Can a Financial Conditions Index Guide Monetary Policy? The Case of Singapore

• Main Author: CHOW, Hwee Kwan
• Format: text
• Language: English
• Published: Institutional Knowledge at Singapore Management University 2013
• Subjects: Financial Conditions; Monetary Policy; Vector Autoregression; Forecast Performance; Asian Studies; Finance; International Economics
• Online Access: https://ink.library.smu.edu.sg/soe_research/1484; https://ink.library.smu.edu.sg/context/soe_research/article/2483/viewcontent/S12_223_20Chow.pdf
• Institution: Singapore Management University

In this study, we explore the issue of whether a financial conditions index can serve as a useful guide to monetary policy in the context of Singapore. To this end, we construct an index that comprises not only the usual monetary variables like interest rates, exchange rates and credit expansions but also asset prices such as stock prices and house prices. The choice of these constituent series is motivated by the role they play in the monetary transmission mechanism with consideration given to the key role leverage plays in modern business cycles and the risk-taking channel magnified by the prolonged period of low interest rate environment. A weighted-sum approach of index construction is adopted whereby the weight assigned to each component is derived from the generalized impulse responses of a monetary VAR model estimated using quarterly data from 1978q1 to 2011q2. Cross correlations and Granger causality tests confirm the financial condition index developed in this paper possesses good in-sample leading qualities over consumer price inflation. More importantly, using the proposed index to generate predictions recursively from a direct multistep forecasting methodology yields substantial gains in out-of-sample prediction performance when compared with forecasts of a benchmark autoregressive time series model for inflation, particularly within the one-year forecast horizon.