. "Efficient Rules for Monetary Policy," International Finance, Wiley Blackwell, vol. 2(1), pages 63-83, April.
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  8. John B. Carlson & Kevin H. Sargent, 1997. "The recent ascent of stock prices: can it be explained by earnings growth or other fundamentals?," Economic Review, Federal Reserve Bank of Cleveland, issue Q II, pages 2-12.
  9. Fuhrer, Jeffrey C, 1997. "Inflation/Output Variance Trade-Offs and Optimal Monetary Policy," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 29(2), pages 214-234, May.
  10. Charles Bean, 2003. "Asset Prices, Financial Imbalances and Monetary Policy: Are Inflation Targets Enough?," RBA Annual Conference Volume,in: Anthony Richards & Tim Robinson (ed.), Asset Prices and Monetary Policy Reserve Bank of Australia.
  11. Alexandros Kontonikas & Alberto Montagnoli, 2004. "Has Monetary Policy Reacted to Asset Price Movements? Evidence from the UK," Ekonomia, Cyprus Economic Society and University of Cyprus, vol. 7(1), pages 18-33, Summer.
  12. Jagjit S. Chadha & Lucio Sarno & Giorgio Valente, 2004. "Monetary Policy Rules, Asset Prices, and Exchange Rates," IMF Staff Papers, Palgrave Macmillan, vol. 51(3), pages 529-552, November.
  13. Clark, Peter B. & Goodhart, Charles A. E. & Huang, Haizhou, 1999. "Optimal monetary policy rules in a rational expectations model of the Phillips curve," Journal of Monetary Economics, Elsevier, vol. 43(2), pages 497-520, April.
  14. Gilchrist, Simon & Leahy, John V., 2002. "Monetary policy and asset prices," Journal of Monetary Economics, Elsevier, vol. 49(1), pages 75-97, January.
  15. Goodhart, Charles & Hofmann, Boris, 2000. "Financial Variables and the Conduct of Monetary Policy," Working Paper Series 112, Sveriges Riksbank (Central Bank of Sweden).
  16. Flood, Robert P & Hodrick, Robert J, 1990. "On Testing for Speculative Bubbles," Journal of Economic Perspectives, American Economic Association, vol. 4(2), pages 85-101, Spring.
  17. Conover, C. Mitchell & Jensen, Gerald R. & Johnson, Robert R., 1999. "Monetary environments and international stock returns," Journal of Banking & Finance, Elsevier, vol. 23(9), pages 1357-1381, September.
  18. Tro Kortian, 1995. "Modern Approaches to Asset Price Formation: A Survey of Recent Theoretical Literature," RBA Research Discussion Papers rdp9501, Reserve Bank of Australia.
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Cited by:

  1. Angelopoulou, Eleni & Balfoussia, Hiona & Gibson, Heather D., 2014. "Building a financial conditions index for the euro area and selected euro area countries: What does it tell us about the crisis?," Economic Modelling, Elsevier, vol. 38(C), pages 392-403.
  2. Mirna Dumičić & Ivo Krznar, 2013. "Financial Conditions and Economic Activity," Working Papers 37, The Croatian National Bank, Croatia.
  3. Kirsten Thompson & Renee van Eyden & Rangan Gupta, 2013. "Identifying a financial conditions index for South Africa," Working Papers 201333, University of Pretoria, Department of Economics.
  4. Swamy, Vighneswara, 2013. "Banking System Resilience and Financial Stability - An Evidence from Indian Banking," MPRA Paper 49597, University Library of Munich, Germany.
  5. Swamy, Vighneswara, 2013. "Banking System Resilience and Financial Stability," MPRA Paper 47512, University Library of Munich, Germany.
  6. Kirsten Thompson & Renee Van Eyden & Rangan Gupta, 2015. "Identifying an index of financial conditions for South Africa," Studies in Economics and Finance, Emerald Group Publishing, vol. 32(2), pages 256-274, June.
  7. Yosra Baaziz, 2015. "Estimating Interest Rate Setting Behavior in Brazil: A LSTR Model Approach," Economies, MDPI, Open Access Journal, vol. 3(2), pages 1-17, April.
  8. Esteban Gómez & Andrés Murcia & Nancy Zamundio, 2011. "Financial Conditions Index: Early and Leading Indicator for Colombia," Ensayos sobre Política Económica, Banco de la Republica de Colombia, vol. 29(66), pages 174-220, Diciembre.
  9. Castro, Vítor, 2008. "Are Central Banks following a linear or nonlinear (augmented) Taylor rule?," The Warwick Economics Research Paper Series (TWERPS) 872, University of Warwick, Department of Economics.
  10. Oreste Napolitano, 2006. "Is The Impact Of Ecb Monetary Policy On Emu Stock Market Returns Asymmetric?," Working Papers 3_2006, D.E.S. (Department of Economic Studies), University of Naples "Parthenope", Italy.
  11. Vítor, Castro, 2011. "Can central banks' monetary policy be described by a linear (augmented) Taylor rule or by a nonlinear rule?," Journal of Financial Stability, Elsevier, vol. 7(4), pages 228-246, December.
  12. Akira Kohsaka & Jun-ichi Shinkai, 2014. "East Asian Financial Cycles: Asian vs. Global Financial Crises," OSIPP Discussion Paper 14E008, Osaka School of International Public Policy, Osaka University.
  13. Ruthira Naraidoo & Leroi Raputsoane, 2015. "Financial markets and the response of monetary policy to uncertainty in South Africa," Empirical Economics, Springer, vol. 49(1), pages 255-278, August.
  14. Jan Willem van den End, 2006. "Indicator and boundaries of financial stability," DNB Working Papers 097, Netherlands Central Bank, Research Department.

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