Risk Premia at the ZLB: A Macroeconomic Interpretation

Abstract

Historically, inflation is negatively correlated with stock returns, leading investors to fear inflation. We document using a variety of measures that this association became positive in the U.S. during the 2008-2015 period. We then show how an off-the-shelf New Keynesian model can reproduce this change of association due to the binding zero lower bound (ZLB) on short-term nominal interest rates during this period: in the model, demand shocks become more important when the ZLB binds because the central bank cannot respond as effectively as when interest rates are positive. This changing correlation in turn reduces the term premium, and hence contributes to explaining the decline in long-term interest rates. We use the model to evaluate this mechanism quantitatively. Our results shed light on the validity of the New Keynesian ZLB model, a cornerstone of modern macroeconomic theory.

Stock returns and inflation shocks in weaker economic times

“…Sections 5.5 to 5.8, respectively, discuss how our principal findings are related to studies on: (1) inflation risk premia in the cross‐section of stock returns and the approximate year‐2000 shift in the relation between inflation and consumption growth (Boons et al., 2020); (2) the zero lower bound on short‐term nominal interest rates (Gourio & Ngo, 2020); (3) deflation risk (Fleckenstein et al., 2017); and (4) other macrofinance studies that link inflation behavior to the sign shift in the stock‐bond correlation around the year 2000 (Campbell et al., 2020; Song, 2017).…”

“…Gourio and Ngo (2020) present evidence that the correlation between inflation and stock returns became more positive over the 2008–15 period, when short‐term Treasury nominal yields were essentially at zero (or, the “zero lower bound” [ZLB]). They suggest an economic channel where this shift in the stock‐inflation correlation could largely be attributed to the ZLB, because the Federal Reserve's response to offset demand shocks is constrained in a ZLB environment.…”

The origins and effects of macroeconomic uncertainty

“…Our paper relates to an emerging literature studying asset prices in New Keynesian models (e.g., Bekaert, Cho, and Moreno (2010), Bikbov and Chernov (2010), Hsu, Li, and Palomino (2014), Rudebusch and Swanson (2012), Dew‐Becker (2014), Bretscher, Hsu, and Tamoni (2017), Weber (2015), Kung (2015), Gourio and Ngo (2020), Segal (2019), and Campbell, Pflueger, and Viceira (2020)). Duffee (2013) provides a survey of the New Keynesian models for explaining the term structure.…”

Discount Rates, Debt Maturity, and the Fiscal Theory

“…More broadly, our quantitative model relates to general equilibrium models that link the stance of government policy to risk premia. For example, Rudebusch and Swanson (2012), Palomino (2012), Dew-Becker (2014, Campbell, Pflueger, and Viceira (2014), Kung (2015), Gourio and Ngo (2020), and Weber (2015) link asset prices to monetary policy. Croce et al (2012), Gomes, Michaelides, and Polkovnichenko (2013), Belo, Gala, and Li (2013), and Yu (2013), andBretscher, Hsu, andTamoni (2017) examine fiscal policy and asset prices.…”

“…More broadly, our quantitative model relates to general equilibrium models that link the stance of government policy to risk premia. For example, Rudebusch and Swanson (2012), Palomino (2012), Dew‐Becker (2014), Campbell, Pflueger, and Viceira (2014), Kung (2015), Gourio and Ngo (2020), and Weber (2015) link asset prices to monetary policy. Croce et al.…”