Prices and Returns: What Is the Role of Inflation?

Abstract

We document that the market dividend yield can positively predict future inflation across advanced economies after the fall of the Bretton Woods system. The inflation predictability reinforces the return predictability and reduces the dividend growth predictability. For example, dividend yields forecast nominal returns (but not nominal dividend growth), meanwhile, dividend yields forecast real dividend growth (but not real returns). The same results also hold for the earnings yields. We extend Campbell-Vuolteenaho's (2004) analysis to other industrialized countries whose stock markets are highly integrated, to deal with the processes and few independent observations issues. Hypothesis tests (related to future growth prospect, the discount rate, and behavior bias) suggest the high correlation between expected inflation and the dividend yield is almost entirely due to the correlation between expected inflation and the economy's future growth prospects. The results are robust across different future inflation measures including the long-term nominal government bond yields, and strongly support Fama's (1981) inflation acting as expected real activity proxy hypothesis. Therefore we argue the persistent inflation should be regarded as the state variable and be introduced as the second long-run risk (besides the consumption risk) into the long-run risk model. The estimated model can reproduce both the inflation predictability and the documented asset pricing facts.