What it means
A central bank's main tool is the interest rate, but for an open economy, the exchange rate also affects demand. A higher interest rate makes borrowing dearer, and a stronger currency makes exports pricier and imports cheaper.
Both squeeze demand and inflation, so looking at only one gives an incomplete picture. The index solves this by giving each factor a weight and adding the changes together.
The weights reflect how much a change in each affects the economy. In the original Canadian version, a one percentage point change in the short-term interest rate was treated as equivalent to roughly a 3% change in the exchange rate, so the weights were in a ratio of about 3 to 1.
An index like this is helpful when markets do some of the central bank's work for it. If the currency suddenly appreciates, conditions tighten even though the central bank has not changed its rate, and the index reflects that.
The central bank might then decide it can hold rates steady, or even cut them, to keep overall conditions where it wants them. There are limits.
The weights are estimates that vary between countries and over time, and they may not remain stable. The index also ignores other factors, such as credit availability, asset prices and expectations, and an exchange rate move caused by a global shock can have different effects from one caused by domestic policy.
For these reasons, central banks that once published an index have mostly moved to broader measures called financial conditions indices, which add bond yields, equity prices and credit spreads. The simple version remains a good teaching tool and a quick check on the combined effect of rates and currency moves.
In practice
Real-world examples.
Example
An analyst at a bank notices that the national currency has strengthened 9% over the quarter while the central bank held interest rates unchanged. Using a 3 to 1 ratio, she calculates a tightening of 3 points, equal to a one percentage point interest rate rise three times over. She writes that conditions have tightened without any policy action.
Example
A central bank economist uses the index in a briefing note to explain why the committee may keep rates on hold. The currency has fallen, which loosens conditions, and he argues that this offsets the effect of the recent rate rise. He shows both on one chart.
Example
A manufacturer that exports 60% of its output reads a market commentary on tightening monetary conditions. Its finance director updates the forecast to reflect weaker overseas demand in the coming quarters. She also reviews the hedging of its foreign currency sales.
Formula
Calculation
MCI change = (Weight on interest rate x Change in interest rate) + (Weight on exchange rate x Percentage change in exchange rate)
Using a 3 to 1 ratio, the weights are 1 for the interest rate in percentage points and 1/3 for the exchange rate in per cent. Suppose the short-term interest rate rises from 2.0% to 3.0%, a change of +1.0 point, and the trade-weighted currency index rises from 100 to 106, a change of +6%. MCI change = (1 x 1.0) + (1/3 x 6) = 1.0 + 2.0 = +3.0 points. Of that tightening, 2.0 of the 3.0 points, or two thirds, came from the currency.Case study
Seen in the real world.
Eastmark Bank is an illustrative, fictional central bank in an export-oriented economy. Over six months, the central bank raised its policy rate by 0.5 percentage points, while the currency appreciated by 12% because of strong capital inflows. Using a ratio of 3 to 1, the MCI change was 0.5 + 12 / 3 = 0.5 + 4.0 = 4.5 points.
The monetary policy committee noticed that most of the tightening came from the currency, not the rate. Exporters were complaining of lost orders, and the committee judged that conditions were tighter than intended. It paused further rate rises.
Three months later the currency had eased by 6%, which lowered the index by 2 points, and the committee resumed gradual rate increases. The illustrative lesson is that watching only the policy rate can give a misleading view of how tight policy really is.
Watch out
Common mistakes.
- Assuming that the index depends only on the policy rate, when the exchange rate often accounts for most of the movement.
- Using the 3 to 1 weighting as if it applied to every economy, when the right ratio differs by country and changes over time.
- Reading a single index value as meaningful on its own, when it only has meaning relative to a chosen base period.
Questions
People also ask.
Who first used a monetary conditions index?
The Bank of Canada developed and published one in the 1990s, and several other central banks adopted similar measures for a time.
What replaced the index at many central banks?
Broader financial conditions indices that include bond yields, share prices and credit spreads, which capture more of what affects spending.
Does a rising index mean interest rates have risen?
Not necessarily, because a stronger currency alone can push the index up even if interest rates are unchanged.
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