Time-varying inflation risk and the cross section of stock returns

Abstract

We show that inflation risk is priced in the cross section of U.S. stock returns with a price of inflation risk that is comparable in magnitude to that of the aggregate market. The inflation risk premium varies over time conditional on the nominal-real covariance—the time-varying relation between inflation and the real economy. Using a consumption-based equilibrium asset pricing model, we argue that inflation is priced because it predicts real consumption growth. The historical changes in the predictability of consumption with inflation, which are mediated by the nominal-real covariance, can account for the size, variability, predictability, and sign reversals—last observed in the 2000s—in the inflation risk premium.