The Federal government is still shutdown, so now seems like a good a time as any to introduce a new U.S. macroeconomic indicator. Let’s dive into the Chicago Fed’s National Financial Conditions Index (NFCI).
This index is published weekly and provides an update on U.S. financial conditions in money markets, debt and equity markets, and the traditional and “shadow” banking systems. The time period covered is through the previous Friday, so this is pretty up-to-date information.
U.S. economic and financial conditions are often highly correlated, so an alternative index is included in the weekly report known as the adjusted NFCI, or ANFCI. This index isolates a component of financial conditions uncorrelated with economic conditions to provide an update on financial conditions relative to current economic conditions.
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Both the NFCI and the ANFCI are constructed to have an average value of zero and a standard deviation of one over a sample period extending back to 1973. Positive values of the NFCI indicate financial conditions that are tighter than on average, while negative values indicate financial conditions that are looser than on average. Similarly, a positive value of the ANFCI indicates financial conditions that are tighter on average than would be typically suggested by economic conditions, while a negative value indicates the opposite. More on this in a moment.
Like the Chicago Fed’s National Activity Index (CFNAI), an indicator that we report on here every month, the NFCI is a weighted average of a large number of variables. There are 105 measures of financial activity, with each being expressed relative to their sample averages and scaled by their sample standard deviations. The ANFCI removes the variation in the individual indicators attributable to economic activity and inflation — as measured by the three-month moving average of the CFNAI and three-month percent change in the Personal Consumption Expenditures (PCE) Price Index — before computing the index.
Some research behind the creation of the index can be found in the paper Monitoring Financial Stability: A Financial Conditions Index Approach.
The Chicago Fed explains a bit more on the index in the below video.
There are three main subindexes of the NFCI that allow for a more detailed examination of the movements: risk, credit, and leverage. Like the NFCI, each is constructed to have an average value of zero and a standard deviation of one over a sample period extending back to 1973.
- The risk subindex captures volatility and funding risk in the financial sector.
- The credit subindex is composed of measures of credit conditions.
- The leverage subindex consists of debt and equity measures.
Increasing risk, tighter credit conditions, and declining leverage are consistent with tightening financial conditions. Thus, a positive value for an individual subindex indicates that the corresponding aspect of financial conditions is tighter than on average, while negative values indicate looser conditions.
Finally, there is a nonfinancial leverage subindex of the NFCI. This best exemplifies how leverage can serve as an early warning signal for financial stress and its potential impact on economic growth. The positive weight assigned to both the household and nonfinancial business leverage measures in this NFCI subindex make it characteristic of the feedback process between the financial and nonfinancial sectors of the economy often referred to as the “financial accelerator.”
Increasingly tighter financial conditions are associated with rising risk premiums and declining asset values. The net worth of households and nonfinancial firms is reduced as credit tightens. This leads to a period of deleveraging, or debt reduction, across the financial and nonfinancial sectors of the economy and ultimately to lower economic activity.
So now let’s look at where the indexes currently stand.
The National Financial Conditions Index was a reading of -0.81 for the week ending Friday, October 4. The negative figure indicates that financial conditions are currently looser than average. However, last week the NFCI reading was -0.82, meaning that although financial conditions may be looser than average, they are slightly tighter than they were a week ago.
The Adjusted National Financial Conditions Index was a reading of -0.38 for the week ending October 4. This compares with a -0.45 reading the week prior, and suggests that, independent of economic conditions, financial conditions are tighter than they were a week ago, but still looser than average.
We can see that financial conditions are back to the looseness of their pre-recession levels.
Since the ANFCI is just the NFCI with the broader economic and highly correlated indicators removed, we will assume that the ANFCI is the market’s opinion of the tightness/looseness of financial conditions and the direction they are headed, in contrast with the current state of affairs. Currently, the ANFCI is tighter than the NFCI, so we can deduce that the market thinks financial conditions are tighter than is reflected in the broader economy (h/t to@Not_Jim_Cramer for insights).
The risk subindex was a reading of -0.80 last week, indicating that financial conditions were looser than average and looser than the -0.79 reading from the week prior.
The credit subindex was a reading of -0.70 last week, indicating that financial conditions were looser than average but tighter than the -0.71 reading the week prior.
The leverage subindex was a reading of -0.56 last week, indicating that financial conditions were looser than average but tighter than the -0.57 reading the week prior.
The nonfinancial leverage subindex was a reading of -0.66 last week, indicating that nonfinancial leverage was below average and unchanged from the week prior.