Inflation and the Stock Market: Understanding the ‘Fed’ Model Geert Bekaert Columbia University...
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Transcript of Inflation and the Stock Market: Understanding the ‘Fed’ Model Geert Bekaert Columbia University...
Inflation and the Stock Market:Understanding the ‘Fed’ Model
Geert Bekaert
Columbia University and NBER
Eric Engstrom
Federal Reserve Board
This work does not necessarily represent the views of the Federal Reserve System or its staff.
1
Bekaert Engstrom, 2008, FedModel 2
Motivation (note: sample ends in 2007)U.S.
Bekaert Engstrom, 2008, FedModel 3
Motivation- Equity yields (EY) and safe nominal bond yields (BY) are
very highly correlated (correlation = 0.78)
- Practitioner’s: Fed Model• EY > BY: Equities are attractive• BY > EY: Bonds are attractive
– Typical practicioner statement“The 10-year Treasury trades at almost 30x earnings, compared to
about 14 times for the S&P 500...…The valuation disparity between Treasuries and stocks is as great today in favor of stocks as it was in favor of Treasuries 20 years ago.”
– Bill Miller, Legg Mason Value Trust Investment Commentary Q42007
Bekaert Engstrom, 2008, FedModel 4
Motivation
:
:
:
:
:
:
EY equity cash yield
BY long bond yield
RRF real risk free rate
ERP equity risk premium
EDIV real cash flow growth
IRP inflation risk premium
EY RRF EDIV ERP
BY RRF EINF IRP
Fed Model Puzzle:Since inflation
compensation is the primary driver of BY, why are EY and BY
so highly correlated?
Bekaert Engstrom, 2008, FedModel 5
Existing Literature
– “Money illusion” is the prevailing explanation:
• Version 1: when expectations rise nominal rates do too, but investors use these nominal rates incorrectly to discount real equity cash flow growth (Modigliani and Cohn 1979,…)
• Version 2: investors correctly discount nominal equity cash flows with nominal rates, but fail to rationally boost nominal cash flow growth rate expectations in the face of higher inflation (Sharpe 2002, Campbell and Vuolteenaho 2005, Cohen, Polk and Vuolteenaho, 2007)
Bekaert Engstrom, 2008, FedModel 6
What we find
– In the U.S. the high EY/BY correlation have arisen as a rational response to instances of stagflation
• Inflation has tended to move with equity yields only because it is correlated with real slowdowns and economic uncertainty that increase risk aversion
– Implication: countries with no stagflationary experiences should not exhibit high EY/BY correlations (and they don’t!)
Bekaert Engstrom, 2008, FedModel 7
General Methodology
Create “dynamic” versions of:EY = RRF – EDIV + ERP
BY = RRF + EINF + IRP
Decompose EY-BY correlation into correlations among the components
Problem: Identification!
Bekaert Engstrom, 2008, FedModel 8
General Methodology
Bond yield decomposition:
Ang, Bekaert, Wei
(JF, 2008)
t t t tBY RRF EINF IRP
We explore alternative identification schemes in robustness exercises
residual SPF Forecasts
(See Ang, Bekaert, Wei)
Bekaert Engstrom, 2008, FedModel 9
General Methodology
Equity yield decomposition:
Ang, Bekaert, Wei
(JF, 2008)
t t t tEY RRF EDIV ERP
statistical model (VAR)
not just residual,
take a stand on risk!
1 2 tt t tERP a b RiskAversion b Uncertainty u
habit-based a la Campbell and Cochrane
survey data residual
Bekaert Engstrom, 2008, FedModel 10
Methodology
( , )
( , ) ( , ) ( , )
( , ) ( , ) ( , )
( , ) ( , ) ( , )
COV EY BY
COV EDIV EINF COV EDIV RRF COV EDIV IRP
COV RRF EINF COV RRF RRF COV RRF IRP
COV ERP EINF COV ERP RRF COV ERP IRP
Armed with an identification strategy, we can decompose
Bekaert Engstrom, 2008, FedModel 11
Empirical Results Non-trivial components of EY-BY comovement:
1. Equity real rate and bond expected inflation7%
2. Equity expected div’s and bond expected inflation12%
3. Equity rational risk premium and bond real rates13%
4. Equity rational risk premium and bond expected inflation51%
5. Equity risk premium residual and bond expected inflation8%
Bekaert Engstrom, 2008, FedModel 12
Empirical Results
Cross-sectional implications: Fed model should “work” in countries with a high incidence of stagflations
There is indeed lots of cross-sectional variation in the (EY, BY) correlation across countries (see also Estrada, 2006)
Bekaert Engstrom, 2008, FedModel 13
Cross Sectional Country ResultsE
Y-B
Y c
orre
lati
on
Stagflation Intensity
Bekaert Engstrom, 2008, FedModel 14
Conclusions
“Fed model puzzle”: EY and BY are very highly correlated,
• not because of money illusion• but are tied to the incidence of stagflation.
In recessions, economic uncertainty and risk aversion increase, increasing equity yields, which “sometimes” is correlated with high (expected) inflation.– And sometimes not…
Bekaert Engstrom, 2008, FedModel 15
Epilogue: data through Dec 2008U.S.
Bekaert Engstrom, 2008, FedModel
1.00
2.00
3.00
2004 2006 2008
12345678
equity (left scale)
bond (right scale)
1.3
1.8
2.3
2.8
2004 2006 2008
expected inflation
2.4
2.6
2.8
3.0
2004 2006 2008
risk aversion
0.0
0.2
0.4
0.6
0.8
1.0
2004 2006 2008
uncertainty
Epilogue: data through Dec 2008