Financial conditions and the macroeconomy: a two-factor view

Summary

Focus

This paper develops a novel financial conditions index (FCI) for the United States to provide a transparent and interpretable measure of financial conditions and their interaction with the macroeconomy. Financial conditions reflect the cost and availability of financing faced by households and firms. As such, they are central to the transmission of monetary policy. Existing FCIs often lack transparency in their construction and fail to disentangle key dimensions of financial conditions. To address these gaps, we use a dynamic factor model to extract two latent factors that summarise financial conditions, offering a flexible and intuitive framework for understanding their macroeconomic implications.

Contribution

Our financial conditions index is constructed using a dynamic factor model applied to a broad data set of financial variables, including interest rates, credit spreads and equity returns, from 2002 to 2025. The model identifies two distinct factors: the Safe Yields Factor, which captures the general level of safe interest rates, and the Risk Factor, which reflects broader financial risk, such as credit spreads and equity market conditions. Together, these factors explain over 60% of the variance in financing conditions various agents face in the economy. This two-factor structure isolates movements in safe interest rates from shifts in financial risk, enabling a clearer understanding of how financial conditions influence economic activity and how monetary policy transmits through different channels.

Findings

The analysis shows that both factors significantly influence macroeconomic outcomes and are affected by monetary policy. Positive shifts in either factor lead to contractions in economic activity, with the Risk Factor exhibiting stronger predictive power for variables such as GDP, investment and inflation. Shocks to the Risk Factor result in substantial declines in economic activity, consistent with the financial accelerator theory, while shocks to the Safe Yields Factor mimic standard monetary policy shocks. Monetary policy transmits through both factors, highlighting the operation of both the interest rate and credit channels. These findings emphasise the importance of disentangling safe interest rates from financial risk to assess financial conditions accurately. The results suggest that central banks should monitor both dimensions to assess how monetary policy decisions transmit to economic activity.

Abstract

We construct a new financial conditions index for the United States based on a dynamic factor model applied to a broad set of financial prices and yields. The resulting two latent factors capture, respectively, the general level of safe interest rates and an overall measure of perceived and priced financial risk. Analysing the interaction between these factors and the macroeconomy, we find that: (i) both factors are affected significantly by monetary policy; (ii) positive shifts in both factors lead to a persistent contraction in economic activity; (iii) relative to the safe interest rates factor, the risk–related factor exhibits stronger predictive power for economic activity. Our results are consistent with both the demand and the credit channels of monetary policy being at work, and emphasize that isolating movements in safe interest rates from shifts in perceived financial risk is essential to accurately assess the transmission of financial conditions to economic activity.

JEL classification: C38, E52, G10

Keywords: financial conditions, monetary policy, financial accelerator, dynamic factor model