Abstract: We study how expected inflation is priced in firm-level corporate credit spreads and equity prices, and uncover evidence that their inflation beta can vary over time. In times of market-perceived “good inflation,” where inflation news is correlated with positive growth outcomes, movements in inflation risk substantially reduce spreads and raise equity valuations. Meanwhile in times of “bad inflation,” these effects are attenuated and the opposite can take place. These dynamics are strongest for riskier firms and operate mainly through a risk premium channel. We develop an economic model with time-varying inflation risk and persistent growth expectations to rationalize these findings.
Abstract: This paper examines the stock market implications of investor uncertainty about the Fed's inflation-fighting ability. In a general equilibrium model, investors learn about the Fed's ability to control inflation. Uncertainty about this ability amplifies volatility and the risk premium, particularly during pronounced monetary tightening and easing cycles. This effect is stronger during tightening, as learning magnifies stock responses to inflation shocks. Moreover, if the Fed's credibility wanes, investors see inflation as more persistent, boosting volatility and the risk premium. Empirical tests validate the model's predictions, underscoring the role of learning about the Fed's inflation management in shaping financial markets.
Discussant: Christian Heyerdahl-Larsen, BI Norwegian Business School
Abstract: We document an information channel for core inflation shocks in the relative pricing of cross-sectional stocks. We estimate stock-level core inflation exposures using an announcement-day approach, as, unlike the energy component, the release of the core component is concentrated on CPI announcement days. We find: 1) significant and persistent cross-sectional spread in core inflation exposure; 2) firms with positive inflation exposure later experience increased cash flow as inflation rises; and 3) the relative pricing of stocks with diverging core inflation exposures significantly predicts core inflation shocks and the economists’ forecasting errors. The predictability is especially strong under heightened inflation risk including the surges in 2021 and 1973, and when the Fed is behind the curve. Our overall results indicate active price discovery in cross-sectional stocks for core inflation shocks through the cash flow channel.
