Time-Varying Risk Premia and the Output Gap
39 Pages Posted: 26 Sep 2006
Date Written: January 2007
The output gap, a production based macroeconomic variable, is a strong predictor of stock and bond 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 at the one month horizon as well as at longer horizons, and out-of-sample. It is robust to a host of checks that have troubled previous research. It subsumes sentiment based predictors, lending support for efficient market explanations of the predictability of excess returns.
Keywords: return predictability, risk premia, output gap
JEL Classification: G12, G14, E44
Suggested Citation: Suggested Citation