Explaining the Stock Price-Inflation Puzzle: Inflation as a Signal for a Rare-Event

Diego Walter Pereira Garmendia

Universitat Pompeu Fabra

April 4, 2011

This paper explains the negative correlation between realized inflation and real stock prices under a rare-event framework. Agents make use of realized inflation rates to update their beliefs on the time-varying probability of a rare-event (stagflation or hyperinflation). A higher stagflation probability implies a higher correlation between inflation and real stock prices (dividend yield). I show that for a Bayesian belief-updating agent, the expectation on the Fed commitment to low inflation is key in order to explain the magnitude of the correlation. To test the model predictions, I perform a Markov Regime switching estimation and identify two statistically different regimes: one regime in which agents expect a strong commitment to low inflation by the Fed; and another regime in which they expect a low commitment to low inflation. Inflation correlates higher with stock prices in the second regime than in the first one. Finally, I show that the rare-event approach is more robust than the money illusion approach a-là Modigliani and Cohn (1979).

Number of Pages in PDF File: 40

Keywords: inflation-stock price puzzle, rare-events, inflation, money illusion

JEL Classification: C11, C14, G12, G15

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Date posted: April 7, 2011  

Suggested Citation

Pereira Garmendia, Diego Walter, Explaining the Stock Price-Inflation Puzzle: Inflation as a Signal for a Rare-Event (April 4, 2011). Available at SSRN: https://ssrn.com/abstract=1802433 or http://dx.doi.org/10.2139/ssrn.1802433

Contact Information

Diego Walter Pereira Garmendia (Contact Author)
Universitat Pompeu Fabra ( email )
Ramon Trias Fargas, 25-27
Barcelona, E-08005
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