The Nonfinancial leverage subindex of the National Financial Conditions Index (ANFCI) rose this week but remains well in economic expansion territiory. Econintersect focuses on non-financial tools to monitor the economy.
The dotted line on the graph below is the ANFCI, and is being used as a recession monitoring tool. When the ANFCI goes above 0, it is a recession warning. This index isolates a component of financial conditions uncorrelated with economic conditions to provide an update on financial conditions relative to current economic conditions.
The ANFCI edged up to –0.45 in the latest week. This level of the ANFCI indicates that current financial conditions are moderately more lax than would typically be suggested by current economic conditions.
Econintersect believes this index, when used with other indices – provides a viable tool for forecasting the economy six months in advance. As this index is relatively new, its real time performance is suspect as it is subject to backward revision. The chart below shows the current index values (blue line) with a red warning line (imperfect warning line) and a green warning line where historically recessions begin approximately six month later. This index may not be in warning territory at the time of the beginning of a recession.
According to the Chicago Fed:
The nonfinancial leverage subindex of the NFCI [ aka AFNAI] best exemplifies how leverage can serve as an early warning signal for financial stress and its potential impact on economic growth. The positive weight assigned to both the household and nonfinancial business leverage measures in this NFCI subindex make it characteristic of the feedback process between the financial and nonfinancial sectors of the economy often referred to as the “financial accelerator.” Increasingly tighter financial conditions are associated with rising risk premiums and declining asset values. The net worth of households and nonfinancial firms is, thus, reduced at the same time that credit tightens. This leads to a period of deleveraging (i.e., debt reduction) across the financial and nonfinancial sectors of the economy and ultimately to lower economic activity.
The solid black line [on the above chart] is the nonfinancial leverage subindex of the Chicago Fed’s National Financial Conditions Index, and the solid blue line is the ratio of private credit to gross domestic product (GDP) detrended. For ease of comparison, both measures have been scaled to have a mean of zero and a standard deviation of one over the period 1973–2012.
The horizontal (time) axis is measured in weeks. We assign the quarterly private-credit-to-GDP ratio to the last week of each quarter to be able to plot it on the same figure panel as the weekly nonfinancial leverage subindex. The shaded regions in panel A correspond with historical periods of financial stress based on the analysis in Brave and Butters (2012). The shaded regions in panel B correspond with U.S. recessions as defined on a quarterly basis by the National Bureau of Economic Research. The dashed black line is the two-year-ahead prediction threshold for a financial crisis (panel A) and a recession (panel B) calculated for the nonfinancial leverage subindex, as explained in the text.
The Chicago Fed Letter Concludes:
Our nonfinancial leverage indicator signals both the onset and duration of financial crises and their accompanying recessions more reliably at longer lead times than the private-credit-to-GDP ratio.
source: Chicago Fed