Habit Formation and Returns on Bonds and Stocks

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Abstract
This paper proposes a habit formation model that captures the ability of the yield spread to predict excess returns on bonds as documented in empirical studies. The model, a generalization of Campbell and Cochrane (1999), also captures the predictability of stock returns by the price-dividend ratio, a high equity premium, excess volatility, positive excess returns on bonds, and an upward sloping average yield curve. The model is shown to imply a joint process for interest rates and consumption. When this process is estimated from the data, a new empirical fact emerges: Controlling for contemporaneous consumption growth, long lags of consumption predict the interest rate. Thus the success of the model is based on a more realistic process for consumption and the interest rate, rather than additional degrees of freedom in the utility function.

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