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Inflation and the Stock Market:Understanding the "Fed Model"

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  • Geert Bekaert
  • Eric Engstrom

Abstract

The Fed model postulates that the dividend or earnings yield on stocks should equal the yield on nominal Treasury bonds, or at least that the two should be highly correlated. In US data, there is indeed a strikingly high time series correlation between the yield on nominal bonds and the dividend yield on equities. This positive correlation is often attributed to the fact that both bond and equity yields commove strongly and positively with expected inflation. While inflation commoves with nominal bond yields for well-known reasons, the positive correlation between expected inflation and equity yields has long puzzled economists. We show that the effect is consistent with modern asset pricing theory incorporating uncertainty about real growth prospects and habit -- based risk version. In the US, high expected inflation has tended to coincided with periods of heightened uncertainty about real economic growth and unusually high risk aversion, both of which rationally raise equity yields. Our findings suggest that countries with high incidence of stagflation should have relatively high correlation between bond yields and equity yields and we confirm that this is true in a panel of international data

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Bibliographic Info

Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 15024.

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Date of creation: Jun 2009
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Publication status: published as Bekaert, Geert & Engstrom, Eric, 2010. "Inflation and the stock market: Understanding the "Fed Model"," Journal of Monetary Economics, Elsevier, vol. 57(3), pages 278-294, April.
Handle: RePEc:nbr:nberwo:15024

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Citations

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Cited by:
  1. Geert Bekaert & Campbell R. Harvey & Christian T. Lundblad & Stephan Siegel, 0. "What Segments Equity Markets?," Review of Financial Studies, Society for Financial Studies, Society for Financial Studies, vol. 24(12), pages 3841-3890.
  2. De Santis, Roberto A & Favero, Carlo A. & Roffia, Barbara, 2012. "Euro Area Money Demand and International Portfolio Allocation: A Contribution to Assessing Risks to Price Stability," CEPR Discussion Papers, C.E.P.R. Discussion Papers 8957, C.E.P.R. Discussion Papers.
  3. Carlo A. Favero & Arie E. Gozluklu & Haoxi Yang, 2011. "Demographics and The Behaviour of Interest Rates," Working Papers 388, IGIER (Innocenzo Gasparini Institute for Economic Research), Bocconi University.
  4. Brière, Marie & Ang, Andrew & Signori, Ombretta, 2012. "Inflation and Individual Equities," Economics Papers from University Paris Dauphine 123456789/7847, Paris Dauphine University.
  5. Alexander David & Pietro Veronesi, 2009. "What Ties Return Volatilities to Price Valuations and Fundamentals?," NBER Working Papers 15563, National Bureau of Economic Research, Inc.
  6. Liew, Freddy, 2012. "Forecasting inflation in Asian economies," MPRA Paper 36781, University Library of Munich, Germany.
  7. Marie Brière & Ombretta Signori, 2011. "Inflation hedging portfolios in different regimes," BIS Papers chapters, in: Bank for International Settlements (ed.), Portfolio and risk management for central banks and sovereign wealth funds, volume 58, pages 139-163 Bank for International Settlements.
  8. Jaewon Choi & Matthew P. Richardson & Robert F. Whitelaw, 2014. "On the Fundamental Relation Between Equity Returns and Interest Rates," NBER Working Papers 20187, National Bureau of Economic Research, Inc.
  9. Li Gu & Dayong Huang, 2013. "Consumption, Money, Intratemporal Substitution, And Cross-Sectional Asset Returns," Journal of Financial Research, Southern Finance Association;Southwestern Finance Association, vol. 36(1), pages 115-146, 01.
  10. Acker, Daniella & Duck, Nigel W., 2013. "Inflation illusion and the US dividend yield: Some further evidence," Journal of International Money and Finance, Elsevier, Elsevier, vol. 33(C), pages 235-254.
  11. Signori, Ombretta & Brière, Marie, 2012. "Inflation-Hedging Portfolios : Economic Regimes Matter," Economics Papers from University Paris Dauphine 123456789/9296, Paris Dauphine University.

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