We document and examine 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 equilibrium model with time-varying volatility, the predictability decline requires changes in several model elements. Lower return predictability is consistent with stronger policy responses to inflation and output, a larger slope in the New Keynesian Phillips curve, and reduced sensitivity of both macroeconomic and financial variables to a volatility factor. Our results contribute to the examination of macroeconomic volatility as a driver of expected asset returns and the instability in predictive regressions. We further identify sources of the Great Moderation using asset price dynamics.
