Abstract: An emerging and influential literature finds a large and significant decline in macroeconomic
volatility since the middle of the 1980's. In this paper, I examine the extent to which the decline in annual
and quarterly real output volatility since the onset of this period of Great Moderation can be attributed to
changes in macroeconomic uncertainty and macroeconomic predictability. I use point forecasts of future
real output growth from the Survey of Professional Forecasters (SPF) between 1969 and 2003 as a proxy
for the predictable component of real output growth. The results indicate that declining predictability has
played a significant role in the Great Moderation. Prior to the Great Moderation, professional forecasts
explained roughly 30 percent of the variance in output growth. Postmoderation, the predictive ability of
professional forecasts quickly vanished. This decline in predictability implies that interpreting the decline
in the volatility of output shocks identified from a fixed parameter autoregressive model overstates the
decline in macroeconomic uncertainty by between 2040 percent. I also examine forecasts of the
probability of a decline in real output from the SPF. Consistent with the findings from the point forecast
data, these probability forecasts indicate that the decline in macroeconomic uncertainty as measured from
an autoregressive model is overstated. While both the average probability of a decline in output and the
uncertainty surrounding future declines in output computed from an autoregressive model decrease
sharply after the mid1980's, the SPF probability forecasts exhibit no such decrease. I assess the
economic significance of the overstatement in the decline of macroeconomic uncertainty in terms of its
effects on forecasts of the future equity premium. These results indicate that using the decline in the total
volatility of real output growth along with the standard CCAPM model overstates the decline in the future
equity premium by roughly 20 percent.
Keywords: Equity premium, forecasting, great moderation, predictability, uncertainty, volatility
Full paper (656 KB PDF)
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Last update: October 15, 2004
