The Declining Asset Return Predictability and Macroeconomic Volatility

74 Pages Posted: 2 Sep 2016 Last revised: 25 Mar 2017

See all articles by Alex Hsu

Alex Hsu

Georgia Institute of Technology - Scheller College of Business

Francisco Palomino

Board of Governors of the Federal Reserve System

Charles Qian

Citigroup

Date Written: March 24, 2017

Abstract

We document strong U.S. stock and bond return predictability from several macroeconomic volatility series before 1982. Return predictability declined significantly during the Great Moderation in the post-1982 sample. Our empirical finding is robust to out-of-sample "real time" forecasts in terms of root mean square errors. We explore this result using a model incorporating monetary policy and shocks with time-varying volatility. The predictability 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 shocks with reduced volatility explain the lower predictability.

Keywords: Return Predictability, Monetary Policy, Stochastic Volatility

JEL Classification: E50, G12, G18

Suggested Citation

Hsu, Alex and Palomino, Francisco and Qian, Charles, The Declining Asset Return Predictability and Macroeconomic Volatility (March 24, 2017). Available at SSRN: https://ssrn.com/abstract=2833075 or http://dx.doi.org/10.2139/ssrn.2833075

Alex Hsu (Contact Author)

Georgia Institute of Technology - Scheller College of Business ( email )

800 West Peachtree St.
Atlanta, GA 30308
United States
4043851123 (Phone)

Francisco Palomino

Board of Governors of the Federal Reserve System ( email )

20th Street and Constitution Avenue NW
Washington, DC 20551
United States

Charles Qian

Citigroup ( email )

388 Greenwich Street
New York, NY 10013
United States

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