Stock Prices, Expected Returns, and Inflation

46 Pages Posted: 17 Apr 1999

See all articles by Steven A. Sharpe

Steven A. Sharpe

Federal Reserve Board - Research & Statistics

Date Written: August 1999

Abstract

This paper examines the effect of expected inflation on stock prices and expected long-run returns. Ex ante estimates of expected long-run returns is derived by incorporating estimates of investor expectations of future corporate cash flows into a variant of the Campbell-Shiller dividend-price ratio model. In this model, the log earnings-price ratio is expressed as a linear function of expected future returns, expected earnings growth rates, and the log of the current dividend-payout ratio. Investor expectations of earnings growth are inferred from equity analysts' earnings forecasts; inflation expectations are drawn from surveys of professional forecasters.

I find that the negative relation between equity valuations and expected inflation is the result of two effects: a rise in expected inflation coincides with both (i) lower expected real earnings growth and (ii) higher required real returns. The earnings channel is not merely a reflection of inflation's recession-signalling properties; rather, a substantial portion of the negative valuation effect appears to be the result of a negative relation between expected inflation and projections of longer-term real earnings growth. The effect of expected inflation on required (long-run) real stock returns is also substantial. A one percentage point increase in expected inflation is estimated to raise required real stock returns about one percentage point, which amounts to about a 20 percent decline in stock prices. At the same time, the inflation-related component in expected real stock returns has a higher degree of commonality with the component related to the expected long-term bond yield.

Note: This is a reprint with an updated version of the abstract and paper.

JEL Classification: G12, E31

Suggested Citation

Sharpe, Steven A., Stock Prices, Expected Returns, and Inflation (August 1999). FEDS Working Paper No. 99-2. Available at SSRN: https://ssrn.com/abstract=155071 or http://dx.doi.org/10.2139/ssrn.155071

Steven A. Sharpe (Contact Author)

Federal Reserve Board - Research & Statistics ( email )

20th & C. St., N.W.
Washington, DC 20551
United States
202-452-2875 (Phone)
202-452-3819 (Fax)

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