Working Paper: CEPR ID: DP4828
Authors: Alberto Locarno; Massimo Massa
Abstract: We study the relationship between inflation and stock returns focusing on the signalling content of inflation. Investors use inflation to learn about the stance of the monetary policy. Depending on investors? beliefs, a change in consumption prices has different effects on the risk premium. A change in consumption prices that confirms investors' beliefs reduces stock risk premia, while a change that contradicts them increases risk premia. This may generate a negative correlation between returns and inflation that explains the Fisher puzzle. We model this intuition and test its implication on US data. We construct a market-based proxy of monetary policy uncertainty, we show that it is priced and that, by conditioning on it, the Fisher puzzle disappears.
Keywords: Asset Pricing; Learning; Risk; Monetary Policy Uncertainty; Risk Factors
JEL Codes: G11; G12; G14
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| inflation (E31) | monetary policy uncertainty (E49) |
| monetary policy uncertainty (E49) | investors' expectations about future cash flows (D84) |
| monetary policy uncertainty (E49) | risk premia (G22) |
| inflation (E31) | risk premia (G22) |
| change in consumption prices (D11) | risk premia (G22) |
| inflation (E31) | stock returns (G12) |
| monetary policy uncertainty (E49) | stock returns (G12) |
| monetary policy uncertainty (E49) | Fisher puzzle (C72) |