Unexpected inflation, inflation uncertainty, and stock returns

This paper advances a hypothesis that the negative correlation between ex post real returns and unexpected inflation is induced by the negative correlation between ex post real returns and the uncertainty premium. The hypothesis is based on an uncertainty-adjusted present value model in which future dividends are more heavily discounted as uncertainty increases. Using an economic model which suggests the time-varying dividend uncertainty is mainly driven by the time-varying inflation uncertainty, this paper presents supportive empirical evidence using two different approaches. In the first approach, parametric models are developed for the conditional variance of inflation and its associated uncertainty premium. The results show that both conditional variance and uncertainty premium are negatively correlated with real returns, and their negative correlations dominate the negative correlation between unexpected inflation and real returns. The second approach uses a regression model in which frequency components of unexpected inflation are used as indicators of varying degrees of inflation uncertainty. The regressions reveal that the higher the uncertainty associated with a frequency component of unexpected inflation, the stronger the negative correlation with real returns.