The Declining Asset Return Predictability and Macroeconomic Volatility
74 Pages Posted: 2 Sep 2016 Last revised: 25 Mar 2017
Date Written: March 24, 2017
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
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