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By Ronald Fink
A new index of 44 financial conditions shows that prospects for the economy may be weaker than other indicators suggest.
The new index, constructed by former Federal Reserve governor and Columbia University professor Frederic Mishkin, Goldman Sachs strategist Jan Hatzius and three other academics and Wall Street economists, goes beyond other indices by taking more financial conditions into account and purging those that merely reflect the business cycle or other economic conditions.
For that reason, Miskin, Hatzius and their colleagues contend the new index has more predictive power than indices put together by other sources, including Bloomberg, Goldman Sachs and the Kansas City Federal Reserve Bank. A report published late last month shows the new index correlates more closely to previous recessions than the other indices do.
What's more, the new index is decidedly more negative about the current economic environment than others are because it focuses on financing conditions.
In particular, the new index includes conditions in the securitization and overnight lending markets that others do not. As a result, the new one reflects more of what's occurring in the so-called "shadow banking" sector, which is widely considered to be an increasingly critical source of financing.
But the index shows that despite the Federal Reserve's attempts to revive the asset-backed securities market, very little new activity is occurring there. Many large companies rely heavily on that market to fund their short-term financing needs.
In addition, the index shows that the so-called repo market where overnight loans are made also remains weak, a sign that many financial institutions still do not trust each other's liquidity.
In their report, the index's developers noted that the index turned negative in the second half of 2009 after returning to positive territory following the Federal Reserve's extraordinary efforts to spur credit of various kinds. And they say the downturn means the financial sector is likely to hinder rather than spur an economic recovery this year.
"The estimated level of our [financial conditions index] as of the end of 2009 pointed to credit conditions that remained somewhat tighter than the norm," the authors wrote, adding that implies "a continuing, if modest, drag from overall financial conditions on economic growth during 2010."
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