A UK financial conditions index using targeted data reduction: forecasting and structural identification

A financial conditions index (FCI) is designed to summarise the state of financial
markets. We construct two with UK data. The first is the first principal component (PC) of
a set of financial indicators. The second comes from a new approach taking information
from a large set of macroeconomic variables weighted by the joint covariance with a
subset of the financial indicators (a set of spreads), using multivariate partial least
squares, again using the first factor. The resulting FCIs are broadly similar. They both
have some forecasting power for monthly GDP in a quasi-real-time recursive evaluation
from 2011-2014 and outperform an FCI produced by Goldman Sachs. A second factor
that may be interpreted as a monetary conditions index adds further forecast power,
while third factors have a mixed effect on performance. The FCIs are used to improve
identification of credit supply shocks in an SVAR. The main effects relative to an SVAR
excluding an FCI of the (adverse) credit shock IRFs are to make the positive impact on
inflation more precise and to reveal an increased positive impact on spreads.