New financial index predicts slower growth

The new index reveals that the economic recovery might not be as strong as some financial indicators suggest. Unlike existing indexes, which are based on interest rates and the money supply made available by banks and loans, the new index takes a broader view, incorporating the many sources of money — such as securities and commercial paper — that affect the availability of financing. In selecting which factors to include in its new index, the team looked back to the financial crisis in 2008 to identify the forces that brought credit to a trickle.

Hooper said that the team, which was part of the larger gathering of economists at the annual forum, decided to create a new index because it was “topical, given the importance of shocks within the financial sector to the recent financial crisis.”

He noted that financial indexes were “indicators for economic prospects and where markets may be headed,” adding that it was important to “improve on the way things were done in the past.”

A crucial enhancement, Hooper said, is the new index’ coverage of “a much wider range of variables.”

One of these variables is securitization. Through securitization, banks combine loans into a single pool and divide and sell the slices of loans as securities to investors. The sale of securities has become an increasingly important source of loanable funds, undermining the accuracy of existing financial indexes, economics professor Beth Bogan explained.

“No other indices included anything on securitization,” Hooper noted. Because the securities market is now weaker than other components of the financial industry, the new index predicts weaker economic growth in 2010 than other indexes do, he said.

A dominant factor in most finance indexes is the federal funds target rate, the interest rate that banks charge each other for overnight loans.

“Since the financial panic, that’s not enough information because banks are not the [only] source of loanable funds,” Bogan said, noting that hedge funds also play a major role in providing credit by selling derivatives.

“We need measures of activities in these derivatives to see if there are loanable funds available,” she added.

The new index utilizes sophisticated econometric techniques. Principal component analyses extract information from a large set of variables, while unbalanced panel techniques analyze data over time. It also provides a more specific view of the financial sector than other indexes do by adjusting for overall economic conditions, Hooper explained.

“This adjustment is unique to this index,” Hooper said. “This is the reason why our index showed a different picture in the second half of 2009. [We’ve found that] recovery of financial variables is not as pronounced as others have expected.”

The index will be published in a paper in a few months, after which Hooper said he hopes to have the index “taken over by a major Federal Reserve Bank to be produced widely on a regular basis.”

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In the meantime, Hooper cautioned, policy makers should not only look to traditional indexes when making decisions that will affect the availability of credit. He added that economists at the Federal Reserve should continue to look at factors outside the finance industry, such as employment statistics.

“It would be appropriate for the Fed to be cautious about tightening policy given this picture [that the new index has presented] for financial conditions,” Hooper said.

Watson did not respond to requests for comment.