Inflation and asset returns in a monetary economy

Postwar U.S. data are characterized by negative correlations between real equity returns and inflation and by positive correlations between real equity returns and money growth. These patterns are closely matched quantitatively by an equilibrium monetary asset pricing model. The model also implies negative correlations between expected asset returns and expected inflation, and it predicts that the inflationasset return correlation will be more strongly negative when inflation is generated by fluctuations in real economic activity than when it is generated by monetary fluctuations. THE CO-MOVEMENTS OF REAL asset returns, inflation, and money growth have been studied extensively over the past fifteen years. Table I displays some of the statistical properties of these series using quarterly U.S. data from 1959 to 1990. Note first the significantly negative correlation between real equity returns and inflation.' Note also the negative correlation between inflation and the ex post- real return to nominally riskless bonds. While this fact is not particularly surprising, numerous studies conclude that the correlations between ex ante real asset returns and expected inflation are also negative.2 In contrast to these patterns, the correlation between money growth and real equity returns is (weakly) positive in the data, while the correlation between money growth and the real bond return is virtually zero. Initially, these empirical patterns were viewed as anomalies. Negative correlations between inflation and ex post real stock returns contradict the traditional view that equities ought to act as an inflation hedge.3 Negative correlations between expected inflation and ex ante real returns violate the