Sorting Out Inflation

Abstract

The inflation risk premium (IRP) in the U.S. stock market varies over time. We use individual stocks to estimate the IRP, because this provides us with a heterogeneous cross-section of exposures. We find that the IRP is a significant -5.5% since the 1960s, but reverses to an insignificant positive value in the recent decade. Consistent with this reversal, we find that the IRP is more negative in recessions historically, but more positive in the two latest recessions. We show that both the introduction of Treasury Inflation Protected Securities (TIPS) in 1997, an attractive alternative inflation hedge, and a reversal in the covariance between inflation and the real economy at the end of the 1990s contribute to this reversal. These findings are consistent with inflation as a state variable in the intertemporal capital asset pricing model (ICAPM).