The correlation between returns on US stocks and Treasury bonds has varied sub-stantially over time. From being highly positive in the 1970's and 1980's, correlationsturned sharply negative in the early 2000's, and were particularly low during the recentnancial crisis. Concurrent with the drastic change in asset correlations, I document asignicant change in the general relation between ination and asset prices. This papersuggests that a time-varying correlation between consumption growth and ination isa likely explanation and that this variation needs to be incorporated into asset-pricingmodels. Results show that ination switched to a procyclical state in the beginningof the 2000's. I calibrate a consumption-based model that rationalizes these ndings.Ination has real eects in the model and aects both equity and bond risk premia. Thesign of the market price of ination risk reects the cyclical nature of ination. Themodel also provides a rational explanation for why the correlation between dividendyields and nominal yields, sometimes referred to as the Fed-model, changes over time.This stands in sharp contrast to the usual explanation of ination illusion.
Management of financial services: stock exchange and bank management science (including saving banks) ; Individual Working Papers, Preprints ; North America. General Resources
