Inflation and the Stock Market:Understanding the "Fed Model"

41 Pages Posted: 3 Jun 2009 Last revised: 22 Jul 2021

See all articles by Geert Bekaert

Geert Bekaert

Columbia Business School - Finance and Economics

Eric Engstrom

Board of Governors of the Federal Reserve System

Date Written: June 2009

Abstract

The Fed model postulates that the dividend or earnings yield on stocks should equal the yield on nominal Treasury bonds, or at least that the two should be highly correlated. In US data, there is indeed a strikingly high time series correlation between the yield on nominal bonds and the dividend yield on equities. This positive correlation is often attributed to the fact that both bond and equity yields commove strongly and positively with expected inflation. While inflation commoves with nominal bond yields for well-known reasons, the positive correlation between expected inflation and equity yields has long puzzled economists. We show that the effect is consistent with modern asset pricing theory incorporating uncertainty about real growth prospects and habit -- based risk version. In the US, high expected inflation has tended to coincided with periods of heightened uncertainty about real economic growth and unusually high risk aversion, both of which rationally raise equity yields. Our findings suggest that countries with high incidence of stagflation should have relatively high correlation between bond yields and equity yields and we confirm that this is true in a panel of international data

Suggested Citation

Bekaert, Geert and Engstrom, Eric C., Inflation and the Stock Market:Understanding the "Fed Model" (June 2009). NBER Working Paper No. w15024, Available at SSRN: https://ssrn.com/abstract=1413588

Geert Bekaert (Contact Author)

Columbia Business School - Finance and Economics ( email )

3022 Broadway
New York, NY 10027
United States

Eric C. Engstrom

Board of Governors of the Federal Reserve System ( email )

20th Street and Constitution Avenue NW
Washington, DC 20551
United States
202-452-3044 (Phone)

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