Structural shocks drive euro area growth-at-risk asymmetry
A new BIS working paper investigates how structural shocks impact the joint distribution of future real GDP growth and inflation in the euro area. It finds that demand and financial shocks reduce expected GDP growth while increasing its conditional variance, leading to negatively skewed future growth distributions.
Demand and finance shape downside risk
The study employs a VAR-quantile regression approach to model the conditional mean and time-varying variance of real GDP growth and inflation.
Impulse response analysis reveals that demand and financial shocks significantly reduce expected GDP growth and simultaneously increase its conditional variance.
This mean-volatility interaction leads to negatively skewed future growth distributions, driving substantial time variation in downside risk for the euro area.
In contrast, supply shocks result in broadly symmetric movements for GDP growth.
For inflation, however, supply shocks drive a positive mean-volatility co-movement, where higher inflation correlates with increased uncertainty, causing time variation in upside risk.
This framework formalizes the analysis of joint tail risks for GDP growth and inflation, offering critical insights for policymakers.
Mapping risks in a volatile era
Monitoring economic outlook risks has become a policy priority globally, intensified by events like the global financial crisis, the European sovereign debt crisis, and the COVID-19 pandemic.
The 'growth-at-risk' literature, building on Adrian et al. (2019), highlights that deteriorating financial conditions are linked to both a lower conditional mean and higher conditional volatility of GDP growth.
This interaction creates an asymmetry in the growth distribution, with significant movements in the lower tail (downside risk) while the upper tail remains stable.
This paper extends existing research by identifying the underlying structural forces driving these tail risks, rather than just forecasting them with indicators.
Beyond the surface: Policy insights
This study offers a crucial advancement by identifying the structural shocks driving growth-at-risk, moving beyond mere indicator-based forecasting.
Its framework for joint tail risks in GDP and inflation provides policymakers with a more nuanced understanding for effective risk management.
The findings underscore the necessity of shock-specific policy responses.