Extreme Inflation and Time-Varying Expected Consumption Growth

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.