Systemic risk, real GDP growth, and sentiment

Abstract

Using a mixed frequency VAR methodology, which can accommodate variables with different frequencies in a VAR framework, we model the relation between monthly systemic risk and real GDP growth. To identify the importance of business and consumer sentiment in this relation, a Kalman filter approach is adopted to extract the systemic risk-driven sentiment expectations. Our contributions are as follows. Systemic risk in the U.S. has a significant and negative impact on real GDP growth, and the channel of this impact is business and consumer sentiment. We illustrate that systemic risk is an important determinant of sentiment and sentiment expectations which, in turn, exercise a significant effect on GDP. These results extend previous evidence on the impact of systemic risk on monthly measures of economic activity, and carry implications for recent research exploring systemic risk and sentiments as factors driving the macro-economy. They also suggest that ‘offsetting’ sentiment-targeting policies may be adopted in order to curtail the detrimental effects of systemic risk on GDP.