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

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