Financial Conditions Index

A Financial Conditions Index is an economy-wide synthesis of financial market conditions. Financial conditions, including the availability and price of debt and equity are a significant driver of future of economic growth affecting fundamental economic drivers such as business investmnet and household consumption. Financial conditions indices should utilitise a mix of financial market data with an emphasis of data available frequently and regularly.

The following provides a Financial Conditions Index for Australia using data covering the period from January 1995 to the which are updated monthly. The index is constructed using factor analysis, the first principal component represents the largest common correlation across the broad range of financial market data.

As at the index stands at: , negative values indicate contractionary or tight financial conditions, positive values indicate expansionary conditions.

Constitutents and methodology

The following table summarises the constitutents of the index. The index includes a broad range of Australian financial data and a small number of key United States indicators. The data is collated monthly from 1995. Some non-stationary time series have been converted into percentage growth rates. All series have been normalised (a rolling 10 year mean has been subtracted) and the series has been divided by its standard deviation. The index is constructed using principal components, where the first principal component is the index. Factor loadings in the table below summarise the influence of each series on the final index.

A limitation of using principal components for deriving a Financial Conditions Index is it does not capture any temporal patterns in the latent factors. A solution is to use a dynamic factor model which captures the auto-regressive dependencies. For the first order prinicpal component the factor model and principal components are very consistent, the auto-regressive index is slightly smoother and includes a forecast which highlights the expected rate of mean reversion. The dynamics of the process vary more substantially in lower order components where the cross auto-correlations between factors have a stronger impact on the latent factor trends. A comparison of the dynamic factor model and principal components indices for the index is here.

There is significant debate as to which factors should be included in a Financial Conditions Index. Use the select boxes in the table below to filter the components of the index, adjusting for the influence of price and volume measures, Australian and United States markets. The following chart compares the the index using only your preferred inputs against the index which uses all inputs.

Trends for individual financial market indices can be viewed using the Financial Indicators Heatmap

Contributions

Contributions (derived from the eigenvectors) from the constituent indices vary over time. When the index is storngly positive or negative almost all contributors are similarly signed, this reflects the strong overall market correlation of the contributing indices.