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The Decline in Asset Return Predictability and Macroeconomic Volatility

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Abstract

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.

Suggested Citation

  • Alex Hsu & Francisco J. Palomino & Charles Qian, 2017. "The Decline in Asset Return Predictability and Macroeconomic Volatility," Finance and Economics Discussion Series 2017-050, Board of Governors of the Federal Reserve System (U.S.).
    • Handle: RePEc:fip:fedgfe:2017-50
    DOI: 10.17016/FEDS.2017.050
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    More about this item

    Keywords

    Asset return predictability; Great Moderation; Monetary policy; Time-varying macroeconomic volatility;
    All these keywords.

    JEL classification:

    • E14 - Macroeconomics and Monetary Economics - - General Aggregative Models - - - Austrian; Evolutionary; Institutional
    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G18 - Financial Economics - - General Financial Markets - - - Government Policy and Regulation

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