Monetary Policy and Equity Valuation
43 Pages Posted: 31 May 2018 Last revised: 17 Nov 2018
Date Written: November 15, 2018
The Taylor rule (1993) states that Fed funds rates have an inflation beta equal to 1.5. If equity investors infer their long-term discount rate based upon guidance from the Federal Reserve using the Taylor rule, then earnings yields should display a positive beta to inflation. This provides a rational explanation to the empirically observed relationship between earnings yield and inflation, refuting the Money Illusion Hypothesis of Modigliani and Cohn (1979). Using an ARDL model, I find that Fed funds rates had an inflation beta between 1.55 and 1.85 over the 1978-2017 period, implying an inflation beta of earnings growth lying around one over the past 40 years. Equity investors therefore rationally discount nominal cash flows at nominal discount rate, accounting for the fact that Fed funds rates are described by the Taylor rule.
Keywords: Taylor rule, Money Illusion Hypothesis, Equity Valuation
JEL Classification: G1
Suggested Citation: Suggested Citation