Financial Condition Index and interest rate settings: a comparative analysis

Abstract

In the last thirty years, there has been a widespread move towards financial liberalisation, both within and across national borders. This economic development brought researchers to investigate the link between asset prices, inflation and the conduct of monetary policy. Stating from the seminal work of Alchian and Klein (1973) it is often argued that the forward-looking nature of asset prices makes them good proxies for the information left out of conventional inflation measures. It is also widely accepted that asset price inflation developments are closely associated with general inflation trends. This paper investigates the role of asset prices in the conduct of monetary policy in United States, Canada and the Euro Area. It has two focal points. First, we construct Financial Condition Indexes for four countries using the Kalman Filter algorithm. This methodology allows us to capture the changes of the weights associated with each financial variable in explaining the output gap over time. Second, we proceed by estimating forward-looking Taylor rules augmented for FCI. Our results suggest that the Financial Condition Index enter positively and statistically significant into the FED, ECB and Bank of Canada interest rate settings. This gives a positive view for the use of the FCI as an important short term indicator to guide the conduct of monetary policy in three out of four countries analyzed.

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