Real Cash Flow Expectations and Asset Prices
47 Pages Posted: 22 Jun 2021 Last revised: 23 Jun 2021
Date Written: June 22, 2021
Using survey forecasts, we find that systematic errors in expectations of long-term inflation and short-term nominal earnings growth are the main driver of prices and return puzzles for bonds and stocks. We demonstrate this by deriving and testing a single necessary and sufficient condition based on accounting identities. Errors in expectations of short-term inflation and long-term nominal earnings growth do not play a role in either asset market. Because of these systematic errors, real cash flow expectations closely match aggregate bond and stock prices, leaving little room for time-varying discount rates. These expectations also accurately match key return puzzles for bonds and stocks: the rejection of the expectations hypothesis and stock return predictability. These results are consistent with a simple model in which agents believe the persistences of inflation and nominal earnings growth are magnified versions of the objective persistences.
Keywords: subjective expectations, inflation expectations, return predictability, expectations hypothesis
JEL Classification: E31, G02, G10, G12, G14
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