The Decline in Asset Return Predictability and Macroeconomic Volatility
75 Pages Posted: 8 May 2017
Date Written: 2017-05
We document strong U.S. stock and bond return predictability from several macroeconomic volatility series before 1982, and a significant decline in this predictability during the Great Moderation. These findings are robust to alternative empirical specifications and out-of-sample tests. We explore the predictability decline using a model that incorporates monetary policy and shocks with time-varying volatility. The decline is consistent with changes in both policy and shock dynamics. While an increase in the response to inflation in the interest-rate policy rule decreases volatility, more persistent and less volatile shocks explain the lower predictability.
Keywords: Asset return predictability, Great Moderation, Monetary policy, Time-varying macroeconomic volatility
JEL Classification: E14, E44, G12, G18
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