Financial Conditions Targeting

Ricardo Caballero, Caravello, Tomás and Alp Simsek

No 21993, CEPR Discussion Papers from Centre for Economic Policy Research

Abstract: Non-fundamental inflows into the stock market loosen financial conditions and raise output, while the policy rate responds gradually. Such financial noise explains up to 20% of the variance of financial conditions and output. These facts motivate a macroeconomic model with noise traders, risk-averse arbitrageurs, and gradual interest rate adjustment. In this model, Financial Conditions Index (FCI) targeting can improve macroeconomic stabilization: the central bank announces its expected FCI as a soft near-term target and adjusts the policy rate to keep conditions near it. This commitment reduces FCI volatility, thereby "recruiting" arbitrageurs to insulate the FCI and aggregate demand from noise.

Date: 2026-09
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