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

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.