How can we measure UK financial conditions?

Financial conditions indices can be used to summarise moves in financial variables that affect the economy. The Bank of England has developed a new daily index, the Monetary and Financial Conditions Index (MFCI), to analyse what variables drive changes in UK financial conditions.

The MFCI is a summary index that captures relationships between asset prices, credit variables and the real economy. It is tailored to the UK economy, and incorporates the key variables that influence the Monetary Policy Committee’s central UK GDP forecast, such as sterling. 

The index is weighted based on the marginal impact on UK GDP of each variable. The GDP impacts used are broadly similar to those used in the MPC forecast, but the MPC forecast relies on extra inputs and can include the use of judgement, so the two will not always match up exactly. The index can be easily decomposed (Chart A), making it easier to understand the key drivers of changes in UK financial conditions.

An increase in the MFCI signals tightening financial conditions and a decrease in the index points to loosening financial conditions. Looser conditions are consistent with an expected positive GDP contribution from asset prices and credit indicators in the central case, and vice versa.

In the run-up to the May Inflation Report, market expectations for interest rates fell relative to the February Inflation Report (yellow bar in Chart A) and equity prices rose (captured in the ‘Other’ bar in Chart A), which would both loosen monetary and financial conditions and would mechanically boost GDP. Acting in the opposite direction, the sterling exchange rate appreciated slightly, which would dampen GDP (lilac bar in Chart A).

This post has been prepared with the help of Sarah Illingworth and Saba Alam.

This analysis was presented to the MPC as part of its May 2019 round.

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