Inflation and Earnings Uncertainty and Volatility Forecasts: A Structural Form Approach

Abstract

We propose a new structural form methodology for understanding the fluctuations and predictability of volatilities and covariances of asset returns. In our model, a representative agent learns about the joint movements in inflation and real earnings through business cycles. We extract investors' beliefs about fundamentals from the prices and volatilities of stocks and bonds. The duration of episodes of enhanced investors' uncertainty are forecastable and lead to forecasts of volatilities that are far more precise than those based on reduced-form models that include lags and macroeconomic variables. The model's success stems largely from endogenous and time varying weights that investors assign to news about real fundamental growth and their pricing kernel.

JEL Classification: G10, G11, G12, G14