FCI-star

Monetary policy transmits through broad financial conditions—interest rates, asset prices, credit spreads and exchange rates—rather than through the policy rate alone. Yet current frameworks remain anchored around r*, the neutral interest rate. We introduce FCI*, the neutral level of financial conditions that closes expected output gaps, within a framework where financial conditions and macroeconomic shocks drive economic activity with inertia. Conceptually, FCI* reflects macroeconomic developments rather than financial market valuations, making it more stable than r*, which responds to both macroeconomic and financial factors. We estimate FCI* using a two-equation model along the lines of Laubach and Williams (2003) with 1990-2024 data. Our empirical estimates reveal three findings. First, estimated FCI* remained stable after the 2008 crisis while r* declined persistently due to asset price declines. Second, since the observed FCI reflects financial market shocks, large FCI gaps emerge especially during recessions. Third, at times of rapid monetary policy changes, FCI gaps more accurately reflect the effective policy stance because FCI is driven by forward-looking markets; for example, FCI gaps correctly identified the 2022 tightening when interest rate measures still suggested accommodation.