Abstract: This paper examines the effect of inflation on stock valuations and
expected longrun returns. Ex ante estimates of expected longrun
returns are constructed by incorporating analysts' earnings forecasts
into a variant of the CampbellShiller dividendprice ratio model.
The negative relation between equity valuations and expected inflation
is found to be the result of two effects: a rise in expected inflation
coincides with both (i) lower expected real earnings growth and (ii)
higher required real returns. The earnings channel mostly reflects a
negative relation between expected longterm earnings growth and
expected inflation. The effect of expected inflation on required
(longrun) real stock returns is also substantial. A one percentage
point increase in expected inflation is estimated to raise required
real stock returns about one percentage point, which on average would
imply a 20 percent decline in stock prices. But the inflation factor
in expected real stock returns is also in longterm Treasury yields;
consequently, expected inflation has little effect on the longrun
equity premium.
Keywords: Inflation, stock returns, equity premium, priceearnings ratio
Full paper (281 KB PDF)
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Last update: July 24, 2001
