New Macro-Finance FCI for euro area outperforms existing indices

This paper presents a novel vector autoregressive (VAR) model that jointly estimates VAR coefficients and FCI weights in one step.

This ensures a model-consistent macro-finance feedback, mapping financial variables into a single index.

The Macro-Finance FCI for the euro area incorporates nine asset prices, including risk-free rates, sovereign spreads, risk assets, and the exchange rate, assigning a dominant role to nominal interest rates.

The model provides a neutral benchmark for financial conditions, representing convergence when inflation is at target and output is at potential.

It significantly outperforms existing indices in out-of-sample forecasts of inflation and output, offering a clearer, more consistent assessment of monetary policy stance.

Structural identification reveals that financial conditions transmit to the real economy within one year and to inflation within two years.

Existing Financial Conditions Indices (FCIs) often struggle with integrating macroeconomic feedback consistently.

Traditional elasticity-based methods derive weights from separate macroeconomic elasticities, while statistical-based approaches rely on latent factors without direct macro feedback.

These methods typically separate financial and macroeconomic estimation steps, leading to inconsistencies and a lack of endogenous variable selection.

The novel Macro-Finance FCI addresses these shortcomings by embedding the index within a single macro-finance vector autoregressive (VAR) framework.

This unified approach fully incorporates mutual feedback between macro and financial variables, ensuring transparency and a clear interpretation of each financial variable's contribution, making it a more robust tool for policy applications.