Prices and Returns: What Is the Role of Inflation?

Abstract

We document that both the dividend yield and earnings yield can predict future inflation across advanced economies. The inflation predictability reinforces the return predictability and reduces the dividend growth predictability. We show that both discount rates and cash flows play an essential role in determining prices. We test three hypotheses related to the future growth prospect, risk aversion, and behavior bias to justify the positive correlation among inflation and dividend (earnings) yields. High expected inflation correlates with periods of lower real economic growth and higher discount rates which lead to the drop in today's prices. To rationalize the inflation predictability, we develop and estimate a long-run risk model featuring inflation non-neutrality. The estimated model can reproduce both the inflation predictability and the documented asset pricing facts.

Keywords: Dividend growth, Dividend yield, International equity markets, Money illusion, Stock returns

JEL Classification: G10