Inflation Expectations and Stock Returns

Abstract

Do stocks protect against rising inflation expectations? We directly measure investors' expectations using traded inflation-indexed contracts and show that, post-2000, stocks offer positive returns in response to higher expected inflation: unconditionally, a 10 basis point increase in 10-year breakeven inflation is associated with a 1.1% increase in the value-weighted stock index. Using high-frequency identification around scheduled CPI releases, we show this relationship is likely causal. We provide evidence that the price increase is driven by lowering future expected excess returns rather than changing risk-free rates or cashflows; VAR decompositions of returns as well as mediation regressions that directly control for alternate channels attribute nearly all the changes to expected excess returns. Finally, we show inflation expectations predict future output and reduced volatility, suggesting that investors use information about high future inflation as a signal for economic growth, lowering risk premia.