A composite index of financial conditions run by RBI is a promising idea

The trouble, however, is that ‘financial conditions’ are notoriously hard to assess. This is no surprise, since they are the outcome of a complex mix of factors.

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At the same time, they have an enormous bearing on the overall health of the system and hence on financial stability. This is where a ‘financial conditions index’ (FCI) of the type proposed in RBI’s monthly bulletin for June could help. The  primary goal, according to the paper’s authors, is to “construct a composite indicator that tracks overall conditions in financial markets at a high frequency.” 

The central bank takes care to preface its bulletins with the caveat that the views expressed therein are only those of the authors and not of RBI, so these are early days yet. But given the complexity of framing monetary policy in an uncertain world, especially since RBI’s tools act with variably long lags, an official FCI could see the light of day sometime in the not-too-distant future.

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The proposed index would use 20 financial market indicators representing five segments: the markets for money, government securities (G-Secs), corporate bonds, foreign exchange and equity. 

The rationale for zeroing in on these five is sound. The money market, for instance, helps us gauge “financial market  conditions” as it is the “fulcrum of monetary policy operations.” Most central banks operationalize monetary policy via the overnight money market. 

Hence, RBI policy’s operating target is the weighted average call rate (at which banks lend one another money for very short spans). But it is not its level as much as  its deviation from RBI’s repo rate that reflects how tight or easy conditions in this market are. 

So, the spread over the repo rate is taken as an indicator. Likewise, the case for including indicators from the four other markets in the FCI has been well argued, although the equity market may be better represented by a broader index like the 50-share Nifty instead of the 30-share Sensex. But then, these details can always be fine-tuned in the light of experience. 

A somewhat surprising omission is that of the economy’s growth rate as one of the indicators. True, good financial conditions favour faster economic expansion as an outcome. But all five broad indicators under consideration are also a function of the underlying state of the economy in various ways, so GDP growth is a valid input for such an index. 

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That an FCI will serve as a useful tracker of financial market conditions—and stability—is undeniable, but two caveats must be borne in mind before it begins to assume any policy relevance. 

First, even the best of tools is just a tool.  It can supplement but never supplant human judgement and discretion. As former RBI governor Y.V. Reddy was fond of saying, “Monetary policy is an art, not a science.” 

Second, the past can only be a guide; it cannot foretell the future. Critically, correlation is not causation. One should never be confused for the other. Two  variables can move without one causing the other to. 

As long as these two stipulations are met, FCI readings could conceivably come to play a role in the formulation of RBI policy. Test runs could give policymakers much to chew on.