Another perspective on financial stability risks

In this staff memo, the authors examine the extent to which macrofinancial conditions, as reflected in, for example, interest rates, asset prices and leverage, can predict extreme negative economic outcomes in Sweden. Macrofinancial conditions can contribute to the build-up of risks and vulnerabilities in the financial system. These risks and vulnerabilities may in turn affect the functioning of the financial system, and lead to financial instability, which can translate into lower economic growth. In the case of a crisis, were macrofinancial risks materialise, resulting output losses can be quite substantial. Monitoring how macrofinancial conditions signal risks about extreme negative growth outcomes in the future is therefore important.

The relation between macrofinancial conditions and economic growth is studied through the recently popularised Growth-at-Risk (GaR) framework. Using the framework, we are able to map possible future states of the economy and assign probabilities to each outcome conditional on the current macrofinancial environment. In other words, we illustrate the full predictive distribution of GDP growth conditional on current macrofinancial conditions. In this way, risks connected to future extreme negative economic outcomes, so called tail-risks, can be monitored in parallel to changes in macrofinancial vulnerabilities and conditions.

We find that, in the short and medium term, information about macrofinancial conditions can be useful when forecasting downside risks to growth. However, its forecasts ought to be taken with caution when shocks, such as the COVID-19 pandemic, do not originate from the financial sector.

The staff memo is available in English (with a Swedish summary) and has been written by Dominika Krygier and Tamás Vasi, both of whom work in the Financial Stability Department.