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The predictive power of dividend yields for future infl?ation: Money illusion or rational causes?

Author

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  • Tom Engsted

    (Aarhus University and CREATES)

  • Thomas Q. Pedersen

    (Aarhus University and CREATES)

Abstract

In long-term US data the stock market dividend yield is a strong predictor of long-horizon inflation with a negative slope coefficient. This finding is puzzling in light of the traditional Modigliani-Cohn money illusion hypothesis according to which the dividend yield varies positively with expected inflation. To rationalize the finding we develop a consumption-based model with recursive preferences and money illusion. The model with reasonable values of risk aversion and intertemporal elasticity of substitution, and either rational or adaptive expectations, implies significantly negative slope coefficients that increase numerically with the horizon in regressions of future inflation onto the dividend yield, in accordance with the data. A purely rational version of the model with no money illusion, but with a link from expected inflation to real consumption growth, also generates a negative inflation-dividend yield relationship.

Suggested Citation

  • Tom Engsted & Thomas Q. Pedersen, 2016. "The predictive power of dividend yields for future infl?ation: Money illusion or rational causes?," CREATES Research Papers 2016-11, Department of Economics and Business Economics, Aarhus University.
    • Handle: RePEc:aah:create:2016-11
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    References listed on IDEAS

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    More about this item

    Keywords

    Modigliani-Cohn money illusion; predictive regressions; long-run risk; Campbell-Vuolteenaho methodology.;
    All these keywords.

    JEL classification:

    • C22 - Mathematical and Quantitative Methods - - Single Equation Models; Single Variables - - - Time-Series Models; Dynamic Quantile Regressions; Dynamic Treatment Effect Models; Diffusion Processes
    • E31 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Price Level; Inflation; Deflation
    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G17 - Financial Economics - - General Financial Markets - - - Financial Forecasting and Simulation

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