Time-Varying Inflation Risk and the Cross-Section of Stock Returns

I provide empirical evidence indicating that inflation risk is time-varying and priced in the cross-section of individual stocks in the U.S. and UK equity markets. I establish that the way inflation risk is priced in equity markets is closely related to the cyclicality of inflation. I show that the market price of inflation shocks is positive (negative) in the cross-section of individual stocks when inflation is procyclical (countercyclical) and hence comoves positively (negatively) with measures of economic activity. As a consequence, risk premiums on stocks with positive/negative exposure to inflation shocks depend on whether the economy is in a pro- or countercyclical inflation regime. A zero-investment strategy that goes long low (high) inflation-beta stocks and short high (low) inflation-beta stocks when inflation is countercyclical (procyclical) yields economically large and statistically significant return premiums in both markets, even after controlling for well-known risk-factors