The Decline of Macroeconomic Volatility Risk and Asset Return Predictability: Monetary Policy or Shocks?

We document a strong predictive power of macroeconomic volatility series for stock and bond returns before 1980, and a significant decline in this power during the Great Moderation. We explore these findings using an equilibrium model with monetary policy and several shocks with time-varying volatility. The model captures the return predictability observed in pre-1980 data, while matching salient properties of U.S. macroeconomic and financial data. The decline in return predictability is consistent with changes in both monetary policy and shock dynamics. While an increase in the response to inflation in the interest-rate policy rule reduces macroeconomic volatility, more persistent cost-push shocks with reduced variation in volatility explain the decline in return predictability.