Expected Inflation, Expected Stock Returns, and Money Illusion: What can we learn from Survey Expectations?

We show empirically that survey-based measures of expected inflation are significant and strong predictors of future aggregate stock returns in several industrialized countries both in-sample and out-of-sample. By empirically discriminating between competing sources of this return predictability by virtue of a comprehensive set of expectations data, we find that money illusion seems to be the driving force behind our results. Another popular hypothesis - inflation as a proxy for aggregate risk aversion - is not supported by the data. keywords: Inflation expectations, Money Illusion, Proxy hypothesis, Stock returns

Schmeling, Maik and Andreas Schrimpf (2008), Expected Inflation, Expected Stock Returns, and Money Illusion: What can we learn from Survey Expectations?, SFB 649 Discussion Papers, Humboldt University, Berlin