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

Journal of Monetary Economics, Vol. 57, No. 3, pp. 278-294, 2010

40 Pages Posted: 21 Oct 2011

See all articles by Geert Bekaert

Geert Bekaert

Columbia Business School - Finance and Economics

Eric Engstrom

U.S. Board of Governors of the Federal Reserve System - Division of Research and Statistics, Capital Markets

Multiple version iconThere are 2 versions of this paper

Date Written: April 2009

Abstract

The so-called Fed model postulates that the dividend or earnings yield on stocks equals the yield on nominal Treasury bonds, or at least that they should be highly correlated. Indeed, there is a strikingly high time series correlation between the yield on nominal bonds and the dividend yield on equities. This positive correlation can be traced to the fact that both bond and equity yields co-move strongly and positively with expected inflation. While inflation co-moves with nominal bond yields for obvious 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 real uncertainty and habit-based risk aversion. In the US, high expected inflation has tended to coincide with periods of heightened uncertainty about real economic prospects and unusually high risk aversion, both of which rationally raise equity yields. Our findings suggest that countries with a high incidence of stagflation should have relatively high correlations between bond yields and equity yields and we confirm that this is true in a panel of international data.

Keywords: Money illusion, Equity premium, Countercyclical risk aversion, Fed model, Inflation, Economic Uncertainty Dividend yield, Stock-Bond Correlation, Bond Yield

Suggested Citation

Bekaert, Geert and Engstrom, Eric C., Inflation and the Stock Market: Understanding the 'Fed Model' (April 2009). Journal of Monetary Economics, Vol. 57, No. 3, pp. 278-294, 2010. Available at SSRN: https://ssrn.com/abstract=1946956

Geert Bekaert (Contact Author)

Columbia Business School - Finance and Economics ( email )

3022 Broadway
New York, NY 10027
United States

Eric C. Engstrom

U.S. Board of Governors of the Federal Reserve System - Division of Research and Statistics, Capital Markets ( email )

20th & C. St., N.W.
Washington, DC 20551
United States
202-452-3044 (Phone)

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