New Macro-Finance FCI improves euro area monetary policy assessment

The paper introduces a novel Macro-Finance Financial Conditions Index (FCI) for the euro area, built on a vector autoregressive (VAR) model.

This model jointly estimates VAR coefficients and FCI weights in a single step, ensuring a consistent macro-finance feedback loop and endogenous variable selection.

The index incorporates nine key asset prices, including risk-free rates, sovereign spreads, risk assets, and the exchange rate, assigning a dominant role to nominal interest rates.

It provides a model-implied long-run mean as a neutral benchmark, outperforming existing indices in out-of-sample forecasts of inflation and output.

The study reveals that financial conditions transmit to the real economy within one year and to inflation in almost two years, offering crucial insights for monetary policy.

Existing Financial Conditions Indices (FCIs) often face construction challenges, primarily lacking consistent feedback from macroeconomic variables or separating financial and macroeconomic estimation steps.

Traditional methods either aggregate information ex-post from multiple bivariate models or rely on latent factors without clear economic interpretation.

The novel Macro-Finance FCI addresses these limitations by fully incorporating mutual feedback between macro and financial variables within one coherent model, enhancing transparency and interpretability for policy applications.