Inflation, interest rates and the predictability of stock returns

Abstract

This paper focuses on the predictive role of inflation and interest rates in forecasting stock returns. We report economically significant in-sample evidence that stock returns are predictable using cyclical components of inflation and interest rates. The out-of-sample analysis results show that these cyclical components have reasonable out-of-sample predictability for the equity risk premium when the comparison is made against a historical average benchmark. We believe this is due to the fact that both inflation and interest rates contain stochastic trends. Accounting for changes in trend inflation (and equilibrium real interest rate) is essential for forecasting stock returns.