Economists writing for the Federal Reserve Bank of Chicago say they’ve come up with a new way to measure the stability of the financial system, creating a tool that could help the central bank and other officials conduct policy better.
In a research note published by the bank, economists Scott Brave and R. Andrew Butters describe two related indexes that look across a broad array of financial activity to determine the health of the banking sector. They reckon what they’ve produced will allow regulators and Federal Reserve officials to make better economic policy and help avoid being surprised by events.
“Major events in U.S. financial history are well captured by the history of our indexes, as is the interdependence of financial and economic conditions,” Brave and Butters wrote. What’s more, “it is possible to use our indexes to improve upon forecasts of measures of economic activity over short and medium forecast horizons.”
The financial sector’s starring role in driving the worst recession in generations has brought about a sea change in how the Federal Reserve looks at the actions of bankers and other money managers. The Fed is now no longer interested in just the performance of economy when it sets policy. Financial stability is something that factors into the decision making process, as Fed officials and others in the government try to ensure that they will never again be in the position they were during the darkest days of the recent financial crisis.
Fed officials and other regulators have been widely criticized for failing to understand all the changes that happened in the financial system ahead of the crash. As part of last year’s financial regulation reform legislation, policy makers picked up responsibility for promoting stability. Even so, many wondered how, having missed the trouble before, officials would get themselves more plugged in and not fall behind again.
Brave and Butters hope their work will go some way toward helping policymakers get a better handle on developments in finance.
As they describe it in the paper, their “novel” method looks at the relationship between many financial variables and then weights them and relates them to the economy. They rely on something called “principle component analysis,” the chief virtue of which “is its ability to determine the individual importance of a large number of indicators so that the weight each receives is consistent with its historical importance to fluctuations in the broader financial system.”
The economists’ financial conditions index is made up of money market, debt and equity and banking system measures, and includes everything from interest rate spreads to surveys of market participants.
“Known periods of financial crisis correspond closely with peak periods of tightness in each index, and the turning points of each index coincide with well-known events in U.S. financial history,” the paper said.
“Furthermore, our indexes contain information on future economic activity beyond that found in nonfinancial measures of economic activity,” the analysts wrote. “Our indexes are also unique in that they derive from an estimation method that captures both the systemic importance of traditional and new financial markets and the dynamic evolution of overall financial conditions,” they added.
Source: http://blogs.wsj.com
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