Financial markets provide insightful information about the level of risk in the economy. However, sometimes market participants might be driven more by their perception rather than any fundamental changes in risk. In a recent Staff Working Paper we study the effect of changes in risk perceptions that can lead to a mispricing of risk. We find that when agents over-price risk, banks adjust their bank lending policies, which can lead to depressed investment and output. On the other hand, when agents under-price risk, excessive lending creates a ‘bad’ credit boom that can lead to a severe recession once sentiment is reversed.
Since March 2009, UK long term rates have moved around a lot – as shown in Figure 1 – despite Bank Rate being held fixed. To understand these movements you need to understand term premia. In this blog, we suggest that much of the movement in term premia reflects global factors.