Inflation and the stock market: Understanding the “Fed Model”

The so-called Fed model postulates that the dividend or earnings yield on stocks should equal the yield on nominal Treasury bonds, or at least that the two should be highly correlated. In US data there is indeed a strikingly high time series correlation between the yield on nominal bonds and the div...

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Bibliographic Details
Published in:Journal of monetary economics 2010-04, Vol.57 (3), p.278-294
Main Authors: Bekaert, Geert, Engstrom, Eric
Format: Article
Language:English
Subjects:
Anti-inflation policy
Bond yield
Central banks
Correlation analysis
Countercyclical risk aversion
Dividend yield
Dividends
Economic models
Economic uncertainty
Equity premium
Fed model
Inflation
Inflation rate
Interest rate policy
Monetary economics
Monetary models
Monetary policy
Money illusion
Money illusion Equity premium Countercyclical risk aversion Fed model Inflation Economic uncertainty Dividend yield Stock-bond correlation Bond yield
Money supply
Risk aversion
Securities markets
Stabilization policy
Stock exchange
Stock prices
Stock–bond correlation
Studies
U.S.A
Yield
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Summary:The so-called Fed model postulates that the dividend or earnings yield on stocks should equal the yield on nominal Treasury bonds, or at least that the two should be highly correlated. In US data there is indeed a strikingly high time series correlation between the yield on nominal bonds and the dividend yield on equities. This positive correlation is often attributed to the fact that both bond and equity yields comove strongly and positively with expected inflation. Contrary to some of the extant literature, we show that this effect is consistent with modern asset pricing theory incorporating uncertainty about real growth prospects and habit-based risk aversion. In the US, high expected inflation has tended to coincide with periods of heightened uncertainty about real economic growth and unusually high risk aversion, both of which rationally raise equity yields.
ISSN:0304-3932
1873-1295
DOI:10.1016/j.jmoneco.2010.02.004