<aside> 💡 This blog post is a summary of the paper by myself and Manav Chaudhary, “Inflation Expectations and Stock Returns”.
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For all the talk about how to invest when inflation is high, economists find it surprisingly difficult to find evidence of a clear relationship between inflation and stock returns. To see why, it’s helpful to consider a basic plot of monthly stock returns against measures of monthly inflation dating back to 1990s. In the figures below, each point refers to the rate of inflation (x-axis) and corresponding stock return (y-axis) in a specific month:
For both inflation and inflation growth, the main pattern is that...there is no pattern. One need not be an economist to see that — at least in the past 30 years — neither measure has a strong relationship with stock returns, nor is the sign of the relationship even clear.
To outside observers, the absence of a clear empirical relationship may seem somewhat odd. Even without an in-depth understanding of macroeconomics or finance, one can recognize that both inflation and stock returns measure changes in prices that speak in different respects to the health of the economy. It is also straightforward to tell a simple cash-flow story for how the two phenomena should be positively related. Stocks are claims on companies, which (for the most part) sell real goods and services. If the prices of goods increase (inflation), so do the revenues of the company, and so claims to those cash flows should retain their real value. But to the extent previous literature has found any relationship, it has tended to be negative, suggesting either the fallibility of the cash-flow story or structural changes that distinguish the present economy from that of the late 20th century.
My coauthor Manav Chaudhary and I have recently come out with a paper that revisits in part this stock-inflation puzzle. Our basic approach is to relate stock returns to inflation expectations rather than realized **inflation. In other words, rather than look how the stock market has actually performed when inflation was actually high, we ask how the stock market has performed when investors expected inflation to be high.
When looking at expectations, we find results that depart from previous literature: when inflation expectations increase, so do stock returns. The magnitudes are quite large: a 0.10 percentage point increase in 10 year inflation expectations is associated with a 1.2 percentage point higher daily stock return. These results suggest that the stock market commands what we call an “inflation insurance premium:” when investors expect inflation to be high, they demand exposure to equities, thereby driving up the price. In the remainder of this post, we walk through the steps involved in this paper with a particular focus on our contributions and approach.
To measure the relationship between inflation expectations and stock returns, it’s helpful to have measures of inflation expectations and stock returns. Stock-returns are easy to come by — any finance website will have a time series — but what about inflation expectations?
Historically the way economists have measured expectations is either to use survey data (i.e. ask people what they expect) or else assume that individuals are on average correct about the future (”rational expectations”). Both methods obviously have their flaws: surveys are few and far between and may not reflect the honest views of participants. Rational expectations measures can be made available at higher frequency, but these models make use of very strong assumptions about how individuals form expectations.