The Equity Premium and Inflation: Evidence from the US

Samih Antoine Azar

Applied Finance and Accounting, 2015, vol. 1, issue 1, 30-36

Abstract: There is recent and strong evidence that nominal stock returns are independent of inflation. In what amounts to the same thing, when real stock returns are regressed on inflation the resulting estimated coefficient on inflation is negative and unitary. These two propositions are mathematically equivalent. The purpose of this paper is to show that the market stock return is also independent of expected inflation, as measured by the T-bill rate. Firstly, regressions of the equity premium on inflation produce invariably slope coefficients that are statistically insignificantly different from -1. The inflation variable on the right hand side of the regression picks up the sign and the magnitude of the T-bill rate in the equity premium on the left hand side of the regression. This is as expected because the T-bill rate is an unbiased predictor of the future inflation rate, or, in other terms, the T-bill rate is a proxy for expected inflation. Hence regressions of real stock returns on inflation are in substance the same as regressions of the equity premium on inflation, and in both cases nominal stock returns are independent of inflation, and of its expected proxy, the T-bill rate. Secondly, additional evidence is provided from regressions of stock market returns on the inflation rate and the T-bill rate taken together. The hypothesis that the sum of the two coefficients on these two variables is statistically insignificantly different from zero is strongly supported. Moreover, the joint null hypothesis that the first coefficient is equal to -1 and that the second coefficient is equal to +1 is also strongly supported. As a conclusion stock prices already reflect macroeconomic shocks and there is neither money illusion nor over and under adjustment on the part of investors.

Keywords: equity premium; inflation; T-bill rate; spurious negative relation; robust standard errors; EGARCH; quantile regressions; robust least squares; Markov switching regressions. (search for similar items in EconPapers)
Date: 2015
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