Prices and Returns: What Is the Role of Inflation?

Abstract

We document that the dividend yield can predict future inflation across advanced economies. 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. To reproduce the inflation predictability, we first test three hypotheses (related to future growth prospect, risk aversion, and behavior bias) to justify the positive correlation among inflation and dividend yields. Results suggest expected inflation can explain most of the variations in future excess cash flows. Then we argue inflation risk is priced in the aggregate market and inflation should be regarded as the state variable. Therefore, we introduce inflation 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