Inflation and the stock market: Understanding the “Fed Model”

The so-called 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 comove strongly and positively with expected inflation. While inflation comoves 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 also habit-based risk aversion. In the US, high expected inflation has tended to coincide 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 a high incidence of stagflation should have relatively high correlations between bond yields and equity yields and we confirm that this is true in a panel of international data.