Time Varying Risk Premia and the Output Gap

Abstract:     
The output gap, a production based macroeconomic variable, is a strong predictor of US stock returns. It is a prime business cycle indicator that does not include the level of market prices, thus removing any suspicion that returns are forecastable due to a "fad" in prices being washed away. The output gap forecasts returns both in-sample and out-of-sample and it is robust to a host of checks. We show that the output gap also has predictive power for excess stock returns in other G7 countries and US excess bond returns.

Number of Pages in PDF File: 48

Keywords: return predictability, risk premia, output gap

JEL Classification: G12, G14, E44

Accepted Paper Series