European Central Bank working paper introduces a Macro-Finance Financial Conditions Index for the euro area and finds nominal rates dominate

The European Central Bank published Working Paper 3193, which presents a new “Macro-Finance” Financial Conditions Index (FCI) for the euro area that is estimated within a single macro-finance vector autoregressive model, jointly determining both the VAR coefficients and the FCI weights. The paper frames the resulting index as a broader, stance-like measure with a model-implied neutral benchmark, and estimates that changes in financial conditions transmit to the real economy over up to one year and to inflation over almost two years. In the euro area application, the baseline FCI aggregates nine asset prices spanning risk-free nominal and real rates, sovereign and corporate spreads, equity valuations and the exchange rate, using monthly data from January 2007 to December 2025 and applying the estimated weights to daily data for real-time use. The index places its largest weight on the euro short-term rate (eSTR), followed by the 10-year nominal overnight index swap rate, with real rates included to capture the lower bound episode. A model-implied long-run mean of 1.83% is used as a neutral reference level, with the paper highlighting loose conditions in 2015–2021 and subsequent tightening during the inflation surge before converging closer to neutral by end-2025. In out-of-sample forecasting, the Macro-Finance FCI outperforms alternative measures including eSTR alone, two existing euro area FCIs, and principal components, and a structural decomposition attributes the pandemic period to a mix of demand, supply and financial shocks while the inflation surge is dominated by supply and demand shocks as financial shocks subside.