When setting monetary policy, one important factor that we consider is whether financial conditions have been tightening or loosening.
Financial conditions can be broadly defined as the ease with which finance can be accessed by firms and households. When financial conditions are tighter, it is harder for people and businesses to access finance. With looser financial conditions, accessing finance is easier.
Monetary policy affects financial conditions. For instance, looser monetary policy should push down interest rates. Financial conditions are also affected by other factors, such as changes in investors’ risk appetite, expected future returns, or the creditworthiness of borrowers.
Financial conditions are a somewhat imprecise economic concept, and not something we can measure directly or easily summarise using any single indicator. Our judgements about financial conditions are based on a broad set of metrics. These may include estimates of risk premia and models that attribute the source of market movements, across countries or by the type of shock.
Financial variables, such as asset prices and credit indicators, can also be aggregated into a financial conditions index (FCI). Used alongside other metrics, these indices can act as a useful summary measure to help investigate how financial variables affect the economy. However, FCIs differ considerably depending on the variables they include and the weights used, and are often looking to answer different questions.
Commonly used FCIs include indices that:
- use principal component analysis, a data-driven technique, to determine the weight for each component;
- use quantities and surveys alongside prices;
- attempt to isolate movements in financial variables that affect the economic outlook from those that reflect the economic outlook; and
- answer the specific question: how do moves in asset prices and credit indicators affect the real economy?
An example of the fourth group is our Monetary and Financial Conditions Index (MFCI), which we have used since 2019, alongside other metrics, to help analyse evolving UK financial conditions. The Excel file at the end of this page gives details of the underlying data sources used to construct this index, and the weights allocated to each of these variables.
The MFCI incorporates the key variables that influence the outlook for UK GDP (or proxies for them), and each variable is weighted based on its estimated marginal impact on UK GDP. These weights are based on a range of empirical estimates. They are similar in principle to those used in the Monetary Policy Committee’s quarterly forecast, but not identical.
The MFCI has the benefit of being a timely summary measure that is simple to construct, and easy to decompose into its constituent variables. But this simplicity also makes it more difficult to assess the impact of these financial market movements, which will depend on what has caused them. So the MFCI is most useful when considered as part of a broad set of metrics.
Chart A shows the contributions from each of the key variables to changes in the aggregate MFCI between the November 2020 and February 2021 Monetary Policy Reports. An increase in the MFCI signals tightening financial conditions – in other words, making it harder for households and businesses to access finance.
Chart A: Our index shows some of the variables that affect UK financial conditions
Decomposition of changes in the MFCI between the November 2020 and February 2021 Monetary Policy Reports
- Note: We tend to look at the MFCI over short periods of time – say, between Monetary Policy Committee forecasts – to get a sense of how recent changes in financial market variables might have influenced the outlook for the economy. Particular care should be taken in interpreting movements in the MFCI over longer time periods, however. That is because the index level exhibits a clear downward trend over time, partly reflecting structural changes in the economy, which affect the equilibrium levels of these variables, and does not necessarily imply that UK financial conditions have continually loosened over that period.
- Sources: Bank of England, Bloomberg Finance L.P., ICE/BoAML, IMF World Economic Outlook, Moneyfacts, Refinitiv Eikon & I/B/E/S, both from LSEG, Tradeweb and Bank calculations.
This post has been prepared with the help of Natalie Burr and Tuli Saha.
This analysis reflects material presented to the Monetary Policy Committee in June 2020, December 2020 and May 2021.
This post, together with the Excel file at the end of this page, provides readers with all necessary information to compile our index. Please refer to our copyright/disclaimer for more information on conditions on how this data may be used.
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