Current Financial Conditions and Future Economic Activity

By James Kwak

David Leonhardt (hat tip Brad DeLong) discusses the risk of a double-dip recession. For Leonhardt, the main risks are the pending expiration of the fiscal stimulus and some of the Fed’s monetary stimulus measures, as well as continuing de-leveraging by households, which deprives the economy of its usual growth engine.

James Hamilton highlights a new financial conditions index developed by five economists — two from major banks and three from universities. The goal of the index is to estimate the impact of current financial variables on the future trajectory of the economy. For example, the level of current interest rates is likely to influence future economic outcomes. The paper evaluates several existing financial conditions indexes and finds that most of them show financial conditions returning to neutral in late 2009. It then describes a new index comprised of forty-four variables, which tends to do a better job of predicting economic activity than the existing indexes. (The authors admit that this is in part because they have the benefit of living through the recent financial crisis, which has shown the value of certain variables not included in previous indexes.)

So what?

“Whereas the existing FCIs show the current level of financial conditions to be back at or slightly better than ‘normal’ levels, our index has deteriorated substantially over the past two quarters. Indeed, it has retraced nearly half of the sharp rebound that had occurred earlier in 2009. This setback suggests that financial conditions are somewhat less supportive of growth in real activity than suggested by other FCIs.”

Hamilton already grabbed the key chart:

Why?

“The improvement in financial conditions since the spring of 2009 has been concentrated in indicators that are included in virtually all financial conditions indexes, namely interest rates, credit spreads, and stock prices. In contrast, several components of our FCI that have not been previously included – particularly quantity indicators related to the performance of the ‘shadow banking system’ such as ABS issuance and repo loans, as well as total financial market cap – have failed to improve much it at all.”

The shadow banking system became increasingly important to the financial system in the past decade, and so to assess the recovery of the financial system, you need to measure its health as well. The implication is that the financial system is not in good shape to support sustained recovery at the moment, which would be another thing to add to Leonhardt’s list of worries.

7 responses to “Current Financial Conditions and Future Economic Activity

  1. Goldilocksisableachblond

    I’m developing my own Financial Conditions Index , based on 308 million financial indicators.

    I’ve taken a good , hard look at the first one and , if it’s at all representative , we’re toast.

  2. Mr. Kwak wrote:

    “The shadow banking system became increasingly important to the financial system in the past decade, and so to assess the recovery of the financial system, you need to measure its health as well. The implication is that the financial system is not in good shape to support sustained recovery at the moment, which would be another thing to add to Leonhardt’s list of worries.”

    Shadow banking system

    “The shadow banking system or the shadow financial system consists of non-bank financial institutions that play an increasingly critical role in lending businesses the money necessary to operate…Many “shadow bank” like institutions and vehicles have emerged in American and European markets, between the years 2000 and 2008, and have come to play an important role in providing credit across the global financial system.[1]… In a June 2008 speech, U.S. Treasury Secretary Timothy Geithner, then President and CEO of the NY Federal Reserve Bank, described the growing importance of the shadow banking system: “In early 2007, asset-backed commercial paper conduits, in structured investment vehicles….”

    In other words, lending through the shadow banking system slightly exceeded lending via the traditional banking system based on outstanding balances.”

    http://en.wikipedia.org/wiki/Shadow_banking_system

    Charles Dickens wrote:

    “It was the best of times, it was the worst of times, it was the age of wisdom, it was the age of foolishness…”

    (1812 – 1870) A Tale of Two Cities

  3. This is no surprise to my intuition. I’m not speaking of the femanine kind, but rather the right brained sense or construct based on absorbing facts and watching trends. I, like the new index, have seen little reason to believe in the strength of the recovery, not so much because of unemployment, but partly because the ones you hear touting recovery are those who benefit from the perception that they can create, who are mostly in areas either a part of or related to the financial sector (mainsteam, not shadow banking). Por exampla, I occasionally tune into CNBC, and regularly hear the “expert” saying that things are generally trending in a positive direction for recovery. Why would they view it otherwise, since they have no stake in what honesty would produce, but rather benefit from any positive impression, which creates a likelihood of having more money gravitate toward their end of the economy.

    For instance, it was mid last year, during the heat of the foreclosure crisis, that we heard about all of the Alt-A and subprime mortgages due for reset early in the second quarter of this year. Sadly, this, combined with a real failure to get employment back in a positive direction (effectively now at least 20%), bodes quite poorly for any potential durability in the ongoing, but incredibly weak recovery.

    I may be all wet in my views, but would welcome someone, like James and Simon, who hold far more neutral ground, to poke holes in what I see, because it seems only logical, that the large banks, which have not successfully offloaded their toxic assets, and not really restored healthy capital levels, considering their amazingly high degree of levery, are still in a very precarious position to be able to offset more substantial derivative losses.

  4. Well son-of-a-gun, I’ve been looking at just two indicators one called “MZM” and the other called “Bank Lending” and I came to the same conclusion 2 months ago.

    I guess that old Economics degree from UC Santa Barbara, (a Monetarist school,) was worth what my professors said it would be.

  5. Until the Fed finds a way and the will to step into the Repo market in a huge way, that source of real money supply to the economy will continue to shrink.

    Hewing to traditional definitions of money will not give enough leverage to move the economy much.

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