The Financial Conditions Index as an additional tool for policy-makers in developing countries: the Mexican case

Abstract

PurposeThe idea of this study is to provide a solid Financial Condition Index (FCI) that allows the monetary transmission policy to be monitored in a country which in recent decades has suffered from major financial and monetary crises.Design/methodology/approachThe authors construct three FCIs for Mexico to analyse the role of financial asset prices in formulating monetary policy under an inflation-targeting regime. Using monthly data from 1995 to 2017, the authors estimate FCIs with two different methodologies and build the index by taking into account the mechanism of transmission of monetary policy and incorporating the most relevant financial variables.FindingsThis study’s results show that, likewise for developing countries as Mexico, an FCI could be a useful tool for managing monetary policy in reducing macroeconomic fluctuations.Originality/valueApart from building a predictor of possible financial stress, the authors construct an FCI for a central bank that pursues inflation targeting and to analyse the role of financial asset prices in formulating monetary policy.HighlightsWe construct three FCIs for Mexico to analyse the role of financial asset prices in formulating monetary policy under an inflation-targeting regime.The FCIs are based on (1) a vector autoregression model (VAR); (2) an autoregressive distributed lag model (ARDL) and (3) a factor-augmented vector autoregression model (FAVAR).FCI could become a new target for monetary policy within a hybrid inflation-targeting framework.FCI could be a good tool for managing monetary policy in developing countries with a low-inflation environment.