The Decline in Asset Return Predictability and Macroeconomic Volatility

Hsu, Alex; Palomino, Francisco J.; Qian, Charles

doi:10.17016/FEDS.2017.050

Working Paper

The Decline in Asset Return Predictability and Macroeconomic Volatility

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.

Keywords: Asset return predictability; Great Moderation; Monetary policy; Time-varying macroeconomic volatility;

JEL Classification: E14; E44; G12; G18;

https://doi.org/10.17016/FEDS.2017.050