Good inflation, bad inflation: implications for risky asset prices

Series: Working Papers. 2525.

Author: Diego Bonelli, Berardino Palazzo and Ram Yamarthy

Inflation

• Prices and margins
• Quantitative methods
• Financial risks

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Good inflation, bad inflation: implications for risky asset prices (2 MB)

Abstract

Using inflation swap prices, we study how changes in expected inflation affect firm-level credit spreads and equity returns, and uncover evidence of a time-varying inflation sensitivity. In times of “good inflation,” when inflation news is perceived by investors to be more positively correlated with real economic growth, movements in expected inflation substantially reduce corporate credit spreads and raise equity valuations. Meanwhile in times of “bad inflation,” these effects are attenuated and the opposite may even occur. These dynamics naturally arise in an equilibrium asset pricing model with a time-varying inflation-growth covariance and persistent macroeconomic expectations.