However, so far economists have failed to agree on which financial variables to focus on.
The BIS, one of the only institutions to voice concern about growing financial imbalances prior to the 2008 financial crises, continues in its latest quarterly review to deepen the understanding of how the financial sector interacts with the real economy.
Macroeconomic models typically take a simplistic and abstract approach to the interaction between the real economy and the financial sector. They mainly focus on real variables, such as GDP and prices, along with money and interest rates as financial variables.
This modelling shortcut does not mean that economists have disregarded financial factors. Charles Kindleberger’s classic work on the history of financial crises, for example, focused on the link between the business and financial cycles.
But Kindleberger, who worked at the BIS shortly before World War II, and other earlier economists adopted a narrative rather than a formally quantitative approach.
Current economic models that incorporate financial variables rarely venture beyond the yield curve and/or the price of assets, such as equity or property, BIS said.
“However, as the experience of the recent crisis underscored, the channels of transmission between the real and financial sectors can be very strong and diverse, working through asset prices as well as the balance sheets of financial institutions, households and firms,” wrote Magdalena Erdem and Kostas Tsatsaronis in the March BIS quarterly review.
The financial crises has triggered a wholesale re-think among economists about their models and work is now underway to build models that reflect the critical role of the financial sector in the real economy.
In their feature, Erdem and Tsatsaronis adopt a purely atheoretical, statistical approach and condense information from a broad array of financial variables into a few representative factors to see if they can be used to help in forecasts.
Around 90 financial variables from four countries - Canada, Germany, the United Kingdom and the United States – is collected and then grouped into four categories: interest rates and spreads, asset prices; credit and debt aggregates, and indicators of performance for the banking system.
“Our results show that, consistently across countries, financial factors do contain information about macroeconomic variables. This is most evident in the case of output,” they write.
Interestingly, the authors find a weaker link between financial variables and inflation, suggesting that “economic processes that work through the financial sector may not influence economic activity through the inflation channel.”
“This may weaken the information content of inflation as a guide to monetary policy when economic shocks originate in the financial sector,” they write.
The policy implication of a weak link between the financial sector and inflation is important because it means that central banks that narrowly focus on inflation may miss the impact of financial cycles on business cycles.