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The St. Louis Fed’s Financial Stress Index, Version 2.0

Economists, banking regulators, policymakers, and financial market analysts use a variety of indicators to monitor financial market conditions. Many indicators are constructed from market-based prices, since information about the health of the economy, a bank, or a firm is often reflected in equity and debt markets. So market prices are forward-looking indicators of potential changes in economic and financial conditions.

The best known macroeconomic measures are interest rate spreads between so-called “risk-free” and “risky” securities. For example, the spread between long-term and short-term Treasury yields—often termed the yield curve—tends to be a reliable forecaster of future economic growth. (See McCracken, 2018, and Owyang and Shell, 2016.)

To help the public monitor financial market conditions on a weekly basis, the St. Louis Fed unveiled a financial market stress index (FSI) in 2010. (See Kliesen and Smith, 2010.) Similar to other FSIs, the St. Louis Fed’s (STLFSI) measures different types of financial market stress. Falling prices of financial market assets—such as stock prices—is an obvious example, since it could signal expectations of lower corporate profits due to slower growth of aggregate economic activity. Other types of stress include changing market perceptions of “risk” in its different forms. As noted above, risk is often measured by examining interest rate spreads: Default risk is regularly measured as the difference between yields on a “risky” asset (e.g., corporate bonds) and a “risk-free” asset (e.g., U.S. Treasury securities). But financial market stress can arise in other dimensions, too.

One type of risk prominent in the 2008-2009 financial crisis is once again present—in the current COVID-19 (novel coronavirus) crisis. It is the inability of many financial institutions to secure funding to finance their short-term liabilities, such as repurchase agreements (repos). This type of risk is known as “liquidity risk.” Yet another type of risk is uncertainty about the future direction of inflation, termed inflation risk.

The STLFSI, as with all other FSIs, attempts to measure financial market stress by combining many indicators into a single index number. This index number then becomes a collective measure of financial market stress. How is this accomplished?

The STLFSI is calculated using principal component analysis (PCA), which is a statistical method of extracting a small number of factors responsible for the co-movement of a larger group of variables. Specifically, the STLFSI is the first principal component of 18 distinct measures of financial stress and is thus a measure of overall financial market stress. The STLFSI used weekly data beginning in late 1993 from 18 data series: 7 interest rates, 6 yield spreads, and 5 other indicators. Values of the STLFSI above 0 indicated higher-than-average levels of financial market stress, while values below 0 indicated lower-than-average levels of stress.

Over time, we understood that the original construction of the STLFSI wasn’t adequately capturing some stresses that had developed in the financial markets. This was easy to spot visually on a graph: Despite several economic and financial market developments, the index fell below 0 in mid-2010 and has indicated below-average levels of financial market stress ever since. So we’ve unveiled an improved version—STLFSI 2.0—that makes a few simple, but necessary, changes to the original version unveiled in 2010.

Our plan is to publish a more thorough analysis later in the year,  documenting our motivation and methodological changes that we believe make STLFSI 2.0 an improvement.

The key difference between versions 1.0 and 2.0 is that 2.0 uses daily changes in interest rates and stock prices, rather than the levels of interest rates and stock prices in the PCA calculation. Why is this important? The full answer is more complicated, but the primary reason is that interest rates have trended lower and stock prices have trended higher, on average, over the period the STLFSI calculation covers. This has introduced a subtle  but nevertheless important statistical bias in the calculation of the STLFSI. This table summarizes the transformation applied to the data series used to construct the STLFSI.

The figure plots the new version of the STLFSI along with the original version we’re retiring. Here are two examples why we believe the STLFSI 2.0 more accurately measures financial stress:

On August 5, 2011, Standard and Poor’s reduced the long-term sovereign credit rating on the United States from AAA to AA+. Although other rating agencies maintained the AAA-rating on U.S. Treasury debt, this action severely rattled equity markets, as the Dow Jones Industrial Average fell nearly 2,000 points over the next two weeks. However, the original version of the STLFSI continued to report below-average levels of financial market stress (values less than 0). The revised STLFSI, however, moved decisively above 0, indicating above-average levels of financial market stress, peaking at 1.2.

The second example is the ongoing turmoil in financial markets stemming from the fear and uncertainty associated with the COVID-19 pandemic. Since mid-February 2020, and continuing through the week ending March 20, 2020, COVID-19 uncertainty has triggered a massive sell-off in stocks and consequent plunge in stock prices, sharp declines in interest rates, and stunning increases in financial market volatility. Still, the original version of the STLFSI continued to report financial stress slightly below average (-0.1). The revised STLFSI, however, has increased sharply—reminiscent of the worst of the financial market turmoil during the Great Recession in 2008-2009—registering a value close to 5.8.

The data and information services of the St. Louis Fed’s Research Division are intended to illuminate economic and financial concepts, educate, and enhance decisionmaking. In this vein, it is our view that STLFSI 2.0 better captures evolving stresses in financial markets. Our new version suggests that the tectonic upheaval in financial market conditions today has, thus far, been surpassed only by the upheaval registered in 2008-2009.

Suggested by Kevin Kliesen and Michael McCracken, with the research assistance of Kathryn Bokun and Aaron Amburgey.

View on FRED, series used in this post: STLFSI, STLFSI2

Fourth large-scale asset purchases program: A new hope

We’ve previously discussed the tapering of the three large-scale asset purchase programs popularly known as “quantitative easing.” On Sunday, March 15, the Federal Open Market Committee (FOMC) brought back this unconventional monetary policy tool. The FOMC directed the New York Fed’s Open Market Trading Desk (the Desk) to purchase at least $500 billion worth of Treasury securities and at least $200 billion worth of mortgage-backed securities. These asset purchases are called unconventional policy measures to distinguish them from the management of the federal funds rate through open market sales and purchases of short-term Treasury securities.

The graph above shows the purchase programs started on November 2008, November 2010, and September 2012. Each program had different sizes, which depended on the monetary policy projections, and their impact on the composition of the Federal Reserve System balance sheet can be seen as three distinctive increases in the levels of mortgage-backed securities (the green area), Treasury securities (the blue area), and federal agency debt (the red area).

Research by Michael Kiley has shown that when the federal funds rate target range is at the zero lower bound, large-scale asset purchases can boost economic activity. To assess the relative size of the recently announced fourth large-scale asset purchase program, hover over the right-hand-side of the graph and compare the amounts of the planned purchase of each type of asset with their current (as of March 11) level, which is in the trillions of dollars. And, in the words of Obi-Wan Kenobi: “May the Force be with you.”

How this graph was created: Search for “Assets: Securities Held Outright: U.S. Treasury Securities” and select the “All: Wednesday Level” series (FRED series ID TREAST). From the “Edit Graph” panel, use the “Add Line” feature to search for and select the “Assets: Securities Held Outright: Federal Agency Debt Securities: All: Wednesday Level” series (FRED series ID FEDDT). Do the same to add the series “Assets: Securities Held Outright: Mortgage-Backed Securities: Wednesday Level” (FRED series ID WSHOMCB). From the “Format” tab, select “Area” for graph type and “Normal” for stacking.

NOTE: Simultaneous to the publication of this blog post, the FOMC issued a statement further expanding its tool set to address current economic challenges.

Suggested by Diego Mendez-Carbajo.

View on FRED, series used in this post: FEDDT, TREAST, WSHOMCB

Tracking the U.S. economy and financial markets during the COVID-19 outbreak

Use FRED dashboards to monitor the economy

Financial FRED dashboard Economic FRED dashboard

To help FRED users navigate the rapidly changing economic and financial environment, the Federal Reserve Bank of St. Louis has assembled two dashboards of FRED graphs. The first dashboard collects higher-frequency financial market variables. The second dashboard collects mostly monthly indicators that track expenditures, employment and unemployment, and key business and consumer surveys.

For some background on why and how economists and other analysts track economic and financial variables during stressful times, read on:

The World Health Organization declared the novel coronavirus—known as COVID-19—a pandemic. Johns Hopkins University is monitoring the spread of the virus and mapping the number of confirmed COVID-19 cases and fatalities worldwide.

The number of confirmed cases in the United States is rising, and U.S. financial markets have been tumultuous. For example, since hitting an all-time high on February 12, the Dow Jones Industrial Average has fallen by about 33 percent as of the writing of this post. Yields on 10-year Treasury securities plunged to an all-time low of 0.54 percent on March 9, though they have since rebounded modestly. Other key financial market indicators, such as commercial paper yields and yields on corporate bonds, have also exhibited stress. Financial market–based measures of inflation expectations have fallen sharply.

These financial market stresses have triggered numerous policy responses by the Federal Open Market Committee (FOMC), including two reductions in the FOMC’s federal funds target rate.

Clearly, the COVID-19 outbreak is a significant and rare event in U.S. history. It has led to widespread disruptions in economic activity, with an unknown duration and magnitude. But it can be characterized and monitored as an economic shock. So, economists and policymakers are monitoring key cyclically sensitive indicators such as initial claims for unemployment insurance, changes in employment, retail sales, and sales of light motor vehicles and new and previously sold (existing) homes.

During times of high and rising uncertainty, financial market variables often serve as reliable forward-looking signals of future economic conditions in the broader economy. A key example is the Treasury yield curve, which usually inverts prior to recessions. This forward-looking perspective is important because most of the important “real” data that economists and policymakers monitor—such as the unemployment rate or industrial production—are backward-looking. For example, the payroll employment numbers for March 2020 will be released on Friday, April 3. However, they will capture only payrolls for the survey week ending March 12. Labor market conditions could have changed dramatically since then, given the fast-moving nature of the COVID-19 outbreak and the responses by firms and the government. To get a more timely measure of labor market conditions, an analyst might instead look at the weekly initial claims data.

Our two new FRED dashboards collect these useful variables to help you monitor and better understand the trajectory of the economy and the state of financial markets. FRED account holders can create their own dashboards, either from scratch or by taking these two as starting points.

Suggested by Kevin Kliesen.

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