Managing GDP Tail Risk
Models for macroeconomic forecasts do not usually take into account the risk of a crisis—that is, a sudden large decline in gross domestic product (GDP). However, policy-makers worry about such GDP tail risk because of its large social and economic costs. Our practical framework provides monetary and macroprudential policy-makers with guidance on the trade-off between GDP tail risk and the most likely growth path for future GDP.
Focusing on Canada, we compare the effectiveness of monetary and macroprudential policies. We first show that monetary and macroprudential policies can manage GDP tail risk by influencing household credit. Specifically, we find that household credit growth is the main driver of GDP tail risk in the medium term: more credit today ultimately increases the risk of a crisis.
We then estimate the trade-off policy-makers face and show that a tighter monetary or macroprudential policy reduces GDP tail risk at the expense of macroeconomic stability in normal times. So policy-makers worried about GDP tail risk would choose a tighter policy stance than a standard macroeconomic forecasting model suggests. Since it is practical, our framework can add crisis risk to macroeconomic forecasts that usually ignore it and give policy-makers a tool to effectively communicate the trade-offs they face.