The Relation between Asset Returns and Inflation at Short and Long Horizons

In analyzing the relationships between expected stock and bond returns and expected inflation at short and long horizons, we measure multi-period expected returns and inflation from a vector-autoregressive (VAR) model involving only one-period variables. Thereby we circumvent the problems with the use of time-overlapping data. We apply the VAR approach on long-term US and Danish stock and bond market data, and the results in general point to large differences between these countries. Expected US bond returns and expected Danish stock returns move closely with expected inflation at long horizons but not at short horizons. For US stocks and Danish bonds, however, the relationship between expected returns and inflation is quite weak at all horizons. Our results for US stocks are in contrast to the results reported by Boudoukh and Richardson (1993): The Fisher model does not perform better as the horizon increases. However, for US bonds and Danish stocks, the model's performance improves as the horizon increases