Fed's Dudley: We Need a Financial Conditions Index

Friday, 26 Feb 2010 04:40 PM

 

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A financial conditions framework would likely be useful when evaluating the economic outlook and the conduct of monetary policy, New York Federal Reserve Bank President William Dudley said on Friday.

In remarks to a panel at the University of Chicago Booth School of Business, Dudley said that the level of the Fed's benchmark federal funds rate impacts other financial market variables, such as credit spreads and stock prices, and it is these that influence the real economy.

"The level of the fed funds rate matters, but it also matters how this gets transmitted to the real economy through the financial sector," Dudley said.

Dudley pointed to the tech bubble in the 1990s and the credit bubble that led to the most recent financial crisis as examples of when the relationship between the fed funds rate and financial conditions have diverged significantly.

"As a result, developments in the financial markets became very important in the conduct of monetary policy," he said.

Dudley was discussing a paper by experts including former Fed Governor Frederic Mishkin and the senior economists at Goldman Sachs and Deutsche Bank, which put together a "financial conditions index" incorporating more data affecting firms outside the traditional banking system than existing measurements of financial variables that influence the future state of the economy.

The authors said they paid greater attention to the issuance of asset backed securities, repurchase lending and total financial market capitalization than traditional gauges of financial conditions.

"Financial market developments matter greatly. The paper successfully makes the case that it would be useful to have a good set of summary statistics to serve as benchmarks to keep track of such developments," Dudley said.

"It would also be useful to have a better understanding of how shifts in financial conditions should be considered in the ongoing conduct of monetary policy," Dudley said.

Dudley said financial conditions indicators could affect how monetary policy is formulated. He noted that he has "always been uncomfortable" with assumptions that the equilibrium real fed funds rate is equal to 2 percent.

This assumption "ignores the possibility that the equilibrium rate changes in response to technology shocks or in response to changes in how monetary policy is transmitted via the financial system to the real economy," Dudley said.

© 2014 Thomson/Reuters. All rights reserved.

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