The Relation Between Asset Returns and Inflation at Short and Long Horizons.

In analyzing the relationship 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 near-nonstationarity of multi-period returns and inflation, and 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, and between stocks and bonds. 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, by contrast, the relationship between expected returns and inflation is positive but quite weak at all horizons, which is in contrast to the results reported by Boudoukh and Richardson (1993): for US stock returns the Fisher model does not perform better as the horizon increases. Our results imply, however, that for US bonds and Danish stocks, the Fisher model's performance improves as the horizon increases.