European Central Bank publishes working paper attributing euro area growth at risk mainly to demand and financial shocks

The European Central Bank published Working Paper No 3171 setting out a VAR-quantile regression framework to analyse how structural shocks affect the full distribution of future euro area real GDP growth and inflation. The results link the pronounced time variation in downside risk to GDP growth primarily to demand and financial shocks, while supply shocks tend to generate broadly symmetric movements in growth risks. The approach models conditional means with a vector autoregression and estimates time-varying shock variances by running quantile regressions on VAR residuals, with structural shocks identified using sign, magnitude and narrative restrictions. Using euro area data up to 2019 (including real GDP, HICP, a shadow short-term rate and the Composite Indicator of Systemic Stress), the paper finds that demand and financial shocks jointly reduce expected GDP growth and raise its conditional variance, producing a negatively skewed growth distribution that is more pronounced during periods of market distress. For inflation, supply shocks are identified as driving a positive mean-volatility co-movement in which higher inflation is associated with greater uncertainty and more volatile upside tail risk; financial shocks are associated with greater downside inflation risk. A historical decomposition of the expected shortfall for GDP growth attributes around 60% of its variation to demand and financial shocks, and a counterfactual exercise holding shock variances at their unconditional mean suggests the model’s uncertainty channel amplified the GDP growth trough during the global financial crisis by about 4 percentage points.