Tail risk and expectations

This paper examines how beliefs of tail risk events influence macroeconomic expectations in a Bayesian learning model with noisy signals. Relative to a Gaussian model, we show theoretically and quantitatively that the misperception of tail risk results in overreaction to first and second-moment shocks. First-moment shocks generate excessive optimism and pessimism in individuals as they provide valuable information about tail risk. Second-moment shocks, which are countercyclical, give rise to more pessimistic forecasts during downturns as higher uncertainty is linked to an increased likelihood of recessions. Our findings shed light on factors driving overreaction in expectations and highlight the importance of uncertainty shocks in propagating macroeconomic stability.