Central banks don’t just care about what is expected to happen. They also care about what could happen if things turn out worse than expected. In line with this, an emerging literature has developed models for measuring and predicting overall levels of macroeconomic risk. This body of work has focused on estimating the level of ‘tail risk‘ in a country by monitoring a range of domestic developments. But this misses a key part of the picture. In a recent Staff Working Paper, we show that monitoring developments abroad is as important as monitoring developments at home when assessing the vulnerability of the economy to a severe downturn.
Meteorologists and insurers talk about the “1-in-100 year storm”. Should regulators do the same for financial crises? In this post, we argue that false confidence in people’s ability to calculate probabilities of rare events might end up worsening the crises regulators are trying to prevent.
relationship between financial conditions and risks to growth in an economy?
And, in a world of highly integrated financial markets, to what extent are
these “local” risks rather than reflections of global developments? In this
post we offer some tentative answers. Financial conditions, measured across a
broad range of asset classes and countries, display an important common
component reflecting global developments. Loose financial conditions today
increase the likelihood of a growth boom over the following few quarters, but
when global financial conditions are loose, they increase the chances of a
sharp contraction further ahead, highlighting some of the challenges of
managing risks to growth across time from a policy maker’s perspective.