RDP 2021-03: Financial Conditions and Downside Risk to Economic Activity in Australia 4. Conclusion

We make 3 important contributions. First, we develop a financial conditions index for Australia. This measure incorporates a broad range of individual indicators over a relatively long time period. Our measure correlates closely with previous financial boom and bust cycles in Australia, and also appears to have some ability to predict some measures of economic activity. In light of this, we suggest the FCI is a useful complement to existing qualitative and disaggregated approaches to monitoring financial conditions and financial stability risks in Australia.

Second, we use this FCI to develop a growth-at-risk framework for Australia. This adds to a rapidly growing body of literature which has developed similar models for a range of other countries. The GaR approach allows us to quantify the effect of current financial conditions on expected future downside risks to economic activity. We find that downside risk to economic activity from changes in financial conditions tends to be more volatile than upside risk. This insight would be missed if we only considered the central tendency and not the full distribution of economic outcomes as they relate to financial conditions. As such, the approach provides a potential way of quantifying the economic costs of financial instability risks.

Third, in contrast to other papers which have focused solely on quantifying downside risk to GDP growth, we examine the relationship between financial conditions and a broader range of macroeconomic variables. In particular, we expand the GaR framework to also examine household consumption, business investment and labour market variables (both employment growth and the unemployment rate). All of these variables have potentially important links to financial stability in their own right. We find that our FCI provides information about downside risks to GDP and employment growth and upside risks to changes in the unemployment rate. However, the FCI is much less useful for explaining downside risks to growth in household consumption and business investment.

Finally, we note that there are some limitations of the GaR approach. First, while the GaR framework is a flexible and parsimonious approach, it is also a reduced-form model and most appropriate for comparative statics analysis. To get a better understanding of the links between financial conditions and economic activity would require a more structured modelling approach. Second, there is some uncertainty with some of our estimation results. As such, the GaR approach is best thought of as a useful complement to other existing approaches to monitoring the potential economic costs of financial instability, rather than a tool to be relied on in isolation.