Abstract: This paper examines the effect of expected inflation on stock prices
and expected longrun returns. An ex ante estimates measure of expected
longrun returns is derived by incorporating estimates of expected of
future
corporate cash flows into a variant of the CampbellShiller
dividendprice ratio model. In this model, the log earningsprice
ratio is expressed as a linear function of expected future returns,
expected earnings growth rates, and the log of the current
dividendpayout ratio. Expectations of earnings growth are inferred
from equity analysts' earnings forecasts, while inflation expectations are
drawn from surveys of professional forecasters.
I find that the negative relation between equity valuations and
expected inflation results from two effects: higher expected
inflation coincides with (i) lower expected real earnings growth
and (ii) higher required real returns. The earnings channel is not
merely a reflection of inflation's recessionsignalling
properties; rather, much of the negative valuation effect results from
a negative relation between expected inflation and expected
longerterm real earnings growth. The effect of expected inflation on
required (longrun) real stock returns is also substantial. A one
percentage point increase in expected inflation raises required real
stock returns about one percentage point, which on average implies a 20
percent decline in the level of stock prices. The inflationrelated
component of expected real stock returns is closely related to the
component
explained by real longterm bond yields.
Keywords: Stock returns, inflation, priceearnings ratio
Full paper (373 KB PDF)
Home  FEDS  List of 1999 FEDS papers
Accessibility
To comment on this site, please fill out our feedback form.
Last update: August 11, 2000
