Francisco Palomino

The Decline in Asset Return Predictability and Macroeconomic Volatility

We document strong U.S. stock and bond return predictability from several macroeconomic volatility series before 1982, and a significant decline in this predictability during the Great Moderation. These findings are robust to alternative empirical specifications and out-of-sample tests. We explore the predictability decline using a model that incorporates monetary policy and shocks with time-varying volatility. The 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 and less volatile shocks explain the lower predictability.

Real and Nominal Equilibrium Yield Curves: Wage Rigidities and Permanent Shocks

The links between real and nominal bond risk premia and macroeconomic dynamics are explored quantitatively in a model with nominal rigidities and monetary policy. The estimated model captures macroeconomic and yield curve properties of the U.S. economy, implying significantly positive real term and inflation risk bond premia. In contrast to previous literature, both premia are positive and generated by wage rigidities as a compensation for permanent productivity shocks. Stronger policy-rule responses to inflation (output) increase (decrease) both premia, while policy surprises generate negligible risk premia. Empirical evidence of the economic mechanism is provided.

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.

Real and Nominal Equilibrium Yield Curves with Endogenous Inflation: A Quantitative Assessment

The links between real and nominal bond risk premia and macroeconomic dynamics are explored analytically and quantitatively in a model with nominal rigidities and monetary policy. The interest-rate policy rule becomes a restriction linking real and nominal risk premia through endogenous inflation. The estimated model captures macroeconomic and yield curve properties of the U.S. economy, implying significantly positive real term and inflation risk bond premia. Both premia are induced by wage rigidities as a compensation for permanent productivity shocks. Stronger policy-rule responses to inflation (output) increase (decrease) both premia. Policy surprises generate significant yield volatility but negligible risk premia.