Prices and returns: Role of inflation

Abstract

We find that the market dividend yield and earnings yield can positively predict future inflation internationally. The inflation predictability of price ratios could invert the standard asset pricing predictive results. For example, dividend yields do forecast real dividend growth but not nominal dividend growth. We extend the analysis to the earnings yield as a robust analysis and document a similar predictive pattern. Further term structure analysis suggests that the financial ratio variation decomposition also differs significantly in nominal and real terms. In nominal-term decomposition, discount rate news is found to be the primary contributor to variations in price ratios while in real-term decomposition, cash flow news plays a more significant role, with its importance increasing over longer investment horizons. Our study utilizes consistent inflation predictability evidence in advanced economies to re-evaluate the global relationship between price ratios and inflation. We confirm that inflation is an international state variable in post-1970s samples and that the correlation between inflation and price ratios can almost entirely be attributed to the relationship between expected inflation and future growth prospects. This finding offers an explanation for the previously puzzling correlation between the dividend-price ratio and future inflation.