DP18003 Inflation and Asset Returns
The past half-century has seen major shifts in inflation expectations, how inflation comoves with the business cycle, and how stocks comove with Treasury bonds. Against this backdrop, we review the economic channels and empirical evidence on how inflation is priced in financial markets. Not all inflation episodes are created equal. Using in a New Keynesian model, we show how "good'' inflation can be linked to demand shocks and "bad'' inflation to supply shocks driving the economy. We then discuss asset pricing implications of "good" and "bad" inflation. We conclude by providing an outlook for inflation risk premia in the world of newly rising inflation.