5 minute read 21 Jun. 2024

EY Australian Financial Conditions Index: March 2024

Authors
Cherelle Murphy

EY Oceania Chief Economist

Mother of teen twins. Economist. Peddler of my profession, especially to women and girls.

Paula Gadsby

EY Oceania Senior Economist

Macroeconomist and fiscal policy specialist. German Shepherd wrangler. Baker. Traveller.

5 minute read 21 Jun. 2024
Related topics Economics
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The EY Australian Financial Conditions Index eased in the March quarter of 2024; however, conditions remain restrictive.

In brief:

  • The EY Australian Financial Conditions Index illustrates the state of financial conditions in Australia for businesses that wish to assess the macro investment environment.
  • The EY Australian Financial Conditions Index shows less restrictive conditions in the March quarter 2024 than in the December quarter 2023. The cash rate remained steady in the March quarter.
  • The index illustrates the importance of examining a broader range of variables than just the cash rate to fully understand conditions impacting Australian business.

Understanding financial conditions beyond just interest rates

Financial conditions are an important contributor to economic growth – an indicator of the stage of the business cycle and what’s ahead.

Tight financial conditions mean it is difficult for businesses to access funding and liquidity is hard to come by, while expansionary conditions mean it is easy for businesses to access capital for growth.

Expansionary conditions (a negative index value) indicate that the financial system is currently supporting the economy. If conditions are restrictive (a positive index value), the financial system is constraining the economy, indicating financial downside risks are present.

The first and most important data point in guiding financial conditions is the cash rate, which the Reserve Bank of Australia sets to steer the economy. However, there are many more variables that are also important.

We draw on a broad number of variables, including asset prices, interest rate spreads, credit and money growth, debt securities outstanding, financial market risk and surveyed measures of consumers’ views on their household finances. We focus mainly on Australian variables, but also include variables from the United States to capture the strong influence this economy has on Australia’s economy.

Financial conditions remain restrictive

Financial conditions eased in the March quarter of 2024 compared to the December quarter of 2023, but remain in restrictive territory given the cash rate has remained steady. This follows the Reserve Bank’s thirteenth interest rate rise in November 2023. Financial markets had priced the end of the current hiking cycle, given inflation had continued to moderate and were looking forward to interest rate cuts at the end of 2024. There was also a slight decrease in bond yields.

Consumers’ perception of their household finances over the next 12 months improved, although it remained poor.

Conditions were still restrictive, though, as total credit growth, especially to the household sector was subdued. The money base continued to fall, as the Reserve Bank’s quantitative easing was slowly unwound.

The Reserve Bank continues to monitor ongoing inflation risks. As the Governor has warned, interest rates could remain around current levels or even increase if both domestic and international inflationary pressures remain high or fluctuate in 2024.

Financial conditions are likely to remain restrictive through 2024.
 

Summary

Financial conditions are an important consideration for business assessing substantial investments. The March quarter 2024 EY Australian Financial Conditions Index showed that financial conditions have become less restrictive compared to the December quarter 2023, but remain in restrictive territory.

  • Technical Appendix

    We use principal component analysis (PCA)1 to construct the EY Australian Financial Conditions Index. We use 25 individual data series covering a range of financial market and economic variables (asset prices; interest rates and spreads; credit and money; debt securities outstanding; financial market risk; and survey measures of consumers’ views on their family finances; full list of variables below in Table 1).2 We carried out standardisation, transforming the data to comparable scales and computed the covariance matrix, summarising the correlation or relationship between all the possible pairs of variables.

    Next, we computed the eigenvectors and eigenvalues of the covariance matrix in order to identify the principal components. Principal components are linear combinations of the initial variables. Our 25-dimensional initial data set gives us 24 principal components. The maximum possible information is squeezed into the first principal component, then the maximum remaining information in the second and so on. This means we reduce dimensionality while minimising information loss.

    Finally, we checked the index against significant economic events such as the global financial crisis and the pandemic to determine if the index has moved in line with our expectations. We also carried out a comparison to the historical performance of the Reserve Bank’s indicator.

    The principal components get ranked based on the percentage of information compressed. We decided to consider the first seven components, as they explain more than 90 per cent of the variation in the initial data set. These principal components are now called the feature vectors. They contain 91 per cent of the variance from the initial data set, implying they contain 91 per cent of the information from the initial data set. Only 9 per cent of information was lost through the process.

    The next step is to recast the data along the principal components axes, meaning the transpose of the original data set will be multiplied by the transpose of the feature vectors. This results in the EY Australian Financial Conditions Index.

    Table 1: Full list of variables used for the EY Financial Conditions Index, using Principal Component Analysis:

    Theme

    Variable name3

    Survey

    Consumer family finances last 12 months

    Survey

    Consumer family finances next 12 months

    Interest rates

    Official Cash Rate

    Interest rates

    Spread: 3-month bank bill to OCR

    Interest rates

    Spread: 3-year AGS to OCR

    Interest rates

    Federal funds rate (FFR)

    Interest rates

    Spread: 3-month Tbill to FFR

    Interest rates

    Spread: 10-year US Treasury Bond (USTB) to FFR

    Interest rates

    Spread: 10-year AGS to 10-year USTB

    Credit & money

    Total Credit

    Credit & money

    Commercial fixed term loan approvals (excl refinancing)

    Credit & money

    M1

    Credit & money

    M3

    Credit & money

    Money Base

    Asset price

    Commodity price index

    Asset price

    Nominal trade-weighted index

    Asset price

    Stock Price Index

    Debt

    Short-term: Australia: non-financial corporations

    Debt

    Long-term: banks

    Debt

    Long-term: Australia: non-financial corporations

    Debt

    Short-term: Australia: government

    Debt

    Long-term: Australia: government

    Debt

    Residential mortgage-backed securities

    Risk indicator

    CBOE Market Volatility Index

    Risk indicator

    Moody's corporate bond yield spread: BAA to AAA

  • Show article references #Hide article references

    1 Hartigan and Wright (2021), ‘Financial Conditions and Downside Risk to Economic Activity in Australia’, Research Discussion Paper 2021-03, Reserve Bank of Australia. Please see inaugural release for discussion on comparison between the EY Financial Conditions Index and the RBA Index.

    2 We now use 25 data series, as one of the debt indicators: ‘Short-term: asset-backed securities’ series has been discontinued by the RBA. The exclusion of one variable from the model has led to a marginal change in historical FCI index values.

    3 If data has not been released yet for the current month we take the average value of the past two months.

About this article

Authors
Cherelle Murphy

EY Oceania Chief Economist

Mother of teen twins. Economist. Peddler of my profession, especially to women and girls.

Paula Gadsby

EY Oceania Senior Economist

Macroeconomist and fiscal policy specialist. German Shepherd wrangler. Baker. Traveller.

Related topics Economics
Upvote