A financial conditions index for Norway

Abstract

The fact that financial conditions have come to play a more prominent role in recent years has been thoroughly demonstrated by the financial crisis and the subsequent economic downturn. This increased importance of financial conditions is particularly relevant from a monetary policy perspective, as policy decisions make themselves felt by altering financial conditions. A good understanding of financial mechanisms and conditions is therefore important. Unfortunately, this part of the economy is not adequately incorporated in macroeconomic models used for policy analysis. Alternative approaches thus need to be taken, and the development of financial conditions indexes (FCIs) may be seen as one important contribution in this respect. FCIs are summary statistics capturing some broad notion of financial conditions. As financial variables typically are forward-looking in nature, they are often found to carry information about future economic activity. Therefore, FCIs may be used as leading indicators and may reflect financial conditions’ impact on real economic activity.

As no such indicator has been developed for the Norwegian economy, the construction of an FCI for Norway is the main contribution of this thesis. Among several possible methods, an underlying factor is estimated by using the method of principal components. This method allows for a large number of variables to be included, while at the same time parsimony is retained. Two different versions of the index are examined: One based on financial variables purged of business cycle effects, and one without such an adjustment. The two versions lead to two somewhat different interpretations. The preferred FCI for Norway is taken to be the first estimated factor from a balanced panel of 13 unpurged financial variables. This indicator is found to have explanatory/predictive power for real economic activity both in- and out-of-sample. It may therefore be used as a leading indicator providing timely information about the economic outlook. Moreover, the FCI is easy to estimate and it can be updated monthly, and is thus seen as a useful, initial step towards an FCI that can supplement policy discussions in Norges Bank.