May 2017

The Decline in Asset return Predictability and Macroeconomic Volatility

Alex Hsu, Francisco Palomino, and Charles Qian


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.

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


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Last Update: January 09, 2020