Abstract: This paper examines the effect of expected inflation on stock prices
and expected long-run returns. An ex ante estimates measure of expected
long-run returns is derived by incorporating estimates of expected of
future
corporate cash flows into a variant of the Campbell-Shiller
dividend-price ratio model. In this model, the log earnings-price
ratio is expressed as a linear function of expected future returns,
expected earnings growth rates, and the log of the current
dividend-payout 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 recession-signalling
properties; rather, much of the negative valuation effect results from
a negative relation between expected inflation and expected
longer-term real earnings growth. The effect of expected inflation on
required (long-run) 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 inflation-related
component of expected real stock returns is closely related to the
component
explained by real long-term bond yields.
Keywords: Stock returns, inflation, price-earnings ratio
Full paper (373 KB PDF)
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Last update: August 11, 2000
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