A financial conditions index is a weekly snapshot of a country’s financial condition in the money, debt and stock markets. In the case of the United States, the main reference in terms of financial conditions is the Chicago Fed’s National Financial Conditions Index (NFCI) of the Chicago Federal Reserve.
Since the financial and economic situation tend to be correlated to a very high degree, there is also the adjusted index or NFCI (ANFCI). This second indicator isolates a component of financial conditions, uncorrelated with economic conditions, to provide an update of the financial situation in relation to the economic situation.
These indicators are very followed for trading in debt or money markets. They are updated once a week (every Wednesday) and cover changes since the previous Friday. If that Wednesday is a US holiday, the index is updated on Thursday.
Why an FCI?
Now that interest rates are rising in the US (short rates), a curve known as IS is created in the GDP of the North American country. The SI represents various combinations of interest and income together with the market for goods in equilibrium. But it is not entirely effective, which is why this FCI or Financial Conditions Index has been created.
The FCI is a weighted average of risk-free interest rates, the exchange rate, equity valuations, and credit spreads that reflect the direct impact of each of these variables on Gross Domestic Product (GDP).
Explaining what it is for is a bit more complicated because it is a complex index. In summary, we can say that -on the one hand- it reflects the response of GDP to the FCI and, on the other hand, the response of the FCI to official interest rates. Thus, changes in the FCI are used to predict changes in real GDP, which is very interesting in order to make better trading and investment decisions.
More specifically, changes in US monetary policy are measured as changes in the yield on government Treasury bonds. These changes are analyzed in one hour windows.
Therefore, experts explain, the Fed can influence the FCI through changes in monetary policy, even though they cannot control these conditions by setting a trend or path for rates.
Although the financial conditions measured by the FCI and their impact on the markets (investment and trading) seem difficult to assess, the truth is that these indicators allow central banks to soften the financial conditions of a country in periods in which inflation or employment rates are below or above stated targets.
The FCIs make it possible to monitor the current situation of a country’s financial markets and predict its short-term impact on the real economy (indicator of future GDP) and, therefore, on the markets and trading.
Europe also has its MCI
The European Union has an indicator similar to the US FCI and calls it the Monetary Conditions Index. It can be defined in a similar way, since it would be an index generated by the linear combination of short-term interest rates and the effective exchange rate in relation to its value in a base period.
This indicator serves to reflect the relative impact of each of these two variables on GDP after two years.
In addition, large US financial institutions have developed their equivalents to the FCI. Built in a different way and with different variables, these other private FCIs also try to anticipate the impact of financial conditions in the markets because they affect trading.
The search for indicators that allow us to predict the future
The markets tend to look for indicators that indicate the trends and expectations in monetary policies, in order to assess their impact on the economy as far in advance as possible. Hence the struggle to have the most accurate FCI, in order to obtain the necessary information to make decisions and to help clients optimize theirs.
As in many other indices, the idea of the FCI is to develop a tool that allows measuring financial conditions and their future behavior. It doesn’t matter if it’s the Fed or an independent financial institution.