Working Paper

Understanding Uncertainty Shocks and the Role of Black Swans

Abstract: Economic uncertainty is a powerful force in the modern economy. Research shows that surges in uncertainty can trigger business cycles, bank runs and asset price fluctuations. But where do sudden surges in uncertainty come from? This paper provides a data-disciplined theory of belief formation that explains large fluctuations in uncertainty. It argues that people do not know the true distribution of macroeconomic outcomes. Like Bayesian econometricians, they estimate a distribution. Our main contribution is to explain why real-time estimation of distributions with non-normal tails results in large uncertainty fluctuations. We use theory and data to show how small changes in estimated skewness whip around probabilities of unobserved tail events (black swans). Our estimates, based on real-time GDP data, reveal that revisions in the estimates of black swan risk explain most of the fluctuations in uncertainty.

Keywords: forecast bias; rational expectations; model uncertainty; expectations formation; bayesian econometrics;

JEL Classification: D80; D84; C11;

https://doi.org/10.17016/FEDS.2022.083

Bibliographic Information

Provider: Board of Governors of the Federal Reserve System (U.S.)

Part of Series: Finance and Economics Discussion Series

Publication Date: 2022-12

Number: 2022-083

Pages: 43 p.