Gone With the Vol: A Decline in Asset Return Predictability During the Great Moderation

64 Pages Posted: 8 Feb 2019

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: January 24, 2019

Abstract

We document a significant shift in the comovement of asset returns and macroeconomic volatility during the Great Moderation. Strong U.S. stock and bond return predictability from several macroeconomic volatility series before 1982 was followed by a significant predictability decline during the Great Moderation (1982-2008). These findings are robust to alternative empirical specifications and out-of-sample tests. In a calibrated time-varying-volatility equilibrium model, the predictability decline is consistent with changes in monetary policy and shock dynamics. A stronger policy response to inflation and lower cost-push shock variance reduce the sensitivity of macroeconomic variables and asset returns to a persistent volatility factor, explaining the lower predictability. The results contribute to examine macroeconomic volatility as a driver of expected asset returns, and identify sources of the Great Moderation using asset price dynamics.

Keywords: Asset Return Predictability, Time-Varying Macroeconomic Volatility, Monetary Policy, Great Moderation

JEL Classification: E44, G12, G18

Suggested Citation

Hsu, Alex and Palomino, Francisco and Qian, Charles, Gone With the Vol: A Decline in Asset Return Predictability During the Great Moderation (January 24, 2019). Georgia Tech Scheller College of Business Research Paper No. 19-04. Available at SSRN: https://ssrn.com/abstract=3322024 or http://dx.doi.org/10.2139/ssrn.3322024

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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