- BoE research shows risk perceptions have spiked
- This could have big consequences for the economy
With a 15th interest rate hike possible later this month, does the Bank of England (BoE) risk tipping the economy into recession? Economists at Investec now forecast a 25 basis point hike in both September and November, taking the Bank rate to 5.75 per cent. They add that “once the winter sets in we expect the economy to enter a period of mild contraction”, and forecast gross domestic product (GDP) growth of 0 per cent in 2024.
Yet interest rates aren’t the only thing that drive economic booms and busts – recent research has highlighted the role of risk perceptions. The intuition goes something like this: a negative shock causes the perception of risk to rise, and triggers a flight to safety. As investors pile into bonds, companies find themselves facing a higher cost of capital as they are forced to compensate investors with higher returns. As a result, new projects are harder to justify and what began as a gyration in financial markets soon spills over to the real economy. Company investment falls, taking employment rates along with it.
Risk perceptions might have fallen from prominence, but the idea has a long economic lineage: John Maynard Keynes highlighted their role in driving economic fluctuations almost 90 years ago. This resonated again after the 2008 financial crisis. According to University of Chile economist Marcela Valenzuela and colleagues, “the global crisis in 2008 reminded us of the importance of the financial sector for the macro economy, a lesson many had forgotten in the decade after the previous global crisis, the Great Depression”. The idea merits closer attention today, too.
Last month, economists Nicholas Vause and Carolin Pfleuger published research on the BoE’s Bank Underground blog, examining the UK case. They found that perceptions of risk moved sharply in the first quarter of the year, reaching levels unseen since the outbreak of Covid-19. Vause and Pfleuger attributed the move to banking turmoil in the US and Europe at the time. This makes sense: they found that the correlation between perceived US and UK risks was high, suggesting that “investor risk perceptions are driven by global factors to a significant degree”.
Macroeconomic aftershocks
Although Silicon Valley Bank-induced turmoil already feels long distant, we could still be feeling the macroeconomic aftershocks. The economists found a clear relationship between investor risk perception and changes in economic activity. Their forecasts suggest that the Q1 crisis of confidence could ultimately trigger a decline in the investment ratio of 0.4 percentage points and an increase in the unemployment rate of 0.5 percentage points.
Crucially, if risk perceptions impact economic activity, it follows that they impact the effectiveness of economic policy, too. Valenzuela and colleagues point out that “even if a domestic monetary authority intends to stimulate or cool down the economy, global risk perceptions and how they drive risk-taking may override domestic monetary policy decisions”.
Past outcomes often shape agents' perceptions of risk today, and these may “point them towards different investment decisions than those desired by the authorities”. The consequences are sobering: Valenzuela and colleagues say that since policy authorities cannot these perceptions, their best efforts to guide the economy can ultimately prove “futile”.
Nor does a perceived absence of risk solve the problem. If a company believes that risk is low, it will be willing to take on more risk itself. This leads to higher asset prices and easier credit conditions, which drives higher economic growth. But there isn't an unlimited supply of high-quality, and low-risk investment options. According to Valenzuela and colleagues, the supply of “good” investments soon falls and the riskiness of investment increases, “rendering the financial system increasingly fragile”.
This is what we saw in 2008, when excessive credit growth coupled with robust risk appetite fuelled a boom-bust cycle, culminating in the financial crisis. Unfortunately, falling risk perceptions don’t necessarily make life easier for policymakers. As the famous quote goes, “stability is destabilising”.
