Wage Rigidity: A Solution to Several Asset Pricing Puzzles

In standard production based models labor income volatility is far too high and equity return volatility is far too low (excess volatility puzzle). We show that a simple modification of the standard model - infrequent renegotiation of labor income - allows the model to match both the smoother wages and the high equity return volatility observed in the data. Furthermore, the model produces several other hard to explain features of financial data: high unconditional Sharpe Ratios; time-varying equity premium, equity volatility, and Sharpe Ratio; as well a higher expected returns for value stocks over growth stocks. The intuition is that in standard models, highly pro-cyclical and volatile wages act as a hedge for the firm, reducing profits in good times and increasing them in bad times; this causes profit and returns to be too smooth. Infrequent renegotiation smoothes wages and smooth wages act like operating leverage, making profits more risky. Bad times and unproductive firms are especially risky because committed wage payments are high relative to output. Consistent with our model, we show that in the data wage growth can forecast long horizon returns, furthermore we find the same predictability at the industry level, with more rigid industries having stronger predictability.