What does financial volatility tell us about macroeconomic fluctuations?

We provide an extensive analysis of the predictive ability of financial volatility for economic activity. We consider monthly measures of realized and implied volatility from the stock and bond markets. In a dynamic factor framework, we extract the common long-run component of volatility that is likely to be linked to economic fundamentals. Based on powerful in-sample predictive ability tests, we find that the stock volatility measures and the common factor significantly improve macroeconomic forecasts of conventional financial indicators, especially over short horizons. A real-time out of sample assessment yields similar conclusions under the assumption of noisy revisions in macroeconomic data. In a nonlinear extension of the dynamic factor model, we identify two distinct volatility regimes, and show that the high-volatility regime provides early signals of the Great Recession, which was associated with severe financial distress and credit disintermediation.