Financial Stress Regimes and the Macroeconomy

Abstract

Some financial stress events lead to macroeconomic downturns, while others appear to be isolated to financial markets. We identify financial stress regimes using a model that explicitly links financial variables to macroeconomic outcomes. The stress regimes are identified using an unbalanced panel of financial variables with an embedded method for variable selection. Our identified stress regimes are associated with corporate credit tightening and with NBER recessions. An exogenous deterioration in our financial condition index has strong negative effects in economic activity, and negative amplification effects on inflation in the stress regime. We employ a novel factor-augmented vector autoregressive model with smooth regime changes (FAST-VAR).