Monetary policy as a key driver of financial conditions
Zoë Arnaut and Michael Bauer, in this FRBSF Economic Letter, examine the relationship between monetary policy and financial conditions. The authors employ several approaches to analyze financial conditions and their drivers:
- Financial Conditions Indexes (FCIs): The paper examines various FCIs, including those from the Chicago Fed, Bloomberg, Goldman Sachs, and the Federal Reserve Board’s Financial Conditions Impulse on Growth (FCI-G) index.
- Event studies: The authors use high-frequency event studies around FOMC announcements to estimate the effects of monetary policy surprises on financial conditions.
- Time-Varying analysis: They investigate the changing sensitivity of financial conditions to macroeconomic data releases, particularly core CPI inflation surprises.
[O]ur event-study analysis in this Letter confirms that monetary policy plays a crucial role for financial conditions, both through direct effects from policy announcements and indirect effects from macroeconomic news via perceptions about the likely future policy response. While the complexity of financial markets makes it difficult to pinpoint the exact determinants of observed changes in FCIs, monetary policy and macroeconomic data are clearly two important and interrelated drivers of financial market conditions.
Monetary Policy and Financial Conditions
By: Zoë Arnaut, Michael Bauer – Federal Reserve Bank of San Francisco
Taming financial noise: A new approach to monetary policy
This working paper by Caballero, Caravello, and Simsek examines the impact of financial noise on macroeconomic activity and proposes a novel monetary policy approach called Financial Conditions Targeting (FCT). The authors develop a “risk-centric” New Keynesian framework that incorporates noise traders, inelastic funds, and risk-averse arbitrageurs and model monetary policy transmission through financial conditions.
For the empirical analysis they measure financial conditions with the Financial Conditions Impulse on Growth index (FCI-G) constructed by Ajello et al. (2023a). “This index applies the macroeconomic models used by the Fed to predict the GDP growth over the next year implied by the recent changes (up to three years ago) in seven different financial variables—the Dow Jones stock price index, the Zillow house price index, the broad dollar index, the federal funds rate, the 10-year Treasury yield, the 30-year fixed mortgage rate, and the triple-B corporate bond yield.” The authors then analyze the relationship between financial conditions and macroeconomic activity using a vector autoregression (VAR) and data from 1990Q1 to 2019Q4.
Key findings:
- Impact of financial noise:
Noise shocks explain up to 55% of financial conditions variance and account for 20-50% of output gap variance over a two-year horizon. - Benefits of Financial Conditions Targeting (FCT):
FCT is welfare-improving compared to traditional monetary policy approaches: it reduces volatility in financial conditions and output gaps and “recruits” arbitrageurs to absorb more noise flows in real-time. - Comparison with interest rate forward guidance:
FCT is shown to be superior to interest rate forward guidance as it allows for better reaction to future noise shocks while reducing data-dependency on macroeconomic shocks. - Empirical evaluation results:
FCT could have reduced variance of output gap by 36%, inflation by 2%, and interest rates by 6%. Conditional variance of financial conditions could have decreased by 55%. - Policy Implications:
The authors suggest central banks should partially stabilize financial conditions beyond their direct impact on output and inflation gaps. They propose an augmented Taylor rule with a large weight on a simplified financial conditions target.
Financial Conditions Targeting
Authors: Ricardo J. Caballero, Tomás E. Caravello, Alp Simsek
From: MIT, Yale University
