Prices and Returns: What Is the Role of Inflation?

55 Pages Posted: 29 Oct 2019 Last revised: 22 Feb 2022

See all articles by Yulong Sun

Yulong Sun

University of Science and Technology of China (USTC)

Date Written: November 20, 2018


We document that the market dividend yield can positively predict future inflation across advanced economies after the fall of the Bretton Woods system. The inflation predictability reinforces the return predictability and reduces the dividend growth predictability. For example, dividend yields forecast nominal returns (but not nominal dividend growth), meanwhile, dividend yields forecast real dividend growth (but not real returns). The same results also hold for the earnings yields. We extend Campbell-Vuolteenaho's (2004) analysis to other industrialized countries whose stock markets are highly integrated. Hypothesis tests (related to future growth prospect, the discount rate, and behavior bias) suggest the high correlation between expected inflation and the dividend yield is almost entirely due to the correlation between expected inflation and the economy's future growth prospects. The results are robust across different future inflation measures including the long-term nominal government bond yields, and strongly support Fama's (1981) inflation acting as expected real activity proxy hypothesis. Therefore we argue that persistent inflation should be regarded as the state variable and be introduced as the second long-run risk (besides the consumption risk) into the long-run risk model. The estimated model can reproduce both the inflation predictability and the documented asset pricing facts.

Keywords: Dividend yield; Inflation predictability; International equity markets; Long-run risk.

JEL Classification: G10

Suggested Citation

Sun, Yulong, Prices and Returns: What Is the Role of Inflation? (November 20, 2018). Proceedings of Paris December 2019 Finance Meeting EUROFIDAI - ESSEC, Available at SSRN: or

Yulong Sun (Contact Author)

University of Science and Technology of China (USTC)

No.96 Jinzhai Road
Hefei, Anhui 230026


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