20 September 2023

Working paper no. 93: A Financial Conditions Index for Iceland

The Central Bank of Iceland has published the working paper “A Financial Conditions Index for Iceland” by Tómas Dan Halldórsson economist at the Central Bank of Iceland, Stella Einarsdóttir, specialist at the Central Bank of Iceland, Eysteinn Einarsson, economist, and Védís Sigríður Ingvarsdóttir, graduade student at DTU Copenhagen. Einarsson and Ingvarsdóttir are former employees of the Central Bank of Iceland.

The paper remedies the lack of formalized relations between financial health and economic activity via a Financial Conditions Index for Iceland (FCI), using a broad spectrum of financial information including price, spread, volatility and quantity variables, for the period 2002-2023. Variable selection is in line with broad consensus in the relevant literature. In addition, we include variables that are shown to have prediction properties vis-à-vis growth of real GDP over the horizon of two and four quarters ahead. The FCI is constructed using principal component analysis and is normalized such that a positive value indicates that financial conditions are looser than the historical average, while a negative value suggest that financial conditions are tighter than the historical average. We show that fluctuations and extreme events in historical real economic activity is captured by the FCI, implying that it is potentially a leading indicator of GDP developments.

The working paper by Tómas Dan Halldórsson, Stella Einarsdóttir, Eysteinn Einarsson and Védís Sigríður Ingvarsdóttir can be accessed here: A financial conditions index for Iceland