Working Paper: CEPR ID: DP18003
Authors: Anna Cieslak; Carolin Pflueger
Abstract: The past half-century has seen major shifts in inflation expectations, how inflation comoves with the business cycle, and how stocks comove with Treasury bonds. Against this backdrop, we review the economic channels and empirical evidence on how inflation is priced in financial markets. Not all inflation episodes are created equal. Using in a New Keynesian model, we show how "good'' inflation can be linked to demand shocks and "bad'' inflation to supply shocks driving the economy. We then discuss asset pricing implications of "good" and "bad" inflation. We conclude by providing an outlook for inflation risk premia in the world of newly rising inflation.
Keywords: Inflation; Risk Premia; Bond Return Predictability; Stagflation; Monetary Policy
JEL Codes: E43; E52; E58
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| good inflation (E31) | increase in asset prices (G19) |
| demand shocks (E39) | good inflation (E31) |
| bad inflation (E31) | decrease in asset prices (G19) |
| supply shocks (E39) | bad inflation (E31) |
| bad inflation (E31) | risky nominal bonds (G12) |
| bad inflation (E31) | decline in stock market valuations (G10) |
| good inflation (E31) | positive correlation between nominal bond prices and stock prices (G12) |
| bad inflation (E31) | negative correlation between nominal bond prices and stock prices (G12) |