Constructing A Financial Conditions Index for the United Kingdom: A Comparative Analysis

We investigate the optimal constituent variable-weighting method for the UK financial conditions index (FCI) using a small number of financial indicators. The criterion for choosing the optimal weighting model focuses on the... [ view full abstract ]

We investigate the optimal constituent variable-weighting method for the UK financial conditions index (FCI) using a small number of financial indicators. The criterion for choosing the optimal weighting model focuses on the index’s ability to forecast economic activity. The optimal estimate of the FCI is expected to be the best predictor of real output. We develop a ‘two-step’ process as a new weighted-sum method and show that it is superior to other existing weighted-sum models in creating an FCI. For comparative purposes, we also create another FCI using a time-varying parameter factor-augmented vector autoregressive (TVP-FAVAR) with stochastic volatility model as a principal-component method. Our estimation results suggest that the TVP-FAVAR model is the best variable-weighting method to create an FCI in relation to its purpose of forecasting economic activity.