Extreme Inflation and Time-Varying Expected Consumption Growth
Abstract
In a parsimonious regime switching model, we find strong evidence that expected consumption growth varies over time. Adding inflation as a second variable, we uncover two states in which expected consumption growth is low, one with high and one with negative expected inflation. Embedded in a general equilibrium asset pricing model with learning, these dynamics replicate the observed time variation in stock return volatilities and stock-bond return correlations. They also provide an alternative derivation for a measure of time-varying disaster risk suggested by Watcher [Wachter J (2013) Can time-varying risk of rare disasters explain aggregate stock market volatility? J. Finance 68(3):987–1035]. implying that both the disaster and the long-run risk paradigm can be extended toward explaining movements in the stock-bond correlation.
This paper was accepted by Kay Giesecke, finance.
Funding: We gratefully acknowledge research and financial support from the Leibniz Center for Financial Research SAFE (formerly Research Center SAFE, funded by the State of Hessen initiative for research LOEWE).
Supplemental Material: The data files and online appendices are available at https://doi.org/10.1287/mnsc.2022.4451.
