NEW YORK - To promote stability in a dynamic financial system, policymakers must continually monitor the system to identify periods of excessive stress that may lead to financial instability. Researchers at the Federal Reserve Bank of Cleveland have developed a tool – the Cleveland Financial Stress Index, or CFSI – that they say can monitor the condition of broad financial sectors and provide insight into the factors that are adversely affecting these markets.

"The CFSI is designed to track stress in the U.S. financial system on a continuous basis, and its unique construction allows the stress to be traced to its market origin," say the developers of the index. "This allows financial system supervisors to monitor stressful episodes as they are building and to consider mitigating actions. Such early detection is very important because when significant stress occurs in multiple markets, overall financial stress is quickly amplified."

The CFSI is constructed using daily data from 11 components reflecting four key financial sectors: credit markets, equity markets, foreign exchange markets, and interbank markets. To interpret the index, the researchers identify four grades that help distinguish the relative levels of stress charted by the index. The researchers note that the CFSI climbed into the "significant stress period" grade in late 2007 and remained there through the middle of 2009. The index is currently in the "moderate stress period" grade.

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