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.