DP4828 Monetary Policy Uncertainty and the Stock Market

Author(s): Alberto Locarno, Massimo Massa
Publication Date: January 2005
Keyword(s): asset pricing, learning risk, monetary policy uncertainty, risk factors
JEL(s): G11, G12, G14
Programme Areas: Financial Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=4828

We study the relationship between inflation and stock returns focusing on the signalling content of inflation. Investors use inflation to learn about the stance of the monetary policy. Depending on investors? beliefs, a change in consumption prices has different effects on the risk premium. A change in consumption prices that confirms investors' beliefs reduces stock risk premia, while a change that contradicts them increases risk premia. This may generate a negative correlation between returns and inflation that explains the Fisher puzzle. We model this intuition and test its implication on US data. We construct a market-based proxy of monetary policy uncertainty, we show that it is priced and that, by conditioning on it, the Fisher puzzle disappears.