Michele Modugno, Benjamin Roscoe, Sarah ZoiWe introduce the Financial Vulnerability Index (FVI), a novel indicator of financial vulnerabilities in the U.S. Unlike financial condition indices, which measure current credit market conditions and spike during periods of financial turmoil, the FVI displays the gradual build-up of structural financial weaknesses and declines as such episodes materialize. We demonstrate that the FVI exhibits properties consistent with theoretical mechanisms of financial vulnerabilities. When the index is high, adverse shocks are substantially amplified, generating larger declines in consumption and investment. We provide new empirical evidence that monetary tightening is associated with gradual declines in the FVI, with this effect substantially delayed, taking a few years to fully materialize. Moreover, monetary policy transmission to prices depends on the state of financial vulnerabilities, with significantly stronger effects when vulnerabilities are low.
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