Does Inflation Explain Equity Risk Premia?

Abstract

I derive a simple linear macro asset pricing model that contains inflation as a risk factor in addition to the standard consumption growth and market return factors. This model nests the baseline CCAPM and Epstein--Zin models as special cases. Inflation arises endogenously in the pricing kernel by assuming an intra-temporal utility that depends on both real and nominal consumption, which suits an investor with partial money illusion. However, the model can not explain the cross-sectional dispersion in risk premia associated with 60 equity portfolios (related to six major CAPM anomalies). Moreover, the inflation risk price estimates, and implied preference parameter estimates, are statistically insignificant and/or economically implausible in most cases. To a large degree, these results hold when one estimates the Euler equations associated with the non-linear macro model. The evidence from this paper largely suggests that inflation does not help explaining the cross-section of stock returns.