Good and Bad Uncertainty: Macroeconomic and Financial Market Implications

Abstract

Does macroeconomic uncertainty increase or decrease aggregate growth and asset prices? To address this question, we decompose aggregate uncertainty into `good' and `bad' volatility components, associated with positive and negative innovations to macroeconomic growth. We document that in line with our theoretical framework, these two uncertainties have opposite impact on aggre- gate growth and asset prices. Good uncertainty predicts an increase in future economic activity, such as consumption, output, and investment, and is posi- tively related to valuation ratios, while bad uncertainty forecasts a decline in economic growth and depresses asset prices. Further, the market price of risk and equity beta of good uncertainty are positive, while negative for bad uncer- tainty. Hence, both uncertainty risks contribute positively to risk premia, and help explain the cross-section of expected returns beyond cash flow risk.