Financial Conditions Index's Construction and its Application on Financial Monitoring and Economic Forecasting

Abstract

Financial Conditions Index (FCI) is a comprehensive index which is constructed based on the combination of some variables, such as currency price and asset price. It can make up the shortage of some conventional indexes, such as money supply and interest rate, in measuring the financial conditions and forecasting the economic trend. FCI has become an important reference index in financial analyzing and policy making in some central banks and international institutions. In this paper, money supply, interest rate, exchange rate, stock price and house price are selected as the variables to construct FCI first. Second, we select the percent change rate of the variable as indicators to construct the FCI, which not only effectively describe the indicators, but also avoid errors arising from of gap measuring. Third, based on the principal component analysis method, dynamic factor model is also introduced to build FCI. Then, the FCIs constructed by two methods are compared, and the robustness of the FCI is tested. The results indicate that FCI can reflect China's financial conditions and can be a crucial financial conditions indicator as well; FCI can also well forecast the overall economy trend, and it is a better leading indicator of GDP and CPI than single variables.