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Monetary Policy Uncertainty and the Stock Market

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Author Info
Locarno, Alberto
Massa, Massimo

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Abstract

We study the relationship between inflation and stock returns focusing on the signalling content of inflation. Investors use inflation to learn about the stance of the monetary policy. Depending on investors’ beliefs, a change in consumption prices has different effects on the risk premium. A change in consumption prices that confirms investors' beliefs reduces stock risk premia, while a change that contradicts them increases risk premia. This may generate a negative correlation between returns and inflation that explains the Fisher puzzle. We model this intuition and test its implication on US data. We construct a market-based proxy of monetary policy uncertainty, we show that it is priced and that, by conditioning on it, the Fisher puzzle disappears.

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Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 4828.

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Date of creation: Jan 2005
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Handle: RePEc:cpr:ceprdp:4828

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Related research
Keywords: asset pricing; learning risk; monetary policy uncertainty; risk factors;

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Find related papers by JEL classification:
G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
G12 - Financial Economics - - General Financial Markets - - - Asset Pricing
G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies

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